Bankruptcy plays a major role in the commercial real estate world but very few real estate investors understand how it works, what it can do for them, and why it can be dangerous.

The 3 types of bankruptcy:  There are 3 types of bankruptcy:

Chapter 7, Chapter 11 and Chapter 13. Chapter 13 is in many respects similar to Chapter 11 while Chapter 7 is very different. First, it is important not to confuse a bankruptcy filing with a foreclosure filing. A bankruptcy filing must be done in Federal Court while a foreclosure is done under regulations established by the State in which the property is located. 

A Chapter 7 Bankruptcy filing (in Federal bankruptcy Court) is used when a Business (in this case a business that owns real property) has so many debts that they believe they do not have a chance to repay them and ask the Bankruptcy Court to set a procedure to totally liquidate these assets (including real estate assets) and parcel out the money received from liquidation among all the creditors. A “secured creditor” is a creditor that (in Colorado) has a deed of trust that was given in conjunction with their loan and was used to “secure” the collateral property. An “unsecured creditor” will typically have to get paid after the secured creditors are paid. The goal of a Chapter 7 filing is so the Court can release the borrower from any further obligations under any of their debt instruments.

The goal of a Chapter 11 or Chapter 13 filing is very different. These Chapters are used to reorganize the debt and give the property owner the chance to pay them off over a longer time frame and/or perhaps have the Court reduce the amount of the debt or the payments due the borrower under this debt. If the debt on the property is delinquent and the lender has filed a foreclosure, the Chapter 11 or Chapter 13 filing will halt the foreclosure until the Judge dismisses the case. This can take anywhere from 1 to 2 years. The good news for the property owner is that they can typically get a longer time to repay their debt secured by their property and may get the terms of their debt made more favorable to them. The bad news is that the Judge can decide to order the owner to sell any property involved in the filing and to sell their property at a specific price to a specific buyer.

Again, as in the Chapter 7, a “secured creditor” will typically get paid first before any “unsecured” creditors. Once a property owner files a Chapter 11 or 13 then the decision on how to sell their property and for what amount is taken out of their hands and left up to the Judge. While it  may seem like a good idea to get more time and halt a foreclosure, by filing bankruptcy, in reality, the owner will not realize as much from the sale of their property as they might have obtained if they had made an agreement with their lender (called a “forbearance agreement”) that gives the borrower and lender the chance to work out a sale between themselves without the interference of the Courts.