Nearly every association has had to deal with the situation where an owner stops paying assessments and does not respond to late notices from the association. The association then refers the owner’s account to legal counsel, who files suit against the owner. At some point during the collection process, however, the owner files for bankruptcy protection. The owner subsequently obtains a discharge from the bankruptcy court, and walks away from a substantial debt owed to the association.
Bad debt unfortunately is an evitable occurrence with most associations. Should the association merely write off the prebankruptcy debt and hope that the owner just pays going forward? Not necessarily. While a bankruptcy discharge eliminates the personal liability of the owner, it does not extinguish the association’s lien on the property. Therefore, the association still retains an important option to recover the full amount owed.
If the owner retained the property in the bankruptcy, the association should consider foreclosing its lien on the property to collect the full amount owed. Filing a foreclosure against the property, or “in rem,” does not seek entry of a personal judgment against the owner. Rather, the association would only be seeking foreclosure of its lien. If the association were paid off at some point during the foreclosure, typically by the owner or a junior lienholder, it would be able to collect all amounts owed prior to the bankruptcy filing, or “pre-petition”, and all amounts owed after the date of filing, or “post-petition.” In the rare event that the association did end up taking title to the property, it would do so in satisfaction of the full amount of debt owed.
When is this advisable? The property should have sufficient equity to ensure that the association is not foreclosing on a property with no resale value. More often than not, however, owners file bankruptcy because they do not have funds to meet their obligations to their lender and the association. These owners often have no equity in their property and ultimately end up in foreclosure with their lender. Therefore, it is important to have your attorney review a title report on the property to determine whether foreclosure is a viable option.
Associations should also be advised that should the owner attempt to refinance or sell the property at a future date, all amounts, both pre and post-petition, are collectable at the closing. The association’s lien, which is unaffected by the bankruptcy discharge, remains on the property and must be paid in full in order for the owner to transfer title to the buyer free and clear of any liens. A lender foreclosure is the only event that extinguishes the association’s lien.
A good practice for associations to follow is to create and maintain two separate ledgers on the discharged owner’s account. One ledger should list both the pre and post-petition debt owed to the association. This ledger would represent the full amount owed to the Association for its lien on the property. The other ledger should list the post-petition debt only, which would represent the owner’s continuing personal liability to the association after the bankruptcy discharge. Separate ledgers facilitate proper record keeping. They also reduce the risk of an inadvertent violation of the automatic stay for attempting to collect pre-petition sums from the owner who has already obtained a discharge from the bankruptcy court.