Strategies to prevent creditors attacking the family home

For many individuals, their family home will represent their most valuable asset, both financially as well as for sentimental reasons. Therefore, it is important to consider strategies to ‘protect’ the family home, particularly in cases where these are owned by a ‘high-risk’ family member (e.g., an individual carrying on a business) whose personal assets (including their family home) can be exposed to potential claims in the event they become bankrupt. 

Where an individual faces bankruptcy, most of the assets that they own (including their family home) will vest in their trustee in bankruptcy (‘the trustee’) and be divided by the trustee amongst the bankrupt’s creditors (such assets are known as ‘divisible property’). This general rule is subject to certain exclusions, which will be discussed later. 

In this regard, the notes discuss the general operation of the bankruptcy rules, strategies that an individual can undertake to protect their assets (including their family home) in the event they become bankrupt in the future, as well as the various benefits and risks that can arise when helping children to buy a home of their own. All legislative references are to the Bankruptcy Act 1966 (‘BA’), unless otherwise stated. 

1. General overview of the bankruptcy rules 

If an individual (i.e., the debtor) is unable to pay their debts or organise suitable repayment arrangements with their creditors, they may become bankrupt in one of the two following ways::

1. (a)  Debtor’s Petition (S.55) – Where the individual voluntarily lodges a petition to become bankrupt. This petition needs to be accompanied by a Statement of Affairs which sets out the particulars of their assets, liabilities and financial circumstances. 
2. (b)  Creditor’s Petition (S.43) – Where a creditor files a petition to have the individual declared bankrupt by order of the Court (this is known as a ‘sequestration order’). A Creditor’s Petition can only be lodged (and a sequestration order can only be made) where the individual has committed an ‘act of bankruptcy’ (refer to S.40). This broadly includes, from 1 January 2021, a failure to comply with a Bankruptcy Notice served by a creditor, within 21 days of the notice being served, in relation to a debt of at least $10,000. 

The main consequence of an individual becoming bankrupt is that most of their assets (including real property such as their family home, shares and other investments) will vest in their trustee in bankruptcy. It will then effectively be available for the trustee to realise (i.e., sell) (such assets are known as ‘divisible property’). Refer to S.58 and S.116. 

Proceeds from the realisation of divisible property will be used to by the trustee to repay as much of the bankrupt’s ‘provable debts’ (broadly, debts owed at the date of bankruptcy) as possible, on a proportionate basis (with special rules appliable to secured creditors, as discussed later). If the trustee is unable to fully repay provable debts (e.g., if the proceeds from realising divisible property are less than provable debts), the bankrupt is generally not liable for any shortfall upon their discharge from bankruptcy (i.e., such debts are referred to as having been ‘extinguished’). 

For completeness, it should be noted the Personal Property Securities Register (discussed elsewhere in the notes) does not apply to a bankrupt’s family home (as the register is not applicable to land, buildings or fixtures).

1.1 Are all assets belonging to a bankrupt ‘divisible property’? 

Certain assets are specifically excluded from being divisible property and, therefore, will not be divided by the trustee in bankruptcy amongst the bankrupt’s creditors. Refer to S.116(2). The table below provides a general overview of some of these exclusions. 

It is important to note that a bankrupt’s divisible property is not limited to assets that belonged to them (or were vested in them) at the commencement of their bankruptcy. These can also include assets that they acquired (or that devolved on them) during the term of their bankruptcy (i.e., between when their bankruptcy commenced and when they were discharged from bankruptcy), as well as certain other rights, powers, property or monies as prescribed in S.116. 

Furthermore, the bankruptcy rules contain what are known as ‘claw-back’ provisions, which broadly allow the trustee in bankruptcy to have a claim on assets belonging to a party other than a bankrupt, where these assets have been transferred to that party to put them outside the reach of the bankrupt’s creditors (these are discussed later in the notes). 

The bankruptcy rules also contain a number of other anti-avoidance provisions, which prevent (among other things) unfair preference payments being made in favour of an unsecured creditor, at the expense of other creditors in a bankrupt estate (these are outside the scope of the notes). 

