The limited utility of “hold harmless” provisions of separation agreements for negative-equity real estate

Sometime around 2007 I encountered a situation involving a marital home I not previously dealt with: negative equity.  Prior to 2007 unhappily married folks often sold their home and used some of their equity to pay attorneys to resolve their remaining marital issues.  However, in this case, the man consulting with me had a few hundred thousand dollars in negative equity in two different homes.

How this happened continues to amaze me: two married doctors with no children and substantial income took the equity from a pre-marital home to furnish a much nicer home that they purchased with no money down.  When the housing market started falling both homes were upside down.  These doctors had no assets to remedy the deficiencies and both parties had their names on each mortgage.  Being unfamiliar at that time with concepts such as “short sale” or “deed in lieu of foreclosure,” my only offered solution to this man’s problem was that he and his wife go into Chapter 13 bankruptcy to discharge the deficiencies before I could help him end his marriage.

Obviously the past five years have educated attorneys on methods of dealing with a home that has debt in excess of its value.  A common solution in family court is for the parties to agree that one party will keep the upside-down home while providing the other party a “hold harmless” clause, guaranteeing that the party keeping the house will prevent any harm from coming to the other party.

Such “hold harmless” protection has limited value.  Too often these upside-down homes end up in foreclosure anyway, as the party keeping the home either cannot make the monthly payments or determines that it’s a waste of resources to continue paying on a property that has no equity.  At that point the mortgage holder is free to seek compensation from all signators to the mortgage, including the spouse who obtained the “hold harmless” agreement.  Such an agreement between the parties, even if ratified by the family court, does not bind the bankers.

Enforcing a violation of a “hold harmless” agreement–typically through a contempt action–against someone who has stopped paying the mortgage or allowed the home to go into foreclosure will generally prompt the delinquent party to file bankruptcy.  Once a party is in bankruptcy the family court can no longer enforce the “hold harmless” provision.  Thus anyone obtaining a “hold harmless” provision for an negative equity home as part of a marital dissolution agreement needs to realize that the hold harmless provision is only as good as the other party’s willingness and ability to make payments on the home.

Anyone giving up hard assets in return for a “hold harmless” agreement should probably draft the agreement to have the assets be transferred only after the mortgage is removed from that party’s name.  Further one should warn a client who is the beneficiary of such hold harmless agreements to closely monitor the mortgage payments to insure that they are being made on time.  Waiting until a mortgage is months delinquent almost guarantees that a bankruptcy, and potentially a large deficiency, will follow from any contempt action.  Finally one should warn that client that these hold harmless agreements may not be enforceable if the other party goes into bankruptcy and that the mortgage holder can then seek to collect any deficiency from the client.

Dealing with an upside-down marital home by awarding one party the property and the other party a “hold harmless” provision allows unhappy spouses to resolve their property division disputes without the trouble or expense of a short sale, foreclosure, or providing significant funds to a mortgage holder.  However, often, this resolution doesn’t solve the problem of an upside down home so much as defer the resolution.  The only way to be truly free of a mortgage obligation on a negative equity home is to reach an agreement that satisfies the mortgage holder.

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