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Seller files bankruptcy after you purchase at a discount. Yikes!

Posted by David F on April 26, 2003 at 6:52 AM

One of the risks in purchasing investment property in foreclosure is you could lose your property and the money you invested in the property(!) if the seller completes a bankruptcy filing soon after the transaction. I have thought of a way to protect my investment (see below). Please critique it. For example, will I run into problems with CA's strict usury laws?

I recently asked a California bankruptcy trustee what he would do if in one of his cases the bankrupt party had sold his/her property before filing for bankruptcy. He said that if the transaction occurred within 90 days before the filing then he investigates the transaction by first determining fair market value of the property (using one of the Internet property valuation services like homegain.com). If he finds that the purchase price was less than the fair market value by more than his litigation costs to nullify the transaction (~$5,000), then he would label the purchase as a "fraudulent transaction" and nullify the sale (for all you land-trust advocates, he further said that he could and would "bust any trust" to get to the property). After nullifying the transaction, he said he would resell the home and distribute the proceeds to creditors (secured creditors first, followed by unsecured creditors). When I asked him about all the money I would have already invested in the property (back payments, foreclosure fees, etc.), he said that I would lose it all. Yikes!

SOLUTION(?)
Wouldn't the following procedure drastically reduce my risk of losing my initial investment? Before transferring ownership to the property from the seller to me (or a land trust), have the seller give me a note secured by a trust deed in the amount of the back payments and foreclosure fees I am about to pay to the seller's lender(s) to cure the loan(s). That way, if the seller later files for bankruptcy, at least I stand a chance of recouping my initial investment because I am now a secured creditor ready to stand in line with all the other creditors to get what is owed me.

EDITORIAL NOTE: To prevent this problem in the first place, I generally try to structure the seller's incentives to get him/her to do what I want. Since I don't want the seller to file for bankruptcy within 90 days after the transaction, I wait to pay much of their equity (using a note from me to them secured by a trust deed) until I resell the property, which is usually 90 days after I purchased it. Instead of just verbally urging them to not file for bankruptcy, I tell them that if they file for bankruptcy, they will not receive the money that's coming to them because it'll be intercepted by a bankruptcy trustee. Money speaks louder than words! (Of course, this would not be much of an incentive if the amount the seller owes other people dwarfs the amount he/she stands to receive when I resell the property. That's why I always pull the seller's credit report to determine their bankruptcy potential)

This entire process leads to a rather strange lending situation in which, within one transaction, I loan money to the seller and the seller loans money to me. The following documents are recorded in this order:
1. trust deed for the money I invest to cure the loan(s)
2. grant deed from seller to me (or land trust)
3. trust deed for the equity money seller will receive upon property resale




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