1.2 Obligations and restrictions that apply to a bankrupt 

In addition to the above, a bankrupt will also be subject to a number of obligations and restrictions, as listed below (note that this is not an exhaustive list): 

1. (a)  They must comply with all requests made by the trustee in bankruptcy. This includes supplying all books, bank statements and other documents requested by the trustee. 
   
   
2. (b)  They must fully and truthfully disclose to the trustee all of their property and its value, and complete a Statement of Affairs which sets out details of their assets, liabilities and financial circumstances (note, in the case of a Creditor’s Petition, the Statement of Affairs must be filed within 14 days of being notified of a sequestration order). 
   
   
3. (c)  They must keep the trustee informed of any change in their circumstances, including a change in address, the receipt of an inheritance, the acquisition of new assets (e.g., a house or a car), any increases in income and the winning of any money or other prizes. 
   
   
4. (d)  They must disclose their bankruptcy if they ask for any form of credit in excess of the indexed amount (at the time of writing, this amount is $5,934). 
   
   
5. (e)  While the bankruptcy rules themselves do not prevent the bankrupt from being employed and earning income, certain professional and licensing organisations may suspend or cancel their membership or licence (or otherwise restrict or prevent them from continuing in that trade or profession), which may affect their ability to earn income. 
   
   
6. (f)  Where they earn income, they may be liable to make payments to the trustee if, broadly, their net (after-tax) income exceeds the indexed amount (at the time of writing, this amount is $59,031.70 for a bankrupt with no dependants). 
   
   
7. (g)  They cannot go overseas without first obtaining the permission of the trustee, and must surrender their passport to the trustee if requested to do so. 
   
   
8. (h)  They cannot dispose of any property that has vested in the trustee. 
   
   
9. (i)  They cannot act as a director or manager of a company without obtaining the Court’s permission, and cannot administer a trust account (e.g., as a solicitor or accountant). They are also not permitted to act as a trustee (or director of a corporate trustee) of an SMSF. 
   
   
10. (j)  Their credit rating can continue to be affected for a period of time following their discharge from bankruptcy (up until the later of two years from when the bankruptcy ends, and five years from the date of bankruptcy). 
    
    
11. (k)  A permanent record of their name and bankruptcy details will appear on the National Personal Insolvency Index (‘NPII’), which is a publicly accessible electronic register that provides information about particular insolvency proceedings in Australia (including bankruptcy). 

1.3 How long does an individual’s bankruptcy last for? 

A bankrupt will generally be automatically discharged from bankruptcy three years and one day from the date on which a Statement of Affairs is filed (note, this will be the case regardless of whether they have become bankrupt as a result of a Debtor’s Petition or a Creditor’s Petition). Refer to S.149. Upon a bankrupt’s discharge from bankruptcy, they will no longer be liable for most of their debts (provided these have been extinguished, as previously discussed). 

However, the general three-year bankruptcy period can be extended to five years (or eight years, in certain circumstances) if, broadly, the trustee in bankruptcy believes the conduct of the bankrupt to be unsatisfactory and objects to the bankrupt being discharged accordingly. Refer to S.149A. 

2. Application of the bankruptcy rules to the family home 

Given an individual’s family home is likely to constitute ‘divisible property’ (as discussed above), it can be exposed to potential claims in the event of their bankruptcy. 

To mitigate this risk, it is generally not advisable, from an asset protection perspective, for a family home to be owned by a ‘high-risk’ family member (e.g., a spouse who carries on a business and is exposed to a higher risk of bankruptcy). Instead, this should be owned by a ‘lower-risk’ member of the family group (common examples being a ‘low-risk’ spouse, a discretionary trust or a company). 

2.1 Will a bankrupt’s family home vest in their trustee in bankruptcy if the property is subject to a mortgage? 

Under the bankruptcy rules, both secured and unsecured assets belonging to a bankrupt can vest in their trustee in bankruptcy and be regarded as ‘divisible property’ (refer to S.58 and S.116). However, special rules apply in the case of secured assets (e.g., a bankrupt’s family home that is subject to a mortgage), which provide the following rights to a secured creditor (e.g., a bank)::

 1.  Right to enforce terms of security – The rights of a secured creditor to realise, or to otherwise deal with, their security are not affected by the vesting of the asset in the trustee in bankruptcy. Refer to S.58(5).

