Bankruptcy is Sometimes a Response to Foreclosure

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            Some years ago there were a lot of foreclosures. But not all foreclosures are over yet. Some borrowers are still struggling with loans that are “adjusting” or “re-setting” after an initial “teaser” period.  Some of these loans offer an initial term of five years with a low interest rate that’s fixed.  At the expiration of that initial term, the loan “re-sets” to an adjustable loan that is amortized over 20 or 30 years.  However, when the loan “re-sets” the borrowers are often unable to pay the higher payment amounts that result from the re-setting of the loan.  Some of these borrowers intended to refinance their loans when the re-setting occurred.  But with the decline in the real estate market, these borrowers often find they can’t refinance their loan because the property is worth less than the amount of the loan.  A refinance in such situations is impossible, because any new lender would have to lend more money than the property is worth.  As a result, such borrowers find themselves unable to refinance unless they pay down their loans to a level below the value of the property.

Borrowers unable to make their loan payments often want to know if bankruptcy is an option.  The answer is that the attractiveness of bankruptcy usually depends on the borrower’s individual situation.  Bankrutpcy is not a “cure-all” and it is now more difficult to qualify for   Chapter 7 discharge than it was years ago.  In a Chapter 7 proceeding, most or all of a debtors debts can be discharged by the Bankruptcy Court.  However, many or most of the debtor’s assets in such a bankruptcy will be liquidated and paid over to creditors.  As noted in one court opinion, the principal purpose of the Bankruptcy Code is to grant a fresh start to the honest but unfortunate debtor.  Hersh v. U.S. ex rel. Mukasey, 555 F. 3d 743 (2008).

Some debtors don’t necessarily need to liquidate their assets and have their debts discharged in order to get a “fresh start.”  These debtors might have valuable assets, but they might be short of cash with which to pay their debts.  Sometimes creditors press such debtors, and if these debtors had some time or “breathing room” then they would be able to sell or liquidate assets and pay the creditors.  These debtors assets are often worth preserving, and the value of their assets typically exceeds their debts.  However, the debtors can have problems meeting their ongoing monthly payment obligations, and if their creditors are pressing them, then these debtors can risk losing assets that are worth far more than their debts.  Some of these debtors elect to file a Chapter 13 Bankruptcy proceeding.  In these proceedings, the debtor proposes a plan for paying off creditors.  The law provides an “automatic stay” of enforcement proceedings against such debtors, thereby giving such debtors some time or “breathing space” to re-organize their financial situations. Chapter 13 is generally used by individuals seeking some “breathing space.”  Corporations or businesses that need such “breathing space” often file a petition in a “Chapter 11″ bankruptcy.

Short Sale Considerations Are Complex

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    The concept of a short sale is simple.  A “short sale” occurs when the sales price of a property isn’t enough to pay off the mortgage.  The sales price is “short” of the amount needed to fully pay off the mortgage.  If the bank agrees to a “short sale” then the property is sold for less than the amount due on the mortgage and the bank receives less than the amount that is owed.  When the Bank receives less than the amount owed, the property is sold “short” of the amount due, and this is known as a “short sale.”

The concept of a “short sale” is simple.  But the decision whether or not to short sell a property can be quite complex.  Each potential short sale situation is unique, and the decision to short sell must be carefully made and evaluated for each borrower.

There are many considerations involved in deciding whether or not a property should be short sold.  Three important considerations involve potential lender liability, tax issues, and credit concerns.

When a property is short sold, the bank won’t receive the full amount due on the loan.  In some situations, the bank forgives the unpaid balance with the result that the borrower won’t be personally liable to the bank for any unpaid amount.  In other situations, the bank may retain a claim against the borrower for the unpaid amount, and in these situations the borrower may be personally liable for the “short” amount.  In still other situations, the bank may neither expressly forgive the debt nor retain a claim against the borrower.  In these situations, the borrower may still be liable to the bank for the unpaid amount after the short sale.

A short sale can involve significant tax considerations.  Some of these tax considerations can be quite complex.  The amount of time a borrower has lived in a property can have important tax consequences in a short sale situation. Sometimes a short sale can result in a significant tax liability, and sometimes a borrower can avoid these taxes by moving back into the property for a period of time.  Many borrowers have refinanced their homes.  Sometimes these borrowers have taken equity out of their property in connection with their refinance.   In some situations these equity withdrawals can create a significant tax liability following a short sale.

A foreclosure will almost always result in negative credit reporting on a borrower’s credit report.  But in many cases the negative credit effects from a short sale will be less than the credit damage from a foreclosure. Whether or not credit is important can vary between borrowers.  The likely negative credit effect of foreclosure versus short sale must be evaluated for each borrower depending on their specific circumstances.

There is no single correct answer as to whether or not a short sale is the best answer for any specific borrower.  Each borrower’s specific situation must be separately evaluated.  Borrowers would do well to seek competent, professional tax and legal advice in connection with any anticipated short sale.

