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Many homeowners are watching their real estate values decline yet their mortgage balance remain the same. The challenging real estate market coupled with unemployment have forced many homeowners to try to exiting their properties through a short sale. But what happens to the short sale when a bankruptcy petition is filed? What are the benefits of filing a bankruptcy before requesting a short sale?Let’s use the following facts. Before the short sale contract and package is uploaded by the lender’s loss mitigation department, the homeowner files a Chapter 7 bankruptcy. The listing agent knows this has happened because he receives from the bankruptcy court because the agent’s client (who is also the debtor in the bankruptcy case) has listed the agent as a creditor.

But it doesn’t end there because the buyer’s agent is calling you, the listing agent, asking you why his client, the short sale buyer, has received notice of the short sale seller’s bankruptcy! This is because the seller-debtor has listed the short sale purchaser as a potential creditor as well.

At this point you are surely asking yourself why a listing and selling realtor are considered creditors. The answer is: listing agreements and the short sale purchase offers are considered executory contracts under bankruptcy law. Executory contracts along with leases can be rejected or assumed by a debtor in bankruptcy. Executory contracts are those that have not been fully performed due to a condition that has yet to occur; for example the seller’s lender’s agreement to release the mortgage lien and approve the short sale.

Being listed as a creditor puts both the short sale buyer and the listing agent in an adversarial position with the debtor (seller). Accordingly, the buyer and the listing agent are prohibited by Section 362 of the Bankruptcy Code from contacting the debtor (seller) directly.

Moreover, upon the filing of the bankruptcy petition, the real estate becomes property of the bankruptcy estate if the debtor has not chosen to or cannot exempt the real property. In most cases, where the debtor (seller) has no equity, the election will not be made to exempt the property from the estate. Thus the Bankruptcy Trustee controls and holds the real estate by operation of law and any attempt by the debtor (seller) to dispose of the property is not possible unless the Bankruptcy Trustee files a Notice of Abandonment of the real estate or the debtor (seller’s) bankruptcy case administratively closes (the debtor’s discharge from the bankruptcy ALONE is not enough).

Therefore, once the bankruptcy petition has been filed the short sale is typically dead in the water until the bankruptcy case closes OR the mortgage lender obtains an order from the Bankruptcy Court for relief from the automatic stay so that it can pursue its legal remedies with respect to the property. Once that order is obtained, the mortgage lender is allowed to pursue the foreclosure of their security interest.
The mortgage lender is barred however from pursuing any personal recourse against the debtor-seller under the promissory note obligation because the debtor has discharged their obligation under the note. Another fun fact is that under IRC section 108(a)(1)(A) there are no taxes on debts discharged in bankruptcy. So the debtor would not have to be concerned about the potential tax liability of the cancelled debt since the debt is considered to be discharged in bankruptcy.

Another reason a debtor seller may want to wait until after the bankruptcy to short sale the home is that the debtor (seller), in a Chapter 7, can take the full mortgage payment as an expense in the means test calculation. Thus, a debtor (seller) whose annualized income exceeds the medium income of his household size for the state of Florida, who at first glance may not meet the means test for filing a Chapter 7 bankruptcy, may indeed qualify for a Chapter 7.

If a debtor’s income exceeds the medium income for the state of filing the debtor must fill out the entire Means Test form which is referred to as B22A form. This further analysis helps to determine if the debtor has disposable income and should file a Chapter 13 bankruptcy. This form includes deductions for actual expenses such as a mortgage payment that is contractually due. Despite the fact that the debtor intends on defaulting on the payments and surrendering the home to the secured creditor, the debtor may deduct the mortgage payment as an expense and by doing so may qualify for relief under Chapter 7 of the bankruptcy code.

However, with a bit of patience on the part of realtors and buyers, a short sale IS possible after the Chapter 7 bankruptcy case closes, even if the lender does not choose to pursue an order from the Bankruptcy Court lifting the automatic stay to remove the property from the bankruptcy estate while the case is still pending. From the debtor (seller’s) perspective, the benefits of participating in a short sale after completion of their Chapter 7 bankruptcy case where the homeowner/debtor has obtained a discharge and the case has been administratively closed by the bankruptcy court is that the homeowner can bypass the discussion about deficiency because the underlying debt has been discharged.

Further, by obtaining an offer for short sale the debtor (seller) cuts off any liability for post petition debts that arise from mere ownership of the property, such as ongoing association assessments (which are not dischargeable after the bankruptcy filing) along with liability for personal injury on the property, code violations, or criminal acts that could occur on the property while the deed is still in the debtor’s name. This allows the debtor to get a true fresh start without waiting around and maintaining the real estate while the mortgage lender takes its time to finish the foreclosure. From the lender’s perspective, it can liquidate the property much more quickly and not have to go through the lengthy foreclosure process in state court.