In the context of a bankrupt’s family home (where this is subject to a bank mortgage), the terms of the mortgage will dictate the bank’s rights with respect to the property. Generally, the bank will have the right to enforce the mortgage if the bankrupt falls behind in their mortgage payments. Notably, even if these payments are made on time, the bank may be able to enforce the mortgage if the act of bankruptcy itself constitutes a default under the terms of the mortgage. 

While this would generally mean the bank has the right to sell the bankrupt’s family home, in many cases, this task will, instead, be left to the trustee in bankruptcy. 

2. Priority to proceeds from the realisation of secured assets by the trustee in bankruptcy – Where a secured asset is realised, the debt owed to the secured creditor with respect to that asset ranks above that of other unsecured creditors. In the context of a bankrupt’s family home (where this is subject to a bank mortgage): 

• • If there is equity in the family home (i.e., if the value of the property exceeds the debt(s) secured against it) – Proceeds from the sale of the property will first be used to pay out the amount owed to the bank in full, with the remaining proceeds then used to repay the bankrupt’s other provable debts, on a proportionate basis. 

•If there is no equity in the family home (i.e., if the value of the property does not exceed the debt(s) secured against it) – Regardless of whether the property is realised by the trustee in bankruptcy or by the bank (where it has exercised its rights to sell the property), the bank (being the secured creditor) is entitled to the full proceeds of sale. 

Any shortfall (being the debt that is not covered by the sale proceeds) is provable in the bankruptcy, meaning the bank can effectively become an unsecured creditor in relation to that shortfall (because the secured asset, being the bankrupt’s family home that has been sold, no longer exists). In these circumstances, the bank will be entitled to a share of the realisation proceeds of other divisible property in the bankrupt estate (albeit on an equal rank with other provable debts of the bankrupt). 

2.2 Can a bankrupt retain their family home in a bankruptcy? 

There are a number of ways in which a bankrupt may be able to effectively retain ownership of their family home in a bankruptcy (regardless of whether this is subject to a mortgage or not), some of which are outlined below (note that this is not an exhaustive list). 

If a bankrupt’s family home is unencumbered (i.e., not subject to a mortgage), a related party such as a spouse may be provided the opportunity to buy the property back from the trustee in bankruptcy if they are able to raise sufficient funds to do so (e.g., through gifts from family members). In this regard, it is important to note the trustee’s obligations to act in the best interests of creditors and, therefore, it is not compelled to make or accept any such offer (e.g., a below market value offer is likely to be rejected). 

Alternatively, where a bankrupt’s family home is subject to a mortgage, a related party of the bankrupt (such as their spouse) may be able to buy the equity in the property (broadly, the excess of the property’s value over the debt(s) secured against it) back from the trustee in bankruptcy. 

Given this will result in the property continuing to be subject to a mortgage (and debt(s) continuing to be secured against it), the agreement of the mortgagee (i.e., the bank) must also be obtained when entering into any such arrangement with the trustee. Additionally, the trustee will be required to act in the best interests of creditors and, therefore, it is not compelled to make or accept any such offer (e.g., a below market value offer is likely to be rejected). 

Notably, even if there is no (or minimal) equity in a bankrupt’s family home (i.e., where the value of the property is less than, or approximately equal to, the debt(s) secured against it), there will remain a number of advantages associated with a related party of the bankrupt (such as their spouse) buying this back from the trustee in bankruptcy for a nominal amount (where this is agreed to by the trustee and the mortgagee). 

By doing so, the bankrupt will be able to effectively retain their family home in the bankruptcy. In addition, any further equity generated on the property (e.g., from an increase in the property’s value and/or from the making of mortgage repayments) will go to the entity acquiring the property (e.g., the spouse) and, therefore, be protected from the bankrupt’s creditors. 

2.3 How do the bankruptcy rules apply to a bankrupt’s family home that they jointly own with their spouse? 

In some cases, an individual may not be the sole owner of their family home but, instead, jointly own it with their spouse (whether as joint tenants or as tenants-in-common). 

