Bankruptcy and Real Estate Transactions Table of Contents I. Bankruptcy Issues Generally II. Filing of Chapter 7 Before or During Escrow III. Selling the Property Short During the Bankruptcy IV. Selling the Property Short After the Bankruptcy has Closed V. Bankruptcy and Landlord/Tenant Issues Introduction Short sellers have increasingly resorted to bankruptcy to extend their stay in the property when a foreclosure (or even a closing date) is looming. It used to be that once a borrower in default filed for bankruptcy protection, the lienholder would quickly obtain permission from the bankruptcy court to continue the foreclosure process. Those days are long gone. Now, very often the lienholders do nothing after a bankruptcy has been filed, but instead simply wait it out until the debtor has received a discharge and the bankruptcy closes. There is simply no hurry for the lienholders to add to their portfolio of REO properties. Agents are now routinely facing a series of novel situations which in times past were rarely encountered. What happens when the seller in contract files for bankruptcy protection? Can real estate licensees sell the property as a short sale during the bankruptcy? Can the property be sold even after the bankruptcy concludes? This Legal Q&A addresses these issues. I. Bankruptcy Issues Generally Q 1. What is the difference between a Chapter 7 and Chapter 13 bankruptcy? A Chapter 7 is a liquidation of the debtor s estate. The debtor gives up all of his or her assets (except for ones that s/he is allowed to keep under an exemption) and in exchange he has all of his debts wiped out (except for ones that bankruptcy law still gives the creditors a right to collect upon). Most bankruptcies are no-asset meaning that there are no assets available for distribution because everything the debtor owns is exempt. A chapter 13 is a rescheduling or reorganization of the debtor s debt. The debtor is given a few months of breathing space and then is put on a 3-5 year plan in which s/he will bring current certain secured debts and other priority debts. All other debts will be partially paid depending upon the debtor s income and expenses. Q 2. What is an example of an exemption mentioned in Question 1? A The major exemptions are homestead, pensions, IRAs, 401Ks, appliances, automobile, various personal property, wages and cash (up to $23,000 if there is no homestead). Each one has a specific dollar amount. So, for example, if an exemption is claimed for a car, it s only for the first $2,725 of value of the car. Anything over that is not exempt. The standard homestead exemption is $75,000 for an unmarried person or $100,000 for a married couple filing jointly (with other higher homestead exemptions for special circumstances). The exemptions are very detailed, but they are mostly found under the California Code of Civil Procedure Sections 704 and 704.140 et seq. Q 3. What are some examples of the types of debts that a Chapter 7 bankruptcy will not "wipe out" (i.e., discharge)? A The common categories of debt that are not "wiped out" (discharged) in a Chapter 7 bankruptcy are certain types of tax claims, unscheduled debts, spousal or child support or alimony, debts for willful and malicious injuries to person or property, governmental fines and penalties, most government funded or guaranteed educational loans or benefit overpayments, DUI-related debts, debts owed to certain tax-advantaged retirement plans, and debts for certain condominium or cooperative housing fees.
Debts for obligations affected by fraud or maliciousness may be excepted from discharge, but this does not happen automatically. Creditors must ask the court to determine that these debts are excepted from discharge. In the absence of an affirmative request by the creditor and the granting of the request by the court, these types of debts will be discharged. (11 U.S.C. 523(a), 727(b).) Q 4. What is the Automatic Stay? A When a bankruptcy is filed, creditors are immediately prohibited, with certain exceptions, from making any effort to collect upon a debt that is owed (or to take any number of actions that affect property of the estate). To do so, violates the automatic stay and thus violates federal bankruptcy law. This is why it s called a stay, because all collection activity is stayed. (11 U.S.C. 362(a).) The scope of the automatic stay is extremely broad and covers a range of creditor activities including proceedings against the debtor; enforcement of prepetition judgments; acts to get property or exercise control over property; placing of liens; set offs; and of course any act