Saturday, August 23, 2014

Texas Homesteads Sold Post-Petition Take Another Hit

Texas bankruptcy judge Jeff Bohm has ruled that a chapter 7 debtor who sold his homestead over a year after filing bankruptcy could not keep the portion of the proceeds when he failed to reinvest them within six months.  In re Smith, 2014 Bankr. LEXIS 3344 (Bankr. S.D. Tex. 8/4/14).    The case concerns the intersection between bankruptcy law, which determines exemptions as of the petition date, and Texas law, which requires reinvestment to maintain the exemption and is part of a continued trend of homestead proceeds at risk

What Happened

 The Debtor filed a chapter 7 petition on March 20, 2012 and claimed his homestead as exempt.   No party objected to the exemption.   The Trustee did not close the case.   On June 21, 2013, the Debtor sold his homestead and received net proceeds of $813,935.77.    The Debtor did not reinvest the proceeds within six months.   On April 11, 2014, the Trustee filed an adversary proceeding seeking to recover the remaining homestead proceeds in the amount of $700,349.09 from the Debtor.   The Debtor filed a Motion to Dismiss.  

The Fifth Circuit and the Vanishing Exemption

The Fifth Circuit has two reported and one unreported decisions dealing with proceeds from sale of a homestead in bankruptcy.  In re Zibman, 268 F.3d 298 (5th Cir. 2001) involved a debtor who sold his homestead, then filed chapter 7 without reinvesting the sales proceeds.   The Fifth Circuit held that the Debtor's exemption was contingent on reinvesting the proceeds and allowed the trustee to recover the funds when they were not reinvested.  In Studensky v. Morgan, 481 Fed.Appx. 183 (5th Cir. 2012), a chapter 7 debtor sold his homestead and paid some of the proceeds to his brother.  When the Trustee sought to recover the funds, the Debtor amended his exemptions to claim the funds as exempt.  The Bankruptcy Court and District Court ruled that the proceeds were exempt, but the Fifth Circuit reversed.  In Frost v. Viegelahn, 744 F.3d  384 (5th Cir. 2014), a chapter 13 debtor sold his homestead during the pendency of the chapter 13 case and did not reinvest the proceeds.   Once again, the Fifth Circuit held that the Debtor lost the exemption when the proceeds were not reinvested.    I wrote about Frost here.  

The difficulty with cases allowing proceeds to lose their exempt status is that exemptions are determined as of the petition date.    An absolutist approach to the snapshot rule would say that if the homestead or the proceeds were exempt on the petition date, they left the estate and could not re-vest.   That is what many of us thought that Taylor v. Freeland & Kronz, 503 U.S. 638 (1992) meant.

However, both cases could be reconciled with the "snapshot" approach.   In Zibman, the asset to be exempted was the proceeds rather the homestead itself.   The exemption of proceeds was a conditional one which depended upon reinvesting them within six months.   As a result, the conditional nature of the exemption was not necessarily at odds with the snapshot.   Frost was a chapter 13 case.  In chapter 13, property which the Debtor acquires post-petition is included in the estate under section 1306(a).    Thus, Frost could have been decided based on section 1306, even though the opinion did not say this.   

Judge Bohm's Ruling

The Smith Trustee could not rely on either of these saving devices.    Because the Debtor had a homestead and not just proceeds on the petition date, the Trustee could not rely on the idea that proceeds were different than the actual property itself.    Because the case was a chapter 7, the after-acquired property provision of section 1306(a) did not apply.   Instead, the Trustee had to argue that a Texas homestead exemption was never really final and could be clawed back if the Debtor sold the property and didn't reinvest the proceeds.     The Trustee made this argument and the Court agreed with him.  

In denying the Motion to Dismiss, the Court ruled that the Six-Month Rule applied to a chapter 7 case and that on the 181st day, "title to the Proceeds automatically passed from the Debtor to the Trustee and the Debtor had a duty to turnover over the Proceeds to the Trustee."   Opinion, at *34.   The Court rejected the arguments that property once exempted remains exempt and that the six-month rule does not apply to chapter 7 cases.  

