When an association finds its bank balance down to zero, the initial instinct is to file for HOA bankruptcy. While bankruptcy is a real option, it is not the only one. There are several steps boards can take before calling it quits and declaring bankruptcy. Even as a last resort, bankruptcy comes in several forms and comes with distinct consequences.
What is HOA Bankruptcy?
An HOA bankruptcy occurs when a homeowners’ association or condominium can no longer pay its debts or legal judgments. Typically, this is due to the association having significant debts and running out of money to settle them.
There are three options for HOA bankruptcy: Chapter 7, Chapter 11, and Chapter 13. Let’s break these down below.
Chapter 7 Bankruptcy
In a Chapter 7 bankruptcy, an association will sell most or all of its assets to secure funding to pay its creditors. Also referred to as a liquidation bankruptcy, this route is rarely chosen because it would mean the complete end of operations. It is more suited to business organizations.
Chapter 11 Bankruptcy
In a Chapter 11 bankruptcy, an association can continue its operations while simultaneously restructuring its debts. This restructure must be a plan approved by a federal court.
Since operations can continue, the HOA board will still collect dues, enforce the rules, and hire vendors. It’s business as usual, but with the added work of restructuring debt.
To restructure debt, the association must negotiate claims, revisit bank loan terms, and ask for extensions on repayment programs. The board will also have to find more funding, which usually comes in the form of increased dues or special assessments.
Because this type of HOA bankruptcy allows the community to remain in operation, it is the most common.
Chapter 13 Bankruptcy
In a Chapter 13 bankruptcy, also known as a wage-earner’s plan, the association continues to operate, retains its assets, and enters into a repayment plan. This plan generally spans three to five years. During this period, the association must allocate a portion of its revenue to repay its debts.
Why Would an HOA Go Bankrupt?
While there are a few possible reasons for HOA bankruptcy, it all boils down to poor financial management. It can be a case of large, unexpected expenses, such as an infrastructure breakdown or a natural disaster.
On the other hand, it can also stem from legal problems. When the association is frequently embroiled in legal battles, it can drain the association’s funds. Foreclosures can also be a cause. While they are designed to secure unpaid dues, the proceedings can be expensive and time-consuming to resolve.
Fraud and embezzlement can play a part, too. While some thefts are covered by insurance, many exceed the policy limit. This results in lost funds and a struggle to return to a healthy balance.
Any of these, especially when taken to extremes, can lead to an HOA bankruptcy. Of course, bankruptcy should be a last resort after the board has exhausted all alternatives.
What Happens if HOA Runs Out of Money?
It is foolish to think that debt will just go away if an association runs out of money. While this may be possible for individuals or certain businesses, it is never true for HOAs.
Creditors know that there is always a way for an association to resolve its debts. This way comes in the form of homeowners.
Homeowners are still responsible for paying dues and assessments, even when the HOA is buried in debt. These dues and assessments can pay for the outstanding balances. Ultimately, it is the homeowners who will suffer if poor management leads to bankruptcy.
What Happens if a Condo Association Goes Broke?
For a condominium, the consequences can be even more severe than those of single-family HOAs. This is because the condo association is responsible for maintaining shared building components such as roofs, siding, elevators, foundations, plumbing systems, and hallways.
In the most extreme cases, owners may decide to terminate the condominium and sell the entire property, especially if repair costs exceed the units’ value. Some states have statutory procedures that allow condominium termination under specific circumstances.
In Virginia, the Condominium Act expressly allows the termination of a condominium. The move generally requires approval from unit owners holding at least 80% of the votes in the association, unless the governing documents require a higher percentage.
After termination, the condominium can be sold. The proceeds are then distributed in accordance with the law and the governing documents.
Can an HOA File Bankruptcy?
Yes, an HOA can technically declare bankruptcy. That said, it is not always a wise decision. In fact, it is a rare move for associations.
Most HOA communities don’t have major creditors demanding millions of dollars. Expenses are usually limited to landscaping, pool maintenance, utilities, insurance, management fees, and routine repairs.
If an association stops paying these bills, vendors just stop providing services. They don’t typically continue services and operate on an IOU basis. This makes it difficult for debt to accumulate.
How HOA Bankruptcy Affects the Community
When an association goes bankrupt, it can negatively impact the entire community and its residents. Bankruptcy can lead to higher dues and assessments, greater challenges in selling a home, reduced amenities and services, and even forced receivership.