designed to collect on a debt. There is even a court case in which a creditor, who posted signs outside a restaurant asking patrons to boycott the restaurant because it didn t pay its debts, was found to be in violation of the automatic stay. (In re Sechuan City, Inc., 96 B.R. 37 (Bankr. E.D. Pa. 1989).) Q 5. Can a bank proceed with a foreclosure despite the filing of a bankruptcy by the owner? A Yes, but the bank must first go to the bankruptcy court and ask for permission to lift the stay by filing a Motion for Relief from Stay. In cases where there is little or no equity in the property, this type of motion will almost always be granted. (11 U.S.C. 362(d)(2).) Q 6. In the past a debtor was able to file a Chapter 7 bankruptcy, and as long as s/he was current on his or her mortgage, s/he would have the right to remain current and keep his or her property even after receiving a bankruptcy discharge. Is that still true? A No. That is no longer the case. There were major changes to the bankruptcy law in 2005, and one of them was the elimination of this right. Some debtors may still file a Chapter 7 and attempt to remain current and retain their secured assets, but they proceed at their own risk. (In re Jensen, 407 B.R. 378 (Bankr. C.D. Cal. 2009).) Q 7. Did the 2005 changes to the bankrupcy law make it near impossible for many people to file a Chapter 7? A The severity of 2005 law has been allayed somewhat, so that essentially any person who makes less than the statewide median income may still file and benefit from a Chapter 7 bankruptcy. There are also other exceptions that allow various types of debtors to file under the old guidelines. The U.S. Trustee lists on the US Trustee Program Web site the table of median income for all of the states. In California it shows the median income for cases filed after March 15, 2011 as $48,009 for a single earner, $62,970 for a family of two, $68,670 for a family of three, and $78,869 for a family of four. For a family in excess of four, add $7,500 for each extra person. (Source: http://www.justice.gov/ust/eo/bapcpa/20110315/bci_data/median_income_table.htm)
Q 8. What is Lien Stripping? A In a Chapter 13 bankruptcy, a debtor must bring all debts secured by real property that is the debtor's principle residence current within and through a 3-5 year plan. However, because of a quirk in bankruptcy law, a junior lien that has no equity behind it is not considered secured, and thus the lien can be stripped. The debt can then be treated just like any other unsecured debt; meaning, it need not be paid off in full but only partially paid off per the Chapter 13 plan. The key here is that there must be no equity none behind the junior lien. Only then will it be considered unsecured and subject to lien stripping. (In re Frazier 448 B.R. 803 (Bankr. E.D. Cal. 2011).) Q 9. I am working with a seller who has received his or her bankruptcy discharge. The discharge letter s/he received talks generally only about the kinds of debts that aren t subject to discharge. How do I know exactly which of his or her debts have been discharged? A Generally, a judge in a Chapter 7 bankruptcy doesn t decide which debts are subject to discharge. When a debtor receives a discharge, s/he will receive a written form notice of the discharge, and on the back of it there is a summary of the various types of debts that aren t subject to discharge (See Question 3). The letter warns the debtor that the law is complicated and that it may be necessary to consult an attorney. If there is a dispute with a creditor, and it really is unclear as to whether a debt has been discharged, then the debtor can seek a formal opinion from the bankruptcy court. So the advice you should give your client is, Speak with your attorney. II. Filing of Chapter 7 Before or During Escrow Q 10. My seller has just informed me that s/he is filing a Chapter 7 bankruptcy, but his or her intention is to not include the property in the bankruptcy. Can s/he do that? A This is a bankruptcy myth the idea that you can pick and choose which assets are included in the bankruptcy. All assets must be declared in a bankruptcy. To intentionally fail to do this is to risk violation of federal bankruptcy law and have your bankruptcy case thrown out. (Hamilton v. State Farm Fire & Cas. Co., 270 F.3d 778 (9th Cir. 2001); 11 U.S.C. 52(a)(1), 11 U.S.C. 727(a)(4), 18 U.S.C. 152, 157.) Q 11. Can the debtor in bankruptcy keep some of his or her property? A Absolutely. Many assets in bankruptcy are exempt (see Question 2), meaning that the bankruptcy law permits the debtor to retain the asset after