If the individual becomes bankrupt, their share (or interest) in the family home will generally vest in their trustee in bankruptcy, with the trustee (together with the non-bankrupt spouse) becoming tenants-in-common in relation to the property. This interest can be realised by the trustee, with the proceeds of realisation divided amongst the bankrupt’s creditors accordingly. 

In realising the bankrupt’s interest in their family home, the trustee will generally provide an opportunity to the non-bankrupt spouse (being the co-owner of the property) to acquire the interest at market value. In this regard, if the property is unencumbered (i.e., not subject to a mortgage), ‘market value’ will typically represent the bankrupt’s proportionate interest in the market value of the property itself. Alternatively, if the property is subject to a mortgage, ‘market value’ will generally refer to the bankrupt estate’s proportionate interest in equity in the property (being the market value of the property less debt(s) secured against it).

In certain circumstances, there may be an opportunity for a reduction in the amount that a non- bankrupt spouse would otherwise be ordinarily required to pay to acquire a bankrupt estate’s equity in a jointly owned family home (i.e., where the equitable principles of the ‘doctrine of exoneration’ apply). 

In basic terms, these principles dictate that, where borrowings against a jointly owned property (e.g., of a bankrupt and non-bankrupt spouse) are applied for the use of only one of these parties (e.g., the bankrupt) without benefit to the other (e.g., the non-bankrupt), they are to be satisfied from the benefiting party’s (e.g., the bankrupt’s) share of the property first. The non-benefiting party (e.g., the non-bankrupt) is merely considered a guarantor whose share in the property is used to meet any shortfall. 

In these circumstances, the doctrine of exoneration can have the broad effect of reducing a bankrupt spouse’s share of equity in a jointly owned family home and, therefore, the amount that a non-bankrupt spouse will need to pay to acquire their interest from the trustee in bankruptcy. 

In the event a non-bankrupt spouse is unable (or unwilling) to buy a bankrupt’s interest in the family home, the trustee in bankruptcy can seek a court order to force the sale of the entire asset (including the sale by the non-bankrupt spouse of their proportionate interest in the property). Any proceeds of sale will then be split between the trustee and the non-bankrupt spouse accordingly (after the mortgage and other relevant expenses have been accounted for). 

In some cases, the trustee in bankruptcy may decide not to immediately sell a bankrupt’s family home. Rather, it will retain it with the view to selling it at a later date (generally, this will be the case where there is little advantage in seeking an immediate sale of the property because it is subject to a mortgage for which the bankrupt has no (or minimal) equity, and the decision is made to try to sell the property at a later date once additional equity has been generated). 

Importantly, if the property is yet to be sold when the bankrupt is discharged (i.e., when their bankruptcy comes to an end), the trustee in bankruptcy’s interest in the property does not immediately re-vest in the bankrupt at this time. 

Instead, the interest remains vested in the trustee for a further six years (with a longer period applying if, broadly, the bankrupt had not properly disclosed the property to the trustee in a Statement of Affairs). Refer to S.129AA. Any proceeds from the sale of the property during the additional vesting period (generally, six years) will belong to the trustee to the extent of its property interest and be divided amongst the bankrupt’s creditors accordingly.

2.4 Can the family home be at risk where it is not owned by a ‘high-risk’ spouse who is bankrupt? 

There are a number of provisions within the BA (known as the ‘claw-back’ provisions), which broadly allow the trustee in bankruptcy to have a claim on assets belonging to a party other than a bankrupt, where these assets have been transferred to that party to put them outside the reach of creditors. 

In this regard, the following discussion examines, in general terms, some of the common ‘claw- back’ provisions (contained in S.120 and S.121) that can apply in the context of a family home. 

2.4.1 Undervalued transactions (S.120) 

The ‘claw-back’ provision in S.120 will apply to a transfer of the family home by an individual (who subsequently becomes bankrupt) to another party where: 

• the transfer took place any time up to five years before the commencement of the bankruptcy; and 
• the transferee gave below market value (or no) consideration for the transfer. The standard five-year ‘claw-back’ period (discussed above) may be reduced to four years (for a transfer to a related party) or two years (for a transfer to an unrelated party) provided the transferee can prove that, at the time of transfer, the individual (i.e., the transferor who subsequently became bankrupt) was solvent. Note, a bankrupt would generally be presumed insolvent for these purposes unless sufficient records have been maintained that demonstrate their solvency at this time. Refer to S.120(3A). 