The Court held that the six-month rule did apply in a chapter 7 case based on the fact that the Frost case did not limit its effect to chapter 13 cases and because Zibman and Morgan applied the rule in chapter 7 cases.    The Court stated:

There is a further point undermining the Debtor's argument that Frost is limited to Chapter 13 cases: Frost never mentioned § 1306(a)(1) as the basis for its decision. Rather, the Fifth Circuit focused on § 41.001 of the Texas Property Code in rendering its ruling. The Debtor, and at least one outside commentator, seem to be at a loss to understand why the Fifth Circuit did not cite § 1306(a)(1) to justify its ruling in Frost and to limit the ruling to Chapter 13 cases. A review of certain pre-Frost opinions from the Fifth Circuit underscores why there should be no surprise that the Fifth Circuit, in Frost, did not use § 1306(a)(1) to limit its holding to Chapter 13 cases.

These two cases—Zibman and Morgan—thus underscore why the Fifth Circuit, in Frost, did not rely on § 1306(a)(1) to justify its holding in that case and to limit§41.001(c) to Chapter 13 cases. The Fifth Circuit had already held that the 6-Month Rule applies in Chapter 7 cases.
Opinion, at *25-26, 29.  

The Court went on to write:
This Court declines the Debtor's invitation to exempt the Proceeds from the bankruptcy estate on the basis that Frost is inapplicable to Chapter 7 cases. Rather, this Court is bound by Fifth Circuit precedent and concludes that Frost applies in this Chapter 7 case. Moreover, § 41.001 sets forth both the scope and limitations of a Texas homestead exemption, and the "snapshot rule" in bankruptcy law instructs courts to apply the law applicable at the time of the filing. As the Fifth Circuit in Zibman noted, when a debtor avails himself of the Texas homestead law, the debtor has to take the "fat with the lean." In re Zibman, 268 F.3d at 304. Here, the Debtor availed himself of the generous Texas homestead exemption, and is therefore bound by both its provisions and its limitations, including the 6-Month Rule. Accordingly, when the Debtor failed to reinvest the Proceeds in a new homestead within six months of selling the Property, the Proceeds lost their exempt status. The Debtor's argument of "once exempt, always exempt" is simply incorrect.
Opinion, at *35-36.

The Court sought to dispel the concern that trustees could lurk in the shadows indefinitely waiting for the Debtor to some day sell his homestead.
Does this Court's holding mean that Chapter 7 trustees can forever make a claim on the proceeds from the sale of a debtor's homestead after six months has passed without the debtor reinvesting those proceeds in a new homestead? The answer is no. Once a Chapter 7 case is closed, any property that the trustee has not administered at the time of closing is abandoned to the debtor under § 554(c). The effect of abandonment is that "the trustee is... divested of control of the property because it is no longer part of the estate... Property abandoned under [§] 554 reverts to the debtor, and the debtor's rights to the property are treated as if no bankruptcy petition was filed." (citation omitted).   For example, if the case at bar had been closed after the Debtor had sold the Property but before six months had expired, the Trustee would have automatically abandoned any future right to the Proceeds after the expiration of six months, and the right to the Proceeds would have reverted to the Debtor on the date of the closing of the case.
 Opinion, at 32-33.

Thus, the Court held that even if the property is properly claimed as exempt and no party objects, the exemption allowed is a conditional one.   If the Debtor sells the property and does not reinvest the proceeds within 180 days while the case remains open, the exemption evaporates.  

What Does It Mean?

I am the outside commentator referenced in Judge Bohm's opinion.   I had argued that the Fifth Circuit should have clarified the Frost decision to limit it to the chapter 13 context.   I had previously written:
The Fifth Circuit might want to take another look at this one.   For one thing, the opinion completely fails to appreciate the case's unique procedural posture which could have provided a more coherent basis for the Court's ruling.  It also seems to fumble the intersection between the Bankruptcy Code and Texas exemption law.   This could result in major mayhem in future cases.
This was a chapter 13 case.   As a result, property acquired post-petition is included in the estate.   11 U.S.C. Sec. 1306.   The proceeds from sale of the homestead could have been analogized to property acquired post-petition which would only be exempt if re-invested in a new homestead within six months.    As a result, the timing that would matter is whether the homestead was sold during the case or subsequently.    The expanded definition of property of the estate in a chapter 13 case could justify the result in the Frost case.   However, this was not discussed by the Court.  How would it be applied in a chapter 7 case?    Judge Tony Davis rejected the application of Zibman to a post-petition sale of a homestead in a chapter 7 case in a well-reasoned opinion in In re D'Avila, 498 B.R. 150 (Bankr. W. D. Tex. 8/21/13), which can be found here.   Hopefully the Circuit would agree with Judge Davis when faced with a Chapter 7 case.    However, like I said, the Frost decision does not make this clear.
My concern that Frost could result in "major mayhem in future cases" appears to have come true.  Judge Bohm followed what he considered to be binding precedent.   I would have distinguished Zibman and Frost based on Taylor v. Freeland & Kronz, 503 U.S. 638 (1992) where the Court stated:
Davis claimed the lawsuit proceeds as exempt on a list filed with the Bankruptcy Court. Section 522(l), to repeat, says that "unless a party in interest objects, the property claimed as exempt on such list is exempt." Rule 4003(b) gives the trustee and creditors 30 days from the initial creditors' meeting to object. By negative implication, the Rule indicates that creditors may not object after 30 days "unless, within such period, further time is granted by the court." The Bankruptcy Court did not extend the 30-day period. Section 522(l) therefore has made the property exempt. Taylor cannot contest the exemption at this time whether or not Davis had a colorable statutory basis for claiming it.

