It is not news to say that today’s real estate market is terrible.  Many “homeowners” are quite literally hundreds of thousands of dollars underwater.  I put homeowners in quotation marks because someone who is underwater does not really own a single molecule of the house.

This leads many to surrender their houses as part of the bankruptcy process.  Surrender of the house can be very sensible if the debtor can’t make the payments, and has negative equity.  When the Bankruptcy Court grants the debtor a discharge, the personal liability on the mortgage is discharged.  Moreover, since the debt is discharged in the bankruptcy, there is no cancellation of debt income, so there is no adverse tax consequence to the surrender.  In addition, any prepetition homeowners association (HOA) dues are discharged because they were incurred prior to filing the bankruptcy papers.

However, postpetition HOA dues are not discharged in the bankruptcy because they are incurred after the filing of the bankruptcy papers.  See 11 U.S.C. § 523(a)(16).  In the current real estate market this unfortunate fact can create a real problem because if the debtor surrenders the property the lender is not required to take possession of it, or record a transfer of title.  In the vernacular:  you take force someone to accept a gift.

Depressed real estate values and oceans of delinquent mortgagors have led banks to act much more slowly than they would in a hot real estate market.  It is not uncommon for a bank to wait a year before taking possession of a surrendered property.  In the meantime, the former bankrupt homeowner is still on title and liable for upkeep, utility bills, and postpetition HOA dues.

A recent bankruptcy case in Florida, In re Spa at Sunset Isles Condominium Association, Inc., 2011 Westlaw 3290239 (Bankr. S.D. Fla.), filed by the HOA – not an individual homeowner – serves as a warning shot to dilatory lenders.  Unfortunately, its holding is designed to help a bankrupt HOA get the unpaid HOA dues from the lender, so any benefit to the former homeowner is indirect at best.  To appreciate this case a little context is in order:

Like California, Florida has recently experienced a horrific decline in real estate values.  Florida condominium owners have seen their property values cut in half, or worse.  In response, many have defaulted on their mortgages and ended up in bankruptcy.  In particular, over fifty percent of the members of The Spa at Sunset Isles Condominium Association (SSICA) had defaulted on their mortgages, were not paying their HOA dues, and in many cases had filed for bankruptcy protection.

As a result, in 2010 SSICA filed for Chapter 11 bankruptcy protection.  Unlike Chapter 7 or Chapter 13, there is usually no Chapter 11 Trustee:  instead the debtor serves as the Debtor-in-Possession, a sort of quasi-trustee.  In that capacity SSICA filed a motion under § 506(c) to surcharge the interests of some of the lenders who held defaulted first mortgages on condominium units within SSICA. 

SSICA asserted that the lenders had deliberately delayed foreclosures as a way of postponing taking title.  SSICA alleged that the lenders didn’t want to take title because under state law they would not have been liable for any dues and assessments until title was transferred.  This practice forced SSICA condo owners who were not in foreclosure to bear a disproportionate share of SSICA’s ongoing expenses.

The lenders defended by appealing to a state law that shielded them from paying the assessments until after title was transferred.  They argued that the bankruptcy court could not override that protection.

At this point, those among the readers of this post who are familiar with the U.S. Constitution undoubtedly recall that:

This Constitution, and the Laws of the United States which shall be made in Pursuance thereof . . . shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.

 U.S. Const. art. VI, ¶ 2,

and the fact that the Bankruptcy Code is made pursuant to:

The Congress shall have Power To . . . establish . . . uniform Laws on the subject of Bankruptcies throughout the United States . . .

U.S. Const. art. I, § 8, cl. 1 and 4,

make the Bankruptcy Code part of the supreme law of the land.  It therefore preempts any conflicting state law.  Of course, there are parts of the Bankruptcy Code that defer to state law.  For example, § 522(b)(3) permits a debtor to use state exemptions rather than the Bankruptcy Code’s exemptions to exempt possessions.

However, § 506(c) does not expressly incorporate state law, indicating that Congress intended federal law to control in this instance.  Therefore, the Bankruptcy Court held that § 506(c) preempted state law.

The court held that the requested surcharge was legitimate under § 506(c) because the HOA’s expenses were necessary to preserve, maintain, and repair the common areas within the condominium project, thus benefiting the lenders’ collateral. 

Interestingly, the Court concluded that the lenders’ deliberate postponing of foreclosures was irrelevant to the case.  Since the costs incurred by the HOA were necessary to preserve the lenders’ collateral, the HOA was entitled to the surcharge, regardless of why the HOA was having to cover the costs.

An interesting unasked, and therefore unanswered, question is:  Does the lender have a right of subrogation against the delinquent homeowner for the HOA dues that the homeowner incurred after filing the personal bankruptcy but didn’t pay?  I think the answer is yes, but I have no case law supporting that position because the SSICA case is too new to have led to such an action.