Greater Financial Obligations for Homeowners
Homeowners are stakeholders in an association. They have an obligation to pay dues and assessments. As a result, owners are liable for the association’s debts.
Legally, an HOA has the right to collect funds from owners. If the association owes $500,000 for roof repairs, insurance claims, lawsuits, or other obligations, the board can generally raise regular dues, levy special assessments, and file legal action against non-paying owners.
More Difficulty in Selling Homes
When an association goes broke, most homeowners’ knee-jerk reaction is to pack up and sell. Yet, it’s hard to sell a home while the HOA is in the middle of bankruptcy filings.
Buyers don’t want to move into a community that doesn’t have any money. It only signals higher dues and significant special assessments in the future. Plus, lenders tend to disfavor HOAs that are bankrupt or in the midst of legal proceedings.
Sellers might think they can hide the bankruptcy from prospective buyers. Not only is this unethical, but it is also impossible. Sellers are legally required to disclose the HOA and its legal troubles to any potential buyers.
Reduced Amenities and Services
When an HOA files for bankruptcy, amenities and services are usually the first to go. This means homeowners can expect poorly maintained facilities or total amenity closures.
Forced Receivership
In severe cases, a court may even appoint a receiver. A receiver is an independent third party who takes over management of the association.
This receiver often has the authority to raise dues, collect delinquent accounts, sign contracts, pay creditors, and manage operations. With a receiver in place, the board may no longer have total control of the association.
While receivership can be beneficial, it also comes with downsides. A receiver usually has one goal in mind: to improve the association’s financial standing. This means paying off all debts and becoming financially solvent again.
A receiver may not care about the association at large or its members’ opinions. It may liquidate all assets, take complete control, and even delay certain operations pending court approval. Plus, receivers are paid a salary, which comes out of the association’s pocket.
Can Homeowners Sue the HOA Board Due to Bankruptcy?
Yes, homeowners can sue their board for breaching its fiduciary duties. The board must practice good faith when making decisions and fulfilling its responsibilities. Improper financial management can constitute negligence.
That said, lawsuits will only add to the problem. An association already struggling with financial solvency will only suffer further when faced with more legal expenses. Homeowners must keep in mind that they are ultimately responsible for paying off the association’s debts, including potential attorneys’ fees and court costs.
Alternatives Before Filing for HOA Bankruptcy
Bankruptcy should not be the initial move in an association’s arsenal. When debts increase, board members must explore other alternatives first.
1. Defer Maintenance
Delaying maintenance can be an easy way to save on costs. While this is a quick solution and offers immediate liquidity, it should be used only in the short term. Long-term postponement of maintenance and repairs can dig a deeper hole for the association.
2. Reduce Services
Boards can pause vendor services, especially non-essential ones. It is important to determine which services to terminate and which to renegotiate.
3. Delay Reserve Contributions
To meet short-term needs, the association can re-allocate reserve contributions to debt repayment. Again, this should not go on for very long, as underfunded reserves can further cripple the association.
4. Increase Regular Dues
Raising dues is perhaps the most popular option, as it increases cash flow without cutting back on essential services. Of course, this decision doesn’t always go over well with owners, as they’re the ones who must pay.
That said, homeowners should never stop paying their dues, even when they disagree with the board’s decisions. Nonpayment can only lead to penalties, such as late fees, legal action, and even foreclosure.
5. Levy Special Assessments
Special assessments are additional fees that owners pay on top of their regular dues. When an HOA goes broke, it is common for the board to levy special assessments to meet financial obligations. Again, while not popular among owners, it is a decision that many associations favor.
6. Borrow Money
Bank loans can offer immediate cash flow for associations. That said, loans must still be repaid, and many view loans as paying a debt with another debt. Ultimately, the board will need to generate more revenue through dues and special assessments to repay the principal and interest.
7. Pursue Delinquent Owners More Aggressively
Unpaid dues can cut off the association’s income stream. Before filing for HOA bankruptcy, boards should first implement more aggressive collection strategies for delinquent accounts. This includes hiring a collection agency, placing liens, and even initiating foreclosure proceedings.
The Best Defense
When money runs out, association boards should turn to other tactics before seriously considering HOA bankruptcy. Of course, prevention is always better than a cure. The best way to avoid bankruptcy is to employ sound financial practices and seek professional assistance.
Keymont Community Management offers expert management services to associations in Virginia, Maryland, and Washington, DC. Call us today at 703.752.8300 or request a proposal to start your journey!
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