the bankruptcy is concluded. Real property may be exempt as a homestead, but this only matters if there is equity in the property. Even then, the homestead exemption is limited to $75,000 for a single person or $100,000 for a married couple. (There are other higher exemptions depending upon age and status.) In the meantime, the lienholder for a deed of trust still has the right to claim the amount of the lien. (Cal. Civ. Proc. Code 704.730.) The exemptions are very detailed, but they are mostly found under the California Code of Civil Procedure Sections 704 and 704.140 et seq. Q 12. How can a buyer's agent verify that the seller has filed a bankruptcy petition during the transaction? A When a seller files a bankruptcy petition, it must include the buyer's name in his or her filings as a type of creditor. Thus, the buyer will receive a notice from the bankruptcy court stating that the debtor (seller) has filed for bankruptcy and that the automatic stay is in effect. But this will usually take at least a week to receive in the mail. If a buyer's agent wants verification immediately, then the seller should be able to provide the buyer with the filing number and court location of the bankruptcy action. But in any event, when a seller indicates that s/he intends to file bankruptcy, the buyer should proceed cautiously. If the seller does not immediately file, the buyer is still in contract. But it s like walking on egg shells. At any time, the
seller might file for bankruptcy and all of the buyer s money and efforts may, as a practical matter, be lost. (However, see Question 20 regarding money placed in escrow.) Q 13. Can a seller just file for bankruptcy at the drop of a hat? Isn t there something that the seller must do prior to filing? A The bankruptcy law was changed in 2005 to require a debtor to engage in credit counseling as a prerequisite to filing for bankruptcy. But as with many rules, there are exceptions, and it is possible for the seller to file for bankruptcy without credit counseling under some circumstances. (11 U.S.C. 109(h)(1).) Q 14. My seller is in contract to sell and has just informed me that s/he has, in fact, filed a Chapter 7 bankruptcy. What happens to the sales contract? A The seller can file a Chapter 7 bankruptcy even if s/he is in contract to sell. The contract to sell is an executory contract and the bankruptcy trustee has 60 days to accept or reject it. However, in the vast majority of cases, the property is upside down and the trustee will therefore have no interest in accepting the contract, so it will automatically be rejected after 60 days. If that happens, the purchase agreement will be unenforceable. (11 U.S.C. 365(d)(1).) One exception to this occurs if the buyer is in contract to purchase and has actually taken possession of the property prior to the seller filing bankruptcy, then the buyer can sue for specific performance (11 U.S.C. 365(i)). Q 15. What are the buyer s rights once the contract is rejected by the bankrupcy trustee? A As stated in Question 14, the purchase agreement will be unenforceable. (Note that the buyer and seller remain in contract until rejected by trustee and the buyer cannot repudiate the contract during the interim.) The rejection of the purchase agreement by the bankruptcy trustee creates a breach of contract, and the buyer is put into the position of an unsecured creditor. As such, the buyer may claim damages only through the bankruptcy estate by filing a Proof of Claim for the money s/he believes s/he is owed. (11 U.S.C. 365(g).) Q 16. What are the actual chances of the buyer recovering anything by filing a Proof of Claim as discussed in Question 15? A Practically none. The vast majority of Chapter 7 bankruptcies are no asset meaning that there are no assets left over for distribution; and, therefore, the unsecured creditors receive nothing at all. Q 17. What if the buyer has incurred expenses for inspections or appraisals when the purchase agreement is rejected by the bankruptcy trustee? A There is really nothing for the buyer to do. An exception to this general rule is that certain costs that a non-debtor incurred in assistance to the trustee may be a priority claim after rejection, but this is an unlikely scenario in a residential property short sale. (11 U.S.C. 503(b).) Q 18. Can the buyer try some alternative means of claiming damages or collecting from the seller when the purchase agreement is rejected by the bankruptcy trustee? A No. Trying to collect from the seller is a violation of the bankruptcy automatic stay and, thus, a violation of federal law. (11 U.S.C. 362(a).)
