One scenario that occasionally shows up in our Short Sale office is where the seller has filed a Chapter 7 Bankruptcy; and how that affects a Short Sale if the lender(s) want a promissory note.
You first have to start off by understanding how loans work and of course how Bankruptcy works as well. This will be a very brief overview. If you want further clarification, consult a BK attorney and your favorite experienced Mortgage professional as this is an opinion and should not be taken as legal advice.
A loan is comprised of a Promissory Note and a Mortgage. The Note spells out the terms of the loan (i.e. 30 years, 7%, etc.) and is the promise to pay the loan. The Mortgage is the collateral on the note. In other words, it’s the instrument that allows the banks to Foreclose and it’s the lien on the property.
There are two different forms of bankruptcy; Chapter 13 and Chapter 7.
Chapter 13 is a reorganization of debt; meaning that the Bankruptcy court will negotiate with all non-secured creditors to create an affordable payment plan. You still have to continue making your mortgage payment on top of the BK payment.
Chapter 7 basically wipes out all debt; including the Promissory Note. However; the mortgage/lien is still in place. What that means is that the lender still has the right to Foreclose.
You typically want to work on a Short Sale only if the BK has been discharged. There is a way to work a Short Sale while it’s in BK; however it requires more steps beyond the scope of this posting.
Ok, so how do Short Sales and Chapter 7 play together?
The purpose of a Short Sale is to be able to sell the property to a new buyer with bank approval for the loss; therefore, you have to be able to provide free and clear title. The only thing that truly has to be released is the Mortgage/Lien and the lender has to agree to do just that. However, in order to best serve your client, you also have to try to get the lender to satisfy the Note as well; otherwise the seller ends up with a deficiency. In the case of a Chapter 7, the Note has been wiped out so the seller is no longer responsible for paying off the Note, but the Mortgage is still in place.
If a seller has filed Chapter 7, the debt CAN be reaffirmed, if the seller agrees to take back an Unsecured Note (i.e. Promissory Note). So it’s the Negotiator’s job to make sure that no Promissory Note is signed.
So here’s how you should approach a Short Sale with these circumstances:
If it’s a first mortgage, they are going to get paid a net of the proceeds of the sale. Typically that will be enough. Second mortgages and Junior Liens will probably also want money in order to release their lien. Normally, you will ask the first mortgage to allow up to 10% of the principal balance be paid to the 2nd and $500 to any Junior Liens below that. They may or may not allow all that money to go to Junior Liens, but that’s the standard. If Junior Liens want more and the Senior Lien won’t allow it, the seller might have to contribute some cash. Remember, this is just to release the lien and you have to make sure that the approval letter says that. A good practice is to be clear about the BK upfront when you are negotiating and that any Promissory Notes will not be accepted by the seller as part of the terms of the Short Sale.
We hope this posting is helpful in your Short Sale negotiations. If you have any questions, please feel free to contact us at info@mnshortsaleinfo.com or visit us on the Web at www.MNShortSaleInfo.com
Disclamer: This post is only an opinion and not legal or financial advise. Please talk to an attorney or an accountant for legal and financial advise.
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