Property Outcomes Can Be Surprising

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            When things go well, a property transfer from one owner to another can go smoothly and relatively seamlessly.  But there are many complex considerations involved in every property transfer.  That’s one of the reasons most people hire professionals to help them with a real property transfer.

There can be additional considerations when a property is owned by several owners, and when a claim is made against just one of the owners.  For example, if three unmarried persons own a single property in equal shares, and if one of them gets sued, then the property is at risk – or at least a third of it is.  If judgment is entered in that suit, then the creditor who sued the debtor may be entitled to sell the debtor’s interest in the property.  That doesn’t mean that the creditor gets to sell the entire property.  Two of the owners have their own property interests, and they may not be willing to sell their interest in the property. That means that the creditor may be able to force a sale of the 1/3 interest of the debtor.  But who wants to own a property with two other strangers?  Somebody probably would – but maybe only at a steeply discounted price.  But under California law, only the debtor’s property interest can be affected by a judgment.  The other owners of the property usually continue to own their respective interests in the property free from any judgment.  The creditor may be able to sell the debtor’s 1/3 interest in the property, but the other 2/3 interest would in most cases remain unaffected by such a sale.

This result can be different in Bankruptcy. The Federal Bankruptcy code provides many protections for bankrupt debtors – but it also contains many protections for the interests of creditors.

This law may not be well known, but in bankruptcy an entire property can be sold, even when it is owned by persons who aren’t in bankruptcy.

In one case, a debtor owned a business that sold mobile homes to consumers.  This debtor, along with several other individuals, purchased real property that was to be turned into a mobile home park. Each of the individuals made a contribution to a down payment, and a loan was obtained for the rest of the purchase price.  The mobile home park was eventually developed in 47 lots, and the rental amounts from these lots were generating profits.  However, the debtor filed a bankruptcy petition in a chapter 7 bankruptcy proceeding.  At the time the debtor filed the bankruptcy petition, he owned a 1/3 interest in the mobile home park.  The mobile home park was worth more than the loan against it.

The Bankruptcy court found that the 47 mobile home sites couldn’t be reasonably split up  between the several owners. The Court also found that the mobile home park was worth considerably more as a single unit that it would be as separate tracts.  Therefore, the Bankruptcy Court ordered that the Bankruptcy trustee could sell the entire mobile home park, even though the non-debtors owners did not want the park to be sold.

This is a significant principle in Bankruptcy law.  In certain situations, an entire property can be sold, even when a debtor is only one of several owners.  This can be true even if the other owners haven’t filed petitions in bankruptcy.  There are protections, of course, such that the non-debtors owners receive the value of their interests when the property is sold.  Also, non-debtor owners are typically given a first right of refusal to purchase the debtor’s interest.  But this Bankruptcy principle can end up having a property be sold through a bankruptcy in some cases when non-debtors owners never thought it would be.   The case is reported as Matter of Woolston 147 B.R. 279 (Bankr. M.D. Ga 1992).

Real Property, Partnership, and Bankruptcy law involve complex considerations. The foregoing involves only a portion of the considerations of the case discussed, and should not be relied on.  Persons involved in real property or partnership matters, and those considering bankruptcy, should seek competent legal advice.

Bankruptcy Can Be an Issue

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Clients file Bankruptcy for all kinds of reasons.  Many times Bankruptcy is the inevitable end result when borrowers experience a negative change in their financial situation.

But there can also be situations where a borrower ends up in Bankruptcy due to surprise.  And one of these surprises can result from foreclosure.

With respect to personal liability, California has two general types of homeowner loans—“recourse” and “non-recourse.”  When a loan is a “recourse” loan then the borrower can have personal liability if the loan is not fully repaid.  When a loan is “non-recourse” then the borrower will generally not have personal liability if the loan isn’t repaid.

Many homeowners don’t know whether their loan is “recourse” or “non-recourse.”  If these homeowners default on their loan, then the nature of their loan can be very important.  If a loan is “recourse” and the borrower defaults, then the borrower may be exposed to personal liability following foreclosure.  If the lender files suit against the borrower following foreclosure, then insolvent borrowers may have little option other than Bankruptcy.

Negotiations with lenders can be greatly influenced by whether a borrower’s loan is “recourse” or “non-recourse.”  Some lenders appear to be very willing to make demands on borrowers for repayment even when a loan is “non-recourse.”  And the “non-recourse” nature of a loan can be lost or damaged if a borrower doesn’t act prudently. A lender on a “non-recourse” loan is generally limited to the value of the property.  Situations can vary, and a borrower’s personal liability isn’t always clear. For these reasons, borrowers should always seek competent, professional legal counsel when trying to determine whether their loan is “recourse” or “non-recourse” or before signing any promissory note in favor of their lender.