Deadlines may lead to unwelcome results, but they prompt parties to act and they produce finality. In this case, despite what respondents repeatedly told him, Taylor did not object to the claimed exemption. If Taylor did not know the value of the potential proceeds of the lawsuit, he could have sought a hearing on the issue, see Rule 4003(c), or he could have asked the Bankruptcy Court for an extension of time to object, see Rule 4003(b). Having done neither, Taylor cannot now seek to deprive Davis and respondents of the exemption.
Taylor, at 644.   In my view, Taylor mandates the "once exempt, always exempt" position advocated by the Debtor and rejected by Judge Bohm (among others).

In Zibman, the Debtor sold their home on November 27, 1998 and filed bankruptcy on February 9, 1999.   They claimed the proceeds from sale of their homestead as exempt.  The Court extended the deadline to object to exemptions until July 6, 1999.   The Trustee filed a timely objection to exemptions on June 3, 1999.    Thus, Zibman was not a failure to object case.    It was simply a case where the Trustee filed a timely exemption to funds which had lost their exempt status as of the date of the objection.  

Frost was more complicated for the reason that the Trustee did not object to the exemptions but at least raised the six month deadline in a written pleading before the deadline had run.    The Debtor filed a chapter 13 petition on November 30, 2009.    He claimed his homestead as exempt at that time.    On March 3, 2010, the Debtor filed a Motion to Sell Property Free and Clear of Liens.   This motion was filed after the exemption had become final.    The Trustee filed a timely objection to the Motion to Sell Free and Clear.    The Trustee argued that "if Debtor is not using proceeds to purchase a new home within the six month exemption period, the proceeds should be paid into the plan to increase the base."    On March 26, 2010, the Court approved the sale but ordered the remaining proceeds deposited with the Chapter 13 trustee.    On January 3, 2011, in connection with the Debtor's proposed chapter 13 plan, the Court released $40,000.00 to the Debtor and allowed the Trustee to retain sufficient funds for a 100% distribution to creditors.   On May 11, 2011, the Court entered a Final Order Regarding Trustee's Objection to Debtor's Motion to Sell Real Property Free and Clear of All Liens and Interests.   The Court ruled that the Debtor would be granted six months to reinvest the $81,108.67 proceeds into a new homestead beginning on January 27, 2011 minus $23,000.00 which had already been spent by the Debtor for non-homestead purposes.   The Debtor moved to vacate the order based upon Taylor v. Freeland & Kronz.   The Court denied this motion and the Debtor appealed.   The Court of Appeals affirmed the Bankruptcy Court's ruling on murky grounds.
While I was troubled by Frost, it can be explained away on several grounds that are at least plausible (even if they are not necessarily compelling).     First, Frost was a chapter 13 case.    Under 11 U.S.C. Sec. 1306, post-petition property, such as homestead proceeds which are not reinvested, are added to the estate.   Second, the Debtor sought the benefits of chapter 13 in order to obtain time to sell his home.    The Chapter 13 Trustee, Mary Viegelahn, essentially argued that if the Debtor wanted to get the benefits of Chapter 13 that he should have to either reinvest the proceeds as provided by Texas law or use them to provide a 100% plan to his creditors.    If the Debtor didn't like that deal, he could have simply exercised his absolute right to dismiss his case and have sold his property outside of bankruptcy.    

