Though coronavirus lockdowns are beginning to ease, small businesses such as restaurants, laundromats, and florists will continue struggling with the devastating fallout from months of, at best, seriously curtailed revenue. While the PPP small-business loan program has kept some of those businesses nominally solvent in the short term, a wave of small-business bankruptcies is imminent once such support runs out.
But experts say many small business owners who consider bankruptcy will discover a devastating trap. The bankruptcy code in many states could force small-business owners to give up their homes to resolve business debts, potentially robbing them of the solid footing needed to rebuild.
The problem arises from two intersecting factors. First, many small businesses are unincorporated sole proprietorships, meaning the businesses’ debts aren’t legally separate from the owners’ personal finances. Even small businesses that are incorporated often rely on owners’ personal guarantees for loans, leases, or other financing, leaving them personally on the hook.
Compounding that reality is the fact that many states have very low caps on the so-called homestead exemption allowed by their bankruptcy codes. In theory, the exemption prevents a primary residence from being handed over to creditors. But it’s no longer working as intended.
“In many states, if not most, the amount of the homestead exemption has lagged far behind the cost of owning a home,” says Ike Shulman, head of the National Association of Consumer Bankruptcy Attorneys. “Over decades, it’s not even close.”
In a 2019 report, the National Consumer Law Center (NCLC) graded states’ bankruptcy homestead protections: 22 states earned an “F” grade, including Alabama, with an exemption of just $15,000 for an individual; and Delaware, with an exemption of just $500 for an individual. California also earned an “F”: Though its homestead exemption tops out at $100,000 for married couples, that’s a small fraction of the statewide average home value of $578,267 (according to data from Zillow), and even less relative protection for homeowners in expensive markets such as San Francisco.
Bankruptcy codes run according to a complex mix of state and federal rules, and many states, particularly in middle America, do have strong homestead exemptions. Florida, Iowa, Kansas, and Texas are among those with unlimited homestead exemptions, enabling bankruptcy filers to protect their home regardless of its value.
In some states, homeowners can choose to use the federal homestead exemption instead of the state exemption. But the federal exemption, too, is meager—around $25,000 for an individual, variable according to inflation.
When bankruptcy filers have equity in their home above homestead exemption limits, Shulman says it is common for bankruptcy trustees to sell the home, give homeowners cash for the exempt amount, then use the rest to pay creditors. That, Shulman says, undermines the basic point of the bankruptcy code.
“It’s so people don’t just leave bankruptcy wearing a barrel,” says Shulman. “They should be able to get a fresh start with something.”
Instead, small-business owners who file for bankruptcy in states with low exemptions could lose both the roof over their head, and the financial security they thought they had been building. “That house is their life savings,” says Shulman.
According to John Rao, an attorney specializing in mortgage and bankruptcy issues for the NCLC, that makes it “very likely” that at least some business owners who need bankruptcy restructuring will not seek it. That will leave them with long-term personal liabilities, and could prevent them from rebuilding their businesses and bringing back the jobs they created.
The problem is partly a result of inertia and neglect. Some states, Rao says, have not adopted federal rules that keep the exemption in line with inflation, leaving its real value to wither over the years.
But in other cases, Shulman says, the problem has been actively prolonged by the banking and debt-collection industry. Shulman was part of a 2016 effort to expand California’s homestead exemption, which he says was actively opposed by lobbyists from those industries, and ultimately defeated.
Rao expects a ramp-up in efforts to reform state and federal homestead exemptions as coronavirus-related bankruptcies accelerate. Such efforts weren’t significant after the Great Recession, he says, because the crash in housing prices left many homeowners with little equity to protect. “This crisis is potentially much different, because home values haven’t dropped.”
More generally, Shulman thinks attitudes about bankruptcy are poised to change, potentially spurring more reform.
“People aren’t thinking of bankruptcy as something that people they know might need,” he says. “Coronavirus might bring that into focus, if people end up losing their homes because their businesses failed through no fault of their own.”
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