Bankruptcy Doctrine of Exoneration
The Doctrine of Exoneration is a principal of law that occasionally crops up in bankruptcy. It is one of the few ways that a spouse can get an equitable share of the family home in the event that the other spouse declares bankruptcy.
A typical scenario is that a couple uses equity in a property to consolidate debt that incurred in only one party’s name. This can be applied to a couple who have a joint mortgage and one party refinances their share of the property to pay out the debts of the “other party”. The most important consideration is that the money must be for the sole benefit of the “other party”. If both parties obtain a benefit from refinancing, then the Doctrine does not apply.
The idea is that a loan only for the benefit of “other party” should be paid out of their share of the debt, and the original party would take care of any subsequent shortfall.
Example: Mr X and his wife own a house. They borrow $25,000 for Mr X to build a business, of which Mrs X has no direct financial interest.
The Doctrine applies if it can be shown that Mrs X did not receive a benefit from the loan. The $25,000 used in Mr X’s business was used only for the benefit of Mr X, and therefore falls under the Doctrine.
Unless there is sufficient equity in the bankrupt parties’ share to pay out the debt, any equity that the other party would otherwise have received after a 50/50 split (or divided as appropriate) of the equity cannot be touched.
Jack and Jill own a house worth $200,000. Jack borrows $150,000 on credit cards in his name to set up his water delivery business, of which Jill has no financial interest. To reduce the interest, the couple consolidates the debt into the house. Soon after plumbing is installed in the town, Jack goes bankrupt. The Doctrine will not prevent the property from being sold; however, it does affect how much each party gets. The house sells for $200,000. How much money does Jill get?
At first glance in might appear that:
The property is sold for $200,000 minus the $150,000 for the debt = $50,000
The $50,000 is split evenly between the Jack and Jill. So Jill gets $25,000.
Jack and Jill are each entitled to a $100,000 share. Jack owes $150,000. Since Jill had no interest in the business, the loan will be taken from Jacks share first. $100,000 – $150,000 = -$50,000. This -$50,000 will then be taken out of Jill’s share, since she is responsible for the shortfall under the Doctrine of Exoneration. $100,000 – $50,000 = $50,000.
Jack gets $0, Jill gets $50,000.
Couples should carefully consider debt consolidation. In the above example, Jill would have walked away with $100,000 rather than $50,000 with a consolidation plan. The creditors would not have been able to pursue Jack for more than his share of the equity.