For many years, note buyers have known that divorce liens can be a desirable and lucrative asset. But over time a serious problem emerged that many still don’t know about: there’s more than one way to buy a divorce lien. One is ideal. The other is very risky.
How the ideal divorce lien is created
A divorcing couple owns a home. They settle, with one spouse keeping the house and the other getting a note and deed of trust (or mortgage) for their share of the home’s value.
The “house spouse” pays the departing spouse until the note is paid off. Most divorce liens are paid off in a single balloon payment at the end of the note’s term, but some have monthly payments. Either way, if the note isn’t paid properly, the note-holding spouse may foreclose and force payment.
Note buyers can purchase this kind of divorce lien, with a note and deed of trust (or mortgage), and have the same power to foreclose that the departing spouse had.
Buying a divorce lien without a note
It’s also possible to buy a divorce lien without a note and deed of trust. In that case, the note buyer purchases a court order or court judgment that describes the divorce lien: a court document with details such as how much is owed to the departing spouse and when it is to be paid.
Usually there is no trouble buying a divorce lien backed only by a court judgment. Most people are solvent and pay their debts. If there’s a default, the note buyer still has the same legal rights the departing spouse had, except…
The bankruptcy exception and the homestead
There’s that nasty word, except. It always spells trouble. The exception is bankruptcy.
If the house spouse decides not to pay the note buyer, he or she can declare bankruptcy and, in certain situations, avoid paying the divorce lien altogether.
How can a bankruptcy defeat a court-ordered divorce lien? The bankrupt house spouse’s main tool is the homestead. Most states have laws that let a householder designate a house and land as a homestead and exempt it from collection by creditors for general debts in bankruptcy. In some states the householder must file a formal declaration to claim the homestead exemption. In others it’s automatic.
Bankruptcy law says that most judicial liens, and a court-ordered divorce lien is a judicial lien, can be avoided if they impair the debtor’s homestead exemption.
The homestead exemption isn’t foolproof, though. Most states limit how much of a home’s equity can be exempted. In Washington State, for example, the exempt amount was $40,000 at the time of writing. That means any equity over $40,000 can be collected in a bankruptcy, but…
Why the court-judgment buyer stands in line
There’s that nasty word, but. It always spells trouble, too.
Even though the departing spouse in this example can collect from any equity over $40,000, he or she has to go through a lot of red tape with the bankruptcy court and stand in line with the other creditors.
Departing spouses are, of course, outraged when this happens. Many have gone to court arguing that a divorce lien should not be avoidable in bankruptcy because it’s like alimony, maintenance or support, which can’t be avoided.
One case went all the way to the U.S. Supreme Court: Farrey v. Sanderfoot, 500 U.S. 291 (1991). The Court ruled that the lien could not be avoided, on the technical ground that Sanderfoot had no pre-existing interest in the home. The divorce decree gave Sanderfoot a new ownership interest and created the lien to Farrey at the same moment, so the lien could not be avoided. Farrey, the departing spouse, kept her lien on the home.
Things got better for departing spouses because of Sanderfoot. In addition, Section 522(f)(1)(A)(i) of the Bankruptcy Code specifically protects spouses and former spouses, as long as the divorce decree states that the debt secured by the divorce lien is “in the nature of alimony, maintenance, or support.” So a divorce lien can be protected from avoidance (voiding or canceling) in bankruptcy, unless…
What changes when you’re a third party
There’s that nasty word, unless. It spells even more trouble.
Unless the divorce lien is assigned to a third party. Then it is likely avoidable. Sanderfoot protects the debt between spouses, but don’t assume you, as a third party, would enjoy the same position. Section 522(f)(1)(A)(ii)(I) of the Bankruptcy Code could override the Sanderfoot result, and your divorce lien could be avoided.
That means buying a divorce lien with only a court judgment carries great risk, because you are a third party. If you have only a court order or judgment, and not a note and deed of trust (or mortgage), you can get stung.
Buy the note, not the judgment
Now the words you do want to hear. If you have a note and deed of trust (or mortgage), you can foreclose and get your money if there’s a default. In most cases that right can’t be avoided, even in bankruptcy.
If you own the note and hold a deed of trust on the real estate as security, you’re a third party who bought standard real estate financing documents. In most cases, those documents make you a secured creditor if the house spouse files for bankruptcy.
You’re a note owner, secured by a valid lien, and you have the documents to prove it. So, eager note buyer, remember what you are: a note buyer, not a court judgment buyer.
