How to Protect Yourself Against a Homebuilder Bankruptcy

When a homebuilder goes bankrupt, the company's creditors aren't the only ones who suffer. Often, so do those who have paid sometimes hefty deposits for houses that remain unbuilt and new homeowners living in a development with half-built homes and incomplete amenities.

In the past year, the tumbling housing market has claimed such large builders as Fort Lauderdale, Fla.-based Levitt & Sons, a unit of Levitt Corp., Elliott Building Group in Pennsylvania, Turner-Dunn Homes Inc. in Arizona, Kara Homes Inc. in New Jersey and Neumann Homes Inc. in Illinois.

When these builders file for bankruptcy, subcontractors stop working, unfinished homes in various stages dot the communities, crippling liens are placed on occupied homes, clubhouses are incomplete and swimming pools and parks are never built.

People who have placed deposits on homes either never get their money back or face delays of months or years before it is returned.

"The houses sit until someone comes in and decides to complete them," says Tracy Cross, of Tracy Cross & Associates, a Schaumburg, Illinois-based real estate research firm. The buyers "can't move in, they can't get their deposit back and they can't get out of the contract."

In November, Levitt and Sons became the nation's largest builder to file for bankruptcy. In its bankruptcy filing, the company lists assets of less than $1 million and debts of more than $100 million.

Some home builders such as Centex Corp. and Pulte Homes Inc. aim to survive by selling houses at bargain prices, scrapping growth plans and slashing jobs. But as the housing market continues its downward slide, other home builders could find their companies in jeopardy.

Problems for homeowners and buyers

Attorney Brian Meltzer, of Meltzer, Purtill & Stelle LLC, in Chicago, Ill., has represented home builders for more than 30 years. He notes that these bankruptcies create numerous problems for homeowners. One of the most pressing issues will be warranty service issues on their homes.

Cross believes that homeowners living in a bankrupted new home community have few options when their home has a major problem. If the foundation has cracks, the floors aren't level, the roof is leaking or the foundation is shifting, the homeowner will have to pay for the repairs. If a new entity takes over the development, it can help the homeowner -- but it has no obligation to do so.

As for the houses partly under construction, what most likely happens is that the lenders or another entity step in and hire the trades to finish those houses. The home buyer will then get the house he or she contracted for. In the meantime, the home buyer is "stuck" and can't get out of the legally binding contract.

How can potential buyers protect themselves?

Both Cross and Allen C. Balk, at Meltzer, Purtill & Stelle LLC, recommend checking out the builder before purchasing a home. Look at the progress in the subdivision. Drive around. Is anyone working? If it looks like there isn't that much production, it may be indicative of other issues.

Knock on doors and ask people if they are happy with their home. If you decide you want to live in that community, purchase a completed inventory home, which eliminates much of the risk.

Look up the company on the Internet. If it's a public company, you'll be able to find out how it's doing in different markets. Find out if land is being revalued.

Buyers should also make sure that their earnest money is in a third party escrow account because if there is a bankruptcy there is a right to terminate the deal.

"If the money is not in such an account, you become an unsecured creditor," he added. However, this provision can vary from state to state so it's up to the buyer to find out if this is done in their state.

Buyers sometimes can add a "springing provision" to their contract. This is a clause in the contract that allows the buyer to walk away if the builder files for bankruptcy protection. Most contracts don't contain them. This clause only "springs" into effect with a bankruptcy filing.

"There is nothing wrong with asking your lawyer to put this in the contract," says Balk. "It's important to check with your state to see how enforceable this clause is."