Q 19. If the seller files for bankruptcy protection, is the listing agent s listing contract enforceable and can the listing agent claim a commission? A The listing agreement is also an executory contract and will typically be rejected automatically after 60 days by the bankruptcy trustee. Thus, the agent s remedy is the same as the buyer s to file a Proof of Claim with the trustee. But, just like the buyer, there will be, as a practical matter, nothing in the bankruptcy estate to distribute; and thus, filing a proof of claim will, in most circumstances, be for nothing. Again, like a buyer, certain expenses that the agent incurred for services rendered on behalf of the trustee during the bankruptcy case may allow the listing agent to make a priority claim. (11 U.S.C. 503(b).) But once again, this is an unlikely scenario where the debtor is a short seller. Q 20. When an escrow has been opened and the seller files for bankruptcy protection, what happens to the money in escrow? A The money is not part of the bankruptcy estate, so it should go back to the buyer. But because of the bankruptcy, it may be stuck in the escrow until the bankruptcy is closed. (In re Summit Airlines, Inc. 94 B.R. 367 (Bankr. E.D. Penn. 1988); Gulf Petroleum, S.A. v. Collazo, 316 F.2d 257 (3d Cir. 1963).) III. Selling the Property Short During the Bankruptcy Q 21. I had a listing and then the seller filed Chapter 7 bankruptcy. We were planning on short selling the property. Is it still possible to do this even during the bankruptcy or must the seller wait until s/he receives a discharge? A It is possible to sell a property even during the bankruptcy. If the property has no equity in it, and it must be sold short, then the standard procedure is for the debtor/seller to obtain from the bankruptcy court an Order for Abandonment of the property. This is typically going to be a requirement of the title company. Even with such an order, many lienholders may not negotiate a short sale during the bankruptcy without first obtaining a Relief from Stay. (11 U.S.C. 522(b), 554; Matter of Shields, 24 B.R. 219 (Bankr. S.D. Ohio 1982) (property abandoned by trustee subject to automatic stay).) Note: lienholders may be unwilling to spend money on an attorney to go to the bankruptcy court to obtain such an order. Q 22. Who obtains an Order for Abandonment of the property as discussed in Question 21? A The seller (debtor) does through the assistance of an attorney. As a practical matter, most sellers are not going to do this. But if a seller is motivated to short sell the property during the bankruptcy, then the seller should arrange with his or her attorney in advance of filing the bankruptcy and see if the attorney will do it as part of the filing. Q 23. What if the property has substantial equity, can it still be sold while the bankruptcy is in process? A If there is equity above the exemption level (see Questions 2 and 11), then the bankruptcy trustee may seek to sell the property on behalf of the estate in order to distribute the proceeds to the unsecured creditors. To do this, the trustee will be required to obtain an order from the bankruptcy court not only to sell the property, but to employ and compensate the listing and selling agents. Any agent seeking to be paid a commission for a sale through the court must be employed by the trustee. An agent who already has extensive knowledge of the property may be wellpositioned to obtain a listing from the trustee; but of course, the trustee is free to employ any agent. IV. Selling the Property Short After the Bankruptcy has Closed Q 24. My seller filed a Chapter 7 bankruptcy and received a discharge, but the bank never foreclosed on the property, and the seller is still the owner. May my seller short sale the property?
A Yes. A debtor who files a Chapter 7 bankruptcy is required to fill out the Statement of Intention indicating one of three actions that s/he intends to take in regard to the secured item of property. If the debtor is upside down, the only realistic option is to surrender the property. So technically, the seller is bound to surrender the secured property to the secured lienholder by deed or otherwise. (Main Street Bank v. Hull, not reported in F. Supp. 2d, 2008 W.L. 783772 (E.D. Mich., 2008).) Interestingly, a debtor who fails to follow through with his stated intention to surrender real property gives up no substantive rights, and the creditor s only remedy is to foreclose in the normal way under state law. All this really means is that, practically speaking, there is a fourth option and that is to short sell the property. As long as the lienholder agrees to a short sale, then that option is a viable option. Q 25. If my seller short sells the property after discharge of a bankruptcy, what is his/her liability to the lienholders after sale? A Because the seller received a discharge in a Chapter 7 bankruptcy, most types of personal debt are wiped out. This includes debt owed on a note. So the seller would have no further liability to any lienholder if a short sale is agreed to. However, the seller might still be liable to a buyer for false or incomplete disclosures that took place during the sale. Q 26. If my seller short sells the property after discharge of a bankruptcy, what is his or her liability for cancellation of debt income tax owed to the IRS and FTB? A Selling a property short during or after a bankruptcy creates no cancellation of debt income. (Source: IRS online article Home Foreclosure and Debt Cancellation, Question 2 at http://www.irs.gov/newsroom/article/0,,id=174034,00.html.) Q 27. If the seller has no personal debt after discharge of a bankruptcy, then shouldn t s/he just be the owner of the property free and clear? A No. The personal debt is wiped out, but not the security interest itself (such as a voluntary lien like a deed of trust). That security interest remains on the property even after the seller receives a Chapter 7 bankruptcy discharge. Note: The personal note is wiped out by the bankruptcy, but not the voluntary lien. Therefore, even though the note is no longer enforceable, the bank still has its security interest. After a bankruptcy is concluded, the automatic stay is no longer in effect. Thus, the lender can proceed to foreclose on the property or agree to a short sale. (See Question 24.) (11 U.S.C. 524(a).) Q 28. Is an involuntary lien on the property, like an abstract of judgment, recorded after a creditor obtains a judgment, automatically eliminated from the property? A An involuntary lien on the property like an abstract of judgment is not automatically eliminated from the property. The phrase not automatically is important here, because the debtor may have the right to remove this type of lien; but only if the debtor files a Motion to Avoid Lien during the bankruptcy process. (11 U.S.C. 522(f)(1).) If the debtor doesn t do that, it will remain on the property even after a discharge is received. Then it will be even more difficult to remove. Q 29. It was my understanding that the banks always pursued foreclosure once the owner filed a Chapter 7 bankruptcy. Is that no longer the case?
