Financing a Car Through “Bank of Mom and Dad”
Retaining property is vital to a bankruptcy fresh start. The bankruptcy laws allow the debtor to keep essential items like clothes, jewelry, tools of the trade, retirement funds, and often a home. Perhaps the most important item after bankruptcy is a motor vehicle needed to get to work, school, or to the grocery store. While bankruptcy laws allow the debtor to retain a motor vehicle, it is subject to a legal exemption in the amount of equity the debtor has in the vehicle.
Determining the amount of equity in a motor vehicle is fairly simple. First, establish the vehicle’s fair market value, and then subtract the amount of outstanding liens. The lien is a security interest in the vehicle that is noted on the back of the title, or by some other agreement. Most states require the lienholder to “perfect” the lien by recording it with the state department of motor vehicles. That way all other creditors have notice that the lienholder is first in line to collect from its collateral. A perfected lien “eats up” any equity available to unsecured creditors in bankruptcy. For instance, if the fair market value of a car is $10,000, and the outstanding loan is $10,000, the car has no equity available for unsecured creditors – provided that the lien is perfected.
Unfortunately, when a vehicle is financed through a private loan with a family member, the lien may not be perfected. When a motor vehicle lien is not perfected, the lienholder loses its place in line and is placed at the same level as unsecured creditors with respect to claims against the bankruptcy estate. The vehicle may be taken the chapter 7 bankruptcy trustee, sold, and the proceeds equally divided amongst unsecured creditors.
So what can be done? First, a perfected lien may not matter if the debtor has sufficient available exemptions to protect the property. Second, the debtor could sell the vehicle prior to filing bankruptcy and purchase another vehicle. The only caveat is that the sale of the vehicle must be an “arm’s length” transaction for a fair price, and the lien must be perfected within 30 days of the purchase. Third, your attorney may advise you to have the lien perfected. Generally, liens perfected within 90 days of a bankruptcy are subject to avoidance by the bankruptcy trustee as a preference. Essentially, a preference is when a creditor receives better treatment than other unsecured creditors. By avoiding the lien, the trustee can take and sell the vehicle. While 90 days is a magic number for general creditors, the preference period is extended to one year for insider creditors such as a friend, business partner, or family member. By perfecting the lien, your attorney is playing a game of poker with the trustee. The trustee is forced to call your attorney’s bluff and file an action to avoid the lien. This may be more trouble than it is worth, especially if the amount of non-exempt equity is small. Finally, you may consider filing a Chapter 13 bankruptcy and paying an amount equal to the non-exempt equity over the repayment period. This allows you to keep your vehicle, but your lienholder only receives an amount equal to other unsecured creditors.
Your attorney is always in the best position to advise you regarding unperfected motor vehicle liens. There are many potential courses of action possible, and your attorney can discuss the best option for you.