When the Seller Is Bankrupt

Understand the complexities of the deal before jumping in.

October 1, 2009

In today’s economy, there’s a good chance you’ll come across a home seller who’s going into bankruptcy or already in it.

Should you take the listing? Before saying yes, it’s smart to know what you’re getting into. Bankruptcy can complicate a transaction, but it’s still possible to work out a successful deal.

Foreclosure or Short Sale?

Bankrupt sellers you work with will typically owe more than their home is worth. Sellers in this situation are likely to want a short sale rather than allow their mortgage to enter foreclosure — a strategy that’s designed to leave a lesser mark on their credit history. They may not know that the negative consequences of a bankruptcy tend to overwhelm any credit-preserving benefits of a short sale.

It’s also worth noting that by pursuing a short sale, some sellers may hasten their exit from their house. If they were to let the house go into foreclosure, their bankruptcy status and the foreclosure process buy them time and protection from creditors, enabling them to stay in their house longer.

Given all this, bankruptcy attorneys are likely to recommend foreclosure rather than a short sale to their clients. You certainly don’t want to discourage sellers from following the advice of their bankruptcy attorney. But if the seller still chooses to pursue a short sale and exhibits a commitment to see the deal through, then a short sale can be a viable option.

If the Seller Has Home Equity

Although you may assume that bankrupt sellers don’t have any equity in their home, that’s not always true. If the seller has equity, bankruptcy might actually help smooth the sale because the bankruptcy’s automatic stay gives the seller time to close on a well-thought-out deal.

On the flip side, the seller could have a diminished sense of urgency to get a sale closed. Particularly in a tough market, a seller who’s not fully committed to seeing a deal through can make your job much more difficult. But if the seller is committed, the bankruptcy can work in everyone’s favor.

To get started, you need to work within the rules of the seller’s bankruptcy estate. Because the seller’s legal status puts the property in the estate, you — the listing agent — must work with the seller’s bankruptcy attorney and bankruptcy trustee. Be sure the trustee affirms that you’re the agent for the estate; otherwise you can face hurdles getting paid at closing. Whatever deal you structure, you’ll have to get permission from the court to close. As a result, the seller’s bankruptcy attorney will need to be involved, and that will mean additional attorney fees.

From the Buyer’s Perspective

Buying a home from a seller in bankruptcy comes with challenges, too, which makes your job trickier when you’re representing the buyer. If the bankruptcy filing comes after the two parties have entered into a purchase agreement, the bankruptcy by itself doesn’t automatically lead to termination of the sales contract. But if the seller can’t meet the closing date or other deadlines specified in the contract, which is often the case in bankruptcies, the buyer has a basis for backing out of the deal.

If the buyer wants to continue with the purchase, the transaction can close if the seller and the bankruptcy trustee are likewise motivated. But these transactions can come with considerable complexity, so it’s smart for the buyer to consult with a bankruptcy attorney. Clients who want to buy a home from a bankrupt builder face the risk of the builder being unable to complete construction or honor warranty obligations. You shouldn’t try to help your client evaluate these risks; recommend the buyer talk to an attorney.

Homestead Exemption: A Tool for Some Buyers

Most states offer some type of "homestead exemption" that helps home owners protect a portion of their home equity in the event of a bankruptcy. If you have prospects who aren’t currently home owners, have some savings, and are facing bankruptcy, you may suggest that they consult with their attorney to find out whether the exemption can work in their favor. It might be possible for them to invest their savings in a house and protect it from creditors. If that’s the case, you could have a motivated buyer on your hands.