Tuesday, August 24, 2010

Bad News for the Non-Filing Spouse

Frequently it makes sense for only one spouse to file bankruptcy. Where the husband has wracked up large business debts in his name only and the wife has significant separate property or sole management property, the husband can file bankruptcy without bringing the wife's non-joint assets into the estate. This allows a certain amount of double-dipping. The husband can claim his assets and the joint assets as exempt and the wife can keep her non-estate assets as well. While this will benefit the couple 99% of the time, two recent cases show a downside for the non-filing spouse.

In Kim v. Kim, No. 3:09-CV-1082-N (N.D. Tex. 8/11/10), which can be found here(PACER registration required), creditors filed an involuntary bankruptcy petition against Mr. Kim and then sought to limit his homestead exemption under 11 U.S.C. Sec. 522(p) for the reason that the property had been acquired within 1,215 days before bankruptcy. As a result, the debtor's homestead exemption was limited to $136,875. Had the spouse joined in the bankruptcy, the couple would have been entitled to double this amount. Instead, Mr. Kim filed a declaratory judgment action against Mrs. Kim to determine whether her homestead interest in the property (1) precluded sale of the property by the estate and (2) whether she was entitled to compensation for her interest. The Petitioning Creditor intervened and opposed the relief.

The Bankruptcy Court granted summary judgment in favor of the Petitioning Creditor and the District Court affirmed. The District Court found that bankruptcy law preempted Texas state homestead law. Because the homestead was joint community property, it became property of the estate. Because it became property of the estate, bankruptcy law determined the extent to which it could be exempted. The result for Mrs. Kim was that the involuntary bankruptcy petition, to which she was not a party, diminished her homestead rights. Not only that, but because she remained outside of the bankruptcy proceeding, the couple received only half of the homestead protection they would have otherwise had under Sec. 522(p).

One of the cases relied upon by the Kim court was In re Douglass, 2008 WL 2944568 (Bankr. W.D. Tex. 2008)(a case that I am intimately familiar with because I was on the losing side). In that case, the husband filed chapter 13. He made a tactical decision not to claim the homestead as exempt. Instead, he argued that the house was contaminated and was worth no more than the value of the land. Because the house was not being occupied as a residence, he was successfully able to cram down the value on the house. Had the case proceeded to discharge, the couple would have been able to retain the house. However, mid-way through the case, the wife moved back into the house and the husband sought to sell the home and pay off his chapter 13 plan early. The parties agreed to allow the sale of the home and to fight over the proceeds. The Bankruptcy Court ruled that (1) the wife was not entitled to any compensation for her homestead rights under Texas law and (2) the wife had failed to establish a separate property interest in the home. (She had provided the down payment for the home from her separate property).

Had the husband not filed bankruptcy, he could not have sold the property without the wife's consent. Therefore, the husband's filing divested the wife of a valuable right without her consent. Of course, if the husband had not filed bankruptcy, the property would have been foreclosed upon and the wife would have lost her interest.

These two cases are a powerful cautionary that sometimes the decision to remain outside of the bankruptcy can have negative consequences for the non-filing spouse. While it may seem unfair, it is a simple matter of reading Sec. 541(a)(2) which includes all joint management community property in the estate.

Hat Tip to Howard Mac Spector for sending me the Kim case.

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