A Correct. That is no longer the case. It used to be that as soon as an owner filed a Chapter 7 bankruptcy, then the bank would run to the federal bankruptcy court to ask for relief from stay and resume the foreclosure process. Those days are long gone. Now it is common, perhaps even the rule, for the bank to simply wait for the bankruptcy to conclude (usually in about 3 and a half months) and then work with the seller to sell the property short. V. Bankruptcy and Landlord/Tenant Issues Q 30. My tenant just filed a Chapter 7 bankruptcy, and s/he is 2 months behind in rent. I ve been asking my tenant to pay up, but a friend told me that I can t do that. Can I take actions to make my tenant pay? A Your friend s right. You can t do that. Once the tenant files for bankruptcy protection any attempt to collect past due rent from the tenant violates the automatic stay. That includes calling him or her or even serving him or her with a 3-day Notice to Pay Rent or Quit. What you have to do is hire an attorney to go to the bankruptcy court and obtain an Order for Relief from Stay. It is a fairly routine process and takes about three to four weeks. After an Order for Relief from Stay is obtained, the landlord may proceed with the eviction process, whether it is demanding rent or setting a trial date. Q 31. What if my tenant is completely current on rent and has filed a bankruptcy. May I continue to collect rent from him or her? A Yes. Assuming the tenant has been paying rent in a timely manner each month, then the tenant will not have been in arrears at the time of filing bankruptcy. Therefore, you will not be collecting money owed prior to the bankruptcy filing. However, if the tenant is behind in rent, then even the mere collection of rent will be a violation of the automatic stay. (In re Germansen Decorating, Inc., 149 B.R. 517 (Bkrtcy. N.D. Ill. 1992).) Q 32. What if my tenant was current before filing bankruptcy but now s/he isn t? Can I demand payment from him or her, since the rent owed was due after the filing? A You may demand rent from your tenant. However, you may not threaten him or her with eviction should s/he refuse to pay by using, for example, a three-day notice to pay rent or quit. The automatic stay does not preclude a creditor from prosecuting an action against a debtor to collect a post-petition debt. (In re Jackson, 403 B.R. 95 (Bankr. D. Idaho, 2009).) However, it does prevent a post-petition creditor from taking action against property of the bankruptcy estate. Since the tenant was in the property prior to filing for bankruptcy, the tenancy is part of the estate. Thus, trying to collect rent by threatening an eviction would probably be acting against the property of the estate. Q 33. I am a landlord in the process of evicting a tenant. In fact, I had just received an Order of Possession from the court. Then the tenant filed for bankruptcy just before the sheriff went out to remove the tenant. Can the sheriff still enforce the judgment or must I go to the bankruptcy court to obtain relief from stay? A The sheriff may enforce the judgment. The bankruptcy code, with special exceptions, allows a judgment for eviction to be enforced immediately as long as the judgment was obtained prior to the filing of the bankruptcy. (11 U.S.C. 362(b)(22)-(23).) Q 34. I am a tenant and my landlord has filed bankruptcy. Is my lease still valid? A A lease, like an executory contract, must be accepted by the trustee to remain in force, and there is no reason for the trustee to accept a residential lease. So in all likelihood, you ll find yourself on a month to month tenancy. (11 U.S.C. 365(d)(1).)
Q 35. I was a tenant and recently vacated an apartment. Now my former landlord has filed bankruptcy and won t return my security deposit. Can I get that money back or has the debt of owing a security deposit been discharged? A Unclear. The cases around the country that have allowed a tenant to recover the security deposit have stressed the existence of deposit money held in trust. In California, a deposit is not held in trust but is simply a debt owed to a tenant. However, in Wisconsin (which has a tenant security deposit law similar to California s) a bankruptcy court held that a landlord who filed bankruptcy was only entitled to withhold money that was properly deducted from the security. (Matter of Wayco, Inc. 947 F.2d 1330 (1991).)