Rental Property and Bankruptcy

September 14, 2011

By: David M. Serafin

How rental property (such as a vacation home or apartment building) is treated in a Colorado bankruptcy filing really depends on the chapter filed and overall circumstances, such as the its fair market value, mortgage debt(s) – if any – and the existence of any monthly rental income. As a Lakewood consumer debt lawyer, I have numerous clients who file bankruptcy intending the keep rental property and who need to be advised not only as to whether the property can be kept but should it be kept.

The most simple type of bankruptcy is chapter 7 liquidation. But, the danger of chapter 7 in Colorado for debtors owning rental property is that the trustee will attempt to either take or force payback of any non-protected value of any property with equity, as the Colorado Homestead Exemption only protects primary residences. Whether any equity exists typically depends on the opinion of one or more objective realtors. If the property is upside down in value, the chapter 7 trustee will not likely care about whether the debtor keeps the property.

A preferable way to keep valuable rental property is through chapter 13. Chapter 13 permits a bankruptcy debtor to reconcile non-exempt equity into a re-payment plan for 36 to 60 months. Put in lay terms, chapter 13 allows for the interest free payback of non-protected equity in a rental property. Hypothetical realtor and title costs can also be applied to reduce the level of equity.

Consider the following example: a vacation house is valued at $300,000 with a $250,000 mortgage. Reasonable realtor and title costs of 8% (and sometimes more) can be subtracted from the remaining $50,000 of equity to equal $46,000 which needs to be paid back into the chapter 13 plan. Here, even if the debtor qualifies for a 36 month plan – by passing the Means Test – a 60 month plan may be appropriate to pay back this equity (especially if other debts, such as for mortgage arrears or taxes, need to also be paid back). For clients who prioritize keeping such property (e.g. if inherited from a family member), this sure beats losing it in chapter 7.

Regardless of the property’s value, any net income received from the rental for the six months before filing must also be considered under the Means Test. I define net income to equal gross income minus any mortgage, insurance, property tax, HOA and/or utility expenses from the property. Any positive net income is subject to the same exemption as are W-2 wages and self-employment income: the trustee is entitled to 25% (to be immediately turned over in chapter 7 or reconciled in chapter 13) of any earned but unpaid income as of the date of the bankruptcy filing. Positive rental income can even push a chapter 7 debtor into a chapter 13 under the Means Test.

Like with a primary residence, mortgage arrears owed for a rental property can be cured in chapter 13 if you’re unable to pay this debt. Or, if the mortgage balance owed exceeds the property’s value, the mortgage debt can be ‘crammed down” to the property’s value and monthly payment can be reduced. But, whether the back mortgage payments are made through the plan or the mortgage debt is crammed down, the debtor must timely and fully make all regular mortgage and plan payments to stave off the lender from foreclosing on the property

Even if no Means Test issues exist, a chapter 7 or 13 trustee can still argue that the bankruptcy filing is not in good faith and does not meet the “best interests of creditors” test if the owner is living lavishly. For instance, why should the monthly mortgage payments (and other expenses) for a vacation home which loses money each month be factored into the Means Test to either qualify a higher income debtor for chapter 7 or reduce an existing chapter 13 debtor’s plan payment to the detriment of unsecured creditors?

Of course, rental property without equity can usually be surrendered in chapter 7 or 13 with all or some of the deficiency discharged. A tenant should be provided notice of your bankruptcy filing as soon as possible.

Please speak with an experienced Denver bankruptcy lawyer to learn how best to address any rental real estate concerns in bankruptcy.