Where the ‘claw-back’ provision in S.120 applies, the transfer of the family home is void against the trustee in bankruptcy (in basic terms, this means an order can be made for the property, or an amount equal to its value, to be transferred back to the trustee by the transferee). 

To the extent some consideration was provided by the transferee for the property (albeit less than market value), this amount must be refunded to them by the trustee. Refer to S.120(4). Importantly, note that, as the refundable amount is equal to the consideration provided by the transferee for the property, this amount is not affected by any changes in the value of the property following its transfer. In other words, the refund amount will remain the same even if the property’s value has increased since being transferred by the bankrupt to the transferee. 

2.4.2 Transfers to defeat creditors (S.121) 

A further ‘claw-back’ provision that can apply with respect to a transfer of the family home by an individual (who subsequently becomes bankrupt) to another party is contained in S.121. As with S.120 (refer above), a transfer to which S.121 applies is void against the trustee in bankruptcy, and any consideration provided by the transferee is refundable to them by the trustee. 

For S.121 to apply to the transfer, both of the following conditions must be met: 

1. (a)  The transferred asset (e.g., the bankrupt’s family home) would probably have become part of the bankrupt estate (or been available to creditors) had it not been transferred. 
2. (b)  The main purpose in transferring the asset was to prevent it from becoming divisible, or to hinder/delay the process of making it available for division, amongst the bankrupt’s creditors. 188/5000

Importantly, if S.121 applies, the trustee in bankruptcy can trace back as far as necessary to determine the application of this ‘claw-back’ provision to a particular transaction involving a bankrupt (i.e., there is no statutory time limit that applies to S.121, unlike with S.120). 

For example, in the case of Trustees of the Property of John Daniel Cummins v Cummins [2006] HCA 6 (‘Cummins’ case’), the High Court held that the transfers of various assets by an individual (Mr Cummins) to related parties 13 years before his bankruptcy (which arose from substantial tax debts owed to the ATO) were void against the trustee in bankruptcy under S.121. 

This was because, although these debts had not been raised by the ATO at the time of the transfers, Mr Cummins was aware that he had built up substantial tax liabilities over many years which the ATO would likely assess once it became aware of them. Accordingly, the High Court concluded that Mr Cummins’ main purpose in making the transfers was to prevent the transferred assets from being divisible amongst his creditors (the largest of which was the ATO). 

Another key characteristic of S.121 is that this can apply even if the transferor was solvent at the time of the transfer and even if the transfer occurred for market value consideration. That is, the application of S.121 relies upon whether it can reasonably be inferred that, at the time of the transfer and based on all the circumstances, the bankrupt was, or was about to become, insolvent. This is because the bankrupt is deemed to have had a main purpose of transferring the asset to defeat creditors in these circumstances. Refer to S.121(2). Note, for these purposes, a bankrupt would generally be presumed insolvent at the time of the transfer unless sufficient records have been maintained that demonstrate their solvency at this time. Refer to S.121(4A). 

A further consideration with respect to S.121 is the ‘good faith’ exception contained in S.121(4). Under this exception, a transfer of the family home from a bankrupt to another party will not be subject to S.121 provided: 

• the transferee has provided at least market value consideration for the property; 
• the transferee did not know, and could not reasonably have inferred, that the bankrupt’s main purpose in transferring the property was to prevent it from becoming divisible (or to hinder/delay the process of making it available for division) amongst the bankrupt’s creditors; and 
• the transferee could not reasonably have inferred that, at the time of the transfer, the bankrupt was, or was about to become, insolvent.

At a practical level, the ‘good faith’ exception will only be applicable to an arm’s length transferee (as it would not generally be possible to argue that a related party transferee was unaware that a bankrupt was, or was about to become, insolvent). 

Disclaimer

This content is intended for general information in summary form on tax and legal matters at the time of first publication and is not intended to provide, and should not be relied upon in place of appropriate professional advice.  Please consult your tax, legal and accounting advisors before acting or relying on any content provided. 

References
https://ntaa.com.au/seminar/172ADDB5-2438-EB11-8106-005056A67392&os=true