02 Sep 2019

The family home and bankruptcy


5 min

The impact of the doctrine of exoneration.

The general rule in bankruptcy is that, under section 58 of the Bankruptcy Act 1966, a person’s property upon becoming a bankrupt, including the family home, vests in the bankruptcy trustee. The bankruptcy trustee has certain duties to discharge including recovering property for the bankrupt estate’s benefit. The bankruptcy trustee will need to turn their mind to section 116 of the Bankruptcy Act that provides limitations on what property the bankrupt holds is divisible among creditors. This is where dealing with jointly owned property (prior to bankruptcy) such as the family home can be tricky. Enter the doctrine of exoneration.

What is the doctrine of exoneration?
The principle of the doctrine of exoneration changes respective interests in real property ownership, depending on the conduct of one or more of its owners. For instance, when a joint owner of real property borrows funds and secures them against the real property and uses these funds for their own benefit at the exclusion of another owner. In applying the doctrine, each owner’s interests in the property’s equity is adjusted.

This can have a significant impact for a bankruptcy trustee particularly where, despite a bankrupt being a registered owner of real property with equity, they have no interest in that equity because they previously borrowed additional funds and secured them against the property. It frequently applies where a person has borrowed against the family home held jointly with someone else to fund a business, and the person who has benefited from the funds is subsequently faced with bankruptcy.

The doctrine is based on an inference with reference to all the matter’s particular facts. Therefore, sufficient records that properly record and explain such borrowings is vital when a co-owner (the non-bankrupt) asserts a claim with the bankruptcy trustee.

When does the doctrine of exoneration apply?
The doctrine applies where a number of parties are registered owners of real property, but where borrowed funds secured against it are used for the benefit of some owners, but not all.

For example, Michael and Samantha who are husband and wife, own their home, subject to a mortgage. The mortgage is for the benefit of both of them. However, Michael takes out an additional loan for his own benefit, and secures it against the family home. Under the doctrine, Michael’s additional loan is for his benefit alone, and Samantha’s interest in the property’s equity is adjusted to reflect this. The doctrine applies in any such similar instance between co-owners regardless of relationship status (i.e. marriage, de facto or familial relationship).

How does the doctrine of exoneration impact an interest in property?
Steve and Robin (husband and wife), own their family home as joint tenants. The house is worth $400,000. They bought the house with a joint loan secured by a mortgage on the property. They owe $100,000 under the mortgage.

Steve ran a business that Robin had no financial interest in. For the benefit of the business, Steve borrowed $200,000 with a loan secured against their home. Steve becomes bankrupt and the bankruptcy trustee is now required to consider what, if any, interest they have in the real property.

Firstly, the doctrine does not affect the mortgagee’s rights. The mortgagee is entitled to the balance of the original loan to purchase the property of $100,000 and the subsequent loan of $200,000. Leaving aside the sale costs, $100,000 remains as the surplus sale proceeds.

In determining whether the doctrine applies, each party’s intentions are considered. In this instance, because the business loan of $200,000 was solely for Steve’s benefit, the doctrine applies and the allocation of the equity is adjusted in Steve’s favour (such that Steve has accessed a portion of his equity in the family home). The allocation of equity and adjustment, would be as follows:

  • The balance of the original mortgage of $100,000 is applied first against the sale proceeds of $400,000, leaving a balance of $300,000.

  • Theoretically, the $300,000 is split equally between Steve and Robin, resulting in a split of $150,000 each.

  • But because the $200,000 business loan was solely for Steve’s benefit, this is applied only against his interest in the property, which means his $150,000 allocation is extinguished.

  • Therefore all of the remaining equity in the real property (the $100,000) is entirely owned by Robin, and Steve in fact owes Robin $50,000, and she can prove in his bankrupt estate for this amount.

This scenario means that the bankrupt estate would receive nothing from the sale of the real property. This is compared to the outcome if the doctrine were not to apply, where the surplus funds, of $50,000 each, are split equally between Steve and Robin.

The doctrine of exoneration generally arises in situations where a property is used as security for a loan taken only by some of the owners, but all of the owners agree to use the property to secure the loan.

It is relatively common for the family home to be used as security to fund the working capital of a business however, if only one of the of the co-owners operates the business then they might be capable of asserting that the doctrine of exoneration applies and the bankrupt co-owner has accessed a portion of their equity.

It is essential that the documentation properly records and explains the borrowings made against the property and advances to the business are maintained to evidence the dealings and intentions of the parties to the property.

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