The act of declaring bankruptcy will typically apply what is known as an “automatic stay,” that bars judicial, administrative, or other actions or proceedings against a debtor. At times, debtors will use bankruptcy to pause a foreclosure [where a creditor or mortgage holder forces the sale of the property in hopes of receiving payment of the debt]. The “bankruptcy estate” is created and contains all legal and equitable interests of the debtor in property at the time the bankruptcy case is commenced, but does not include things like a debtor’s interest in a terminated or expired lease. If a tenant is the bankruptcy debtor, and an eviction judgement was given to that tenant-debtor before the bankruptcy was declared, the automatic stay will not protect the debtor’s interest in the right of possession unless the debtor can prove that they are permitted to cure the default under landlord tenant laws and deposited the due rent with the bankruptcy court clerk within 30 days of the bankruptcy’s commencement, i.e. the tenant can’t declare a bankruptcy in response to an eviction and stay in the property unless they can cure the default.
When a person is under contract with a property owner to purchase the property and the property owner declares bankruptcy, the process gets messy. Upon filing of bankruptcy, a bankruptcy trustee will typically be appointed to handle the estate and that trustee can elect to assume or reject contracts that have been struck with the debtor. The bankruptcy court will need to approve the trustee’s decisions, but deference is given to the trustee’s decisions. If the trustee assumes the contract, the Buyer and Trustee are now locked in the transaction dance and are both obligated to fully perform their obligations under the contract. If the trustee rejects the contract, the sales agreement has been officially “breached” and the Buyer can potentially file a claim with the bankruptcy estate for the damages that were caused by the breach as an unsecured claim that takes a pro rata share of the estate’s remaining money after secured creditors are paid, with that recovery capped at the amount of damage caused to Buyer by the breach. Generally, escrow deposits are recoverable by Buyer at this stage so rejection of the contract will normally mean earnest money will be refunded to Buyer.
If you have a scenario where the seller declares bankruptcy mid-transaction, one of the first places to go is to the bankruptcy trustee or the seller’s bankruptcy attorney. If the contract is approved, the sale will not be thrown off kilter and the sale can proceed, albeit with potentially different people captaining the seller’s side of the transaction.