As the housing market continues to slowly recover from the foreclosure crisis in Michigan, and other areas of the country, many community associations are still facing significant challenges with unit owners who file for personal bankruptcy. Numerous unit owners are beginning to utilize an old technique, previously used primarily against second mortgages and other junior liens, against community association liens. These unit owners are utilizing what is known as the “lien stripping” provisions of the Bankruptcy Code to avoid pre-bankruptcy (pre-petition) assessments that are due to their associations. If these unit owners are able to demonstrate to the bankruptcy court that they owe more to the first mortgage holder than what their real property is worth as of the date of their bankruptcy filing, the bankruptcy laws enable the unit owner to wipe away second mortgages, lines of credit and association liens tied to their real property.
Section 506 of the Bankruptcy Code: Lien Stripping
Section 506 of the Bankruptcy Code provides the basis for lien stripping. It acknowledges that a lien is only a secured claim to the extent there is value in the asset to which it attaches. To the extent that the claim exceeds the value of the collateral, that portion of the claim is unsecured. 11 USC § 506. The vast majority of the lien stripping actions have taken place in Chapter 13 cases, which are sometimes called personal reorganization bankruptcy. Some jurisdictions have allowed lien stripping in Chapter 7 cases, but the Sixth Circuit Court of Appeals has determined that § 506 is unavailable to Chapter 7 debtors seeking to avoid a consensual junior mortgage. In re Talbert, 344 F.3d 555 (6th Cir. 2003). The United States Supreme Court will be deciding this issue this spring to resolve the split in the circuits. In re Caulkett, 566 Fed. Appx. 879 (11th Cir. (Fla.) May 21, 2014), cert. granted, Bank of America, N.A. v Caulkett, 135 S.Ct. 674 (US Nov. 17, 2014) (No. 13-1421) and In re Toledo-Cardona, 556 Fed. Appx. 911 (11th Cir. (Fla.) May 15, 2014), cert. granted, Bank of America, N.A. v Toledo-Cardona, 135 S.Ct. 688 (US Nov. 17, 2014) (No. 14-163).
The Chapter 13 unit owner employs an individual repayment program over a three to five year period by using his/her disposable income to pay their mortgage arrears and their current regular monthly mortgage payment and any priority secured debts, such are IRS / Michigan tax obligations and a portion of their unsecured obligations. The portion of unsecured obligation that is repaid during the term of the Chapter 13 Plan depends on the degree of the unit owner’s debt and income. Although most unit owners who have filed Chapter 13 are attempting to save their home from foreclosure, they are not intent on paying their entire delinquency to the association. Instead, Michigan unit owners, much like other unit owners across the nation, are now seeking to “strip off” their association liens.
The unit owner will file a motion to value the real property, begin an adversary proceeding against the association and other junior lien holders or address the valuation in their Chapter 13 Plan. In order to gain the benefit of lien stripping and the avoidance of the unit owner’s obligations to the association of the pre-petition assessments, the bankruptcy court first needs to determine that the real property is underwater and that the Association’s lien may be stripped. Once the underwater status has been determined, the unit owner must complete their Chapter 13 Plan by remitting all payments due under the Plan and receive a Chapter 13 discharge. However, if the unit owner’s Chapter 13 case is dismissed for any reason or if the case is converted to a Chapter 7 liquidation, then the association’s lien will not be stripped, but will be reinstated against the unit.
To be clear, the lien stripping described above does not affect any assessments made after the date of the bankruptcy filing. Pursuant to 11 USC §523(a)(16), the unit owner will remain liable for all post-petition assessments.
Actions Every Association Should Take to Reduce the Likelihood or Impact of Lien Stripping
To avoid large delinquent amounts from being stripped, there are a few steps an association may take to lessen the likelihood or impact of lien stripping. First, an association must be vigilant in pursuing and staying on top of its collections. Also, if the association stays on top of its collection accounts and is able to foreclose prior to the filing of the bankruptcy case, it can avoid the valuation issue altogether.
Second, when the unit owner files his/her valuation of the real property, the association will need to counter it with its own appraisal demonstrating that the value of the unit at the time of the bankruptcy filing was greater than the amount due under the unit owner’s first mortgage. A valuation hearing is truly an all or nothing matter. The issue typically becomes a “battle of appraisers” and the results, of course, will vary based on the amount that the unit owner owes under their first mortgage and the strength of the association’s higher appraisal. Should the bankruptcy court determine that the unit has even just a single dollar of equity, then the unit owner will be required to repay all of the unit owner’s arrears over the life of the Chapter 13 Plan. However, on the other hand, if the court finds that the unit is underwater and lacks equity, then the unit owner will be entitled to strip the pre-petition amount due to the association. Thus, given the inherent risks in an all or nothing situation, the parties will often amicably resolve the matter wherein the association will agree to accept a portion of the arrears paid through the bankruptcy plan by the debtor/owner, as opposed to having the association’s lien avoided entirely.
The association can also raise other defenses to the unit owner’s lien stripping claims, such as claiming that the association lien is not a junior lienholder due to deficiencies in the purported first mortgage’s recording with the register of deeds or by seeking to convert the unit owner’s case into a Chapter 7 due to abuse of relief.
It is clear that with the increase in bankruptcy filings and attempts to strip association liens for pre-petition assessments, associations must not only be vigilant to protect their interests, but also strategic in how to protect themselves.
Even if nothing can be done with respect to the unit owner’s pre-petition assessments, not all is lost. As set forth above, post-petition assessments are non-dischargeable. Also, the Michigan Condominium Act, like those in other states, provides that a “subsequent owner” is liable to the association for the prior owner’s outstanding maintenance obligations. MCL 559.211. Though the debtor can strip the lien and discharge the debt, the personal obligation survives as to the subsequent purchaser of the property as a result of the provisions in the Michigan Condominium Act. Thus, the debtor who strips his/her association lien may find that he/she cannot sell his/her property without the association being paid for the amount that had been stripped and discharged as to the debtor. In re Sain, 2013 WL 5852496 (Bankr. S.D.Fla. 2013).
Thus, a subsequent purchaser will be liable for the pre-petition assessments when and if the bankrupt unit owner sells. In other words, no matter what a unit owner in bankruptcy accomplishes in their bankruptcy case with respect to their liability for association assessments, nothing can impact a subsequent owner’s personal liability for the unpaid assessments and nothing in the prior owner’s bankruptcy impacts the association’s right to pursue payment from that subsequent owner.
Finally, 11 USC § 1322 only prevents stripping if the real property is the primary residence of the unit owner. Thus, associations that contain second/vacation and/or investment/rental homes need to be even more vigilant as unit owners will be able to cram down and/or strip the association’s lien even if there is some equity in the home.
The lien stripping provisions of the bankruptcy code have taken a financial toll on many community associations throughout the country and are now beginning to affect Michigan community associations. Therefore, it is imperative that community associations not back off from actions taken by a unit owner in a bankruptcy case seeking to avoid an association lien. Rather, associations should apprise themselves of their rights as a creditor in the bankruptcy case and understand that the filing of bankruptcy by a unit owner does not automatically result in a loss to the association. Although the bankruptcy process is complex, associations have rights in bankruptcy court and they should seek the advice of experienced counsel in asserting those rights.
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