However, Smith is the case which completely slides down the slippery slope.    Rather than looking for a clever distinction, Judge Bohm applied what he considered to be a straightforward reading of the precedent. The problem with Smith is that the Debtor will potentially lose his homestead proceeds due to the Trustee's two-fold inaction.   First, the Trustee did not object to the homestead exemption which duly became final.    Second, the Trustee left the case open while the Debtor proceeded to sell his home.    Had the Trustee closed the case, we wouldn't be having this discussion.   Instead, because the Trustee chose to lurk in the shadows waiting for the Debtor to make a mistake the Debtor will potentially lose one of the most valuable rights available to him under Texas law.    In my view, Judge Davis's opinion in  In re D'Avila, 498 B.R. 150 (Bankr. W. D. Tex. 2013) has the better side of the argument. 
Is the Proceeds Provision A Limitation or an Expansion on the Homestead?

I would like to throw out one more issue for discussion.   The recent cases interpreting the six months to reinvest provision have assumed that it was a limitation on the homestead exemption.  What if they are wrong?   What if it is actually an expansion of the exemption?   If the proceeds provision adds to the rights otherwise available, then it would be a mistake to consider it to be grounds for eviscerating the exemption.   In Frost, the Fifth Circuit stated that "a change in the character of the property that eliminates an element required for the exemption voids the exemption."    Opinion, p. 11.   Where did they get that from?   Section 522(l) states that "Unless a party in interest objects, the property claimed on the list is exempt."   It does not state that unless the property retains its character until the case is closed, it is exempt.  In my view, the Fifth Circuit has re-written the statute.

Protection of proceeds under Texas law is the exception rather than the rule.   The only provisions that I am aware of under Texas law are the six month provision allowing for reinvestment of homestead proceeds and the provision in the Insurance Code stating that proceeds from a life insurance policy are exempt.    Every other Texas exemption says that the thing itself is exempt.   Normally, when Texas exempt property is converted into cash, it loses its exempt character.   For example, current wages are exempt while money obtained from depositing your paycheck is not.   The six month provision adds to what would normally be exempt.   Your homestead is exempt and if you sell it, the proceeds remain exempt for six months.   During that six months, you can reinvest it in a new home or blow it on wild living.    Any money left over after six months becomes subject to claims of creditors.    Thus, homestead proceeds unlike wages deposited into the bank retain their exempt for an extended period of time.
The normal rule with exempt property is that once property is exempt, it remains exempt.  Section 522(c) and (l) state that whatever property is claimed as exempt is not liable for any claims that arose prior to the petition date.   What the Debtor does with the exempt property after it leaves the estate is irrelevant.  If the Debtor decides to sell his $50,000 Mercedes and use the money to pay living expenses while he stays home and plays video games, the money is still exempt because the asset giving rise to the proceeds left the estate.  

Under the rationale of Frost and Smith, no exemption is final until the case is closed.   If the Debtor has a yard sale and sells his used yard furniture, that money belongs to the Trustee.   If the Debtor wrecks his car and receives a check from his insurance company, that money is not exempt and belongs to the Trustee.   This is madness because it means that there would never be any finality to any exemption ever.    

Let's go back to Taylor v. Freeland & Kronz.   In that, case the Debtor claimed something that was not exempt and no one made a timely objection.   The Supreme Court said sorry, you missed your chance to object.   However, under Frost and Smith, property only remains exempt if it retains its exempt character throughout the case.   As a result, property that should never have been claimed as exempt could be recovered at any time.    In my opinion, there is a serious problem with using a provision intended to grant additional protection to homesteads to gut the homestead exemption.   This is wrong, wrong, wrong and someone (other than me) needs to say so.        

Final Thoughts

I have known Judge Bohm since he was in private practice in Austin.  He is a very smart guy with a lot of integrity.   While I have been free about disagreeing with him here, opinions of judges have more weight than opinions of bloggers.   Judge Bohm did not engage in judicial activism, but rather tried to follow in the direction the Circuit was pointing.    The error comes from above and that's where it needs to be remedied. In my view, the Circuit has dangerously drifted away from the principle of finality in exemptions and should give this issue another look.   Seriously, Fifth Circuit, I'm saying this as a friend.   


Patrick Hughes said...

My heart agrees with you Steve, but my head says that proceeds are fungible, and also not a place of shelter that serves what the purpose of the exemption intends to protect. Also, if the state intended that proceeds were exempt forever they can say that. Seems like an alternate fix is to get the state legislature to modify the property code to make it clear that 6 months is now infinity, regardless of reinvestment. That serves the intention of the exemption by affording bankrupts the means to obtain shelter when circumstances now, v the 1800s, entail a mobile society where selling a residence over a lifetime is the norm, not the exception. Keep up the commentary. Always great food for though.

Ron Satija said...

great writing as usual, but I agree with Judge Bohm and the Circuit on this one!