Buying real estate that is in bankruptcy

When buyers think of purchasing distressed properties, they are usually thinking about a short sale or bank-owned (REO) property, or perhaps purchasing a home at a foreclosure auction. One category that isn’t talked about as much is homes that are part of a bankruptcy. Homes that are part of a bankruptcy represent their own unique challenges and operate by a completely different set of rules required by the US Bankruptcy Court.

Foreclosure Auction

Chapter 7 versus Chapter 13 bankruptcy

Real estate is treated very differently if it is part of a Chapter 13 versus Chapter 7 bankruptcy proceeding. Homes in Chapter 13 bankruptcy remain in the control of the seller. To purchase one, you would negotiate with the owner directly. There is a requirement for bankruptcy court approval of your offer. This is a check to make sure that creditors are being protected and that the seller isn’t receiving any proceeds. Chapter 7 bankruptcies are very different. All of the owner’s assets are transferred to the possession of the bankruptcy trustee, who is appointed by the court. The trustee is responsible for the sale and disposition of all assets and the owner is no longer involved in the negotiations for the sale of their home. We’ll talk more about buying homes out of Chapter 7, as that is where the process differs wildly from a regular transaction.

Making an offer on a home in Chapter 7 bankruptcy.

A trustee often lists real estate in bankruptcy on the open market. If you decide to place an offer on such a property, there is usually a specific contract required by the bankruptcy court that has similarities to a typical real estate contract, but contains many bankruptcy-specific terms.

  1. Subject to approval by bankruptcy court – Once the trustee signs your offer, it is not yet mutually accepted. They will set a court hearing a few weeks later during which a judge will review and approve the offer. You don’t have a valid contract until that point.
  2. Right to accept higher bids – Up until the court approves your offer, bankruptcy law requires that the trustee continue to accept other offers if they are better than yours. The law allows you the opportunity to match those higher offers, but the risk that someone else beats your bid remains all the way until the court hearing. There could even be an oral auction at the court hearing to determine the final price and winning buyer. There is no way to avoid these risks, so you have no assurance that the home will be yours until the judge issues court approval of your offer.

Beware of looming foreclosures

Almost all properties in bankruptcy have a mortgage against them. Most times those mortgages are underwater and the banks stand to lose a considerable amount of money when the property sells. When the trustee accepts your offer, they will notify all of the lienholders on the home of the proposed sale. This gives lenders a chance to object to the sale to protect their asset from being sold for less than they would like.

Banks will make their own analysis of the fair market value of the home and what they are owed. They use this data to figure out what their likely proceeds will be if the home gets foreclosed versus being sold by the bankruptcy court. If the bankruptcy offer is too low, they will object and proceed with foreclosure instead. Remember that the bankruptcy court is trusted with protecting creditors, not getting you a great deal on the house, so the potential that the home you are bidding on will be foreclosed is quite high.

Trustee fees & unsecured creditors

To successfully sell a property in bankruptcy, the trustee needs to collect their fee. Oftentimes the court also wants to see some money being paid to unsecured creditors as well. There is a complex dance that plays out differently on every single property to come to the right deal that the lenders will approve and that the court will also approve. If there is equity in the home, some of these excess fees may come from that, but beware that the buyer may be asked to pay some of these fees to make the deal work.

Every bankruptcy is different

This post gives an overview of some of the major challenges when buying real estate through the bankruptcy court. However, the most important thing to remember is how different each and every transaction will play out in the bankruptcy process. There is no great way to predict your success or failure, and you need to be prepared for a bumpy process where you may or may not get the home. There is a ton of complexity that can’t be discussed in a short article like this, and you will be best served by working with real estate professionals and attorneys who are well-versed in the bankruptcy process if you intend to make an offer. Seek your counsel carefully, as most agents and attorneys have no experience in this type of transaction.