District Court Rules that Proceeds of a Texas Homestead Sold Post-Petition Lose Their Protection After Six Months in a Chapter 7 Case

Overruling a bankruptcy court decision, a District Judge in the Western District of Texas has ruled that proceeds from sale of a homestead can be recovered if not timely reinvested in a Chapter 7 case.   The Court ruled that the Frost decision applied equally in both a Chapter 13 and a Chapter 7 setting.   Lowe v. DeBerry, No. 5:15-cv-1135-RCL (W.D. Tex. 3/10/17).    The opinion can be accessed through PACER here.    The opinion raises serious questions about whether an exemption can ever be truly final.

What Happened

The Debtors filed for Chapter 7 bankruptcy relief on February 10, 2014 and claimed their Texas homestead as exempt.    No party in interest objected.   On September 12, 2014, the Debtor filed a motion for permission to sell the homestead.   The Court granted the motion but found that nothing prohibited the Trustee from seeking to claw back the funds to the extent that they were no longer exempt under Tex. Prop. Code Sec. 41.001(c).

Rather than investing in a new homestead, the Debtor paid $50,000 to his criminal attorneys and deposited the remaining funds in accounts in the name of the Debtor's spouse.   When the funds were not reinvested in a new homestead within six months, the Trustee sued the Debtor, his spouse and the attorneys.   The Bankruptcy Court dismissed the action,  relying upon In re D'Avila, 498 B.R. 150 (Bankr. W.D. Tex. 2013).    The Bankruptcy Court's opinion can be found here.

However, on appeal, Judge Royce Lamberth reversed.

The District Court's Ruling

The District Court found In re Smith, 514 B.R. 838 (Bankr. S.D. Tex. 2014), an opinion by Bankruptcy Judge Jeff Bohm, to be persuasive.   The Court wrote:

This Court finds persuasive the reasoning of the Smith court and holds that Frost applies in Chapter 7 cases such as this one. First, nothing in Frost itself limits its holding to Chapter 13. Chapter 13 is not mentioned at all in the opinion, nor are any Chapter 13 provisions relied on by the court in coming to its conclusion. The only section of the Bankruptcy Code examined by the Frost court is Section 522, which applies to both Chapter 7 and Chapter 13 cases. The court found that interpreting Section 522(c) under Zibman to mean that "the failure to reinvest the proceeds within six months voided the proceeds exemption, regardless of whether the sale occurred pre- or post-petition" was in accordance with the policies underlying the Texas Proceeds Rule. See Frost, 744 F.3d at 388. There is no indication that Section 522 was or should be interpreted differently based on whether a case is brought under Chapter 7 or 13.

In addition, the Frost opinion analyzes Section 41.001 of the Texas Property Code, finding that when the debtor "sold his homestead, the essential character of the homestead changed from 'homestead' to 'proceeds,' placing it under section 41.001(c)' s six month exemption. Because he did not reinvest those proceeds within that time period, they are removed from the protection of Texas bankruptcy law and no longer exempt from the estate." Frost, 744 F.3d at 387 (emphasis added). Again, there is no indication that this provision of Texas law should be applied differently in Chapter 7 cases.

Furthermore, the Court finds that the snapshot rule, as explained in Zibman, directs the same outcome even where the homestead is sold post-petition. As explained by the Smith court, the Texas  homestead exemption contains an explicit exception: although the homestead is exempt, and the proceeds from a sale of the homestead retain that exemption temporarily, the sale proceeds lose their exempt status if not reinvested within six months. See Smith, 514 B.R. at 847-48.

Zibman instructs that "it is the entire state law applicable on the filing date that is determinative" and that "[c]ourts cannot apply a juridical airbrush to excise offending images necessarily pictured in the petition-date snapshot." In re Zibman, 268 F.3d at 304. The state law here Section 41.001 of the Texas Property Code contains the following "inextricably intertwined" and "integral component": if the homestead sale proceeds are not reinvested in another homestead within six months, they lose their status as exempt. See Id. at 300, 304. At the time of the petition "snapshot" in this case, the debtor had claimed the Texas homestead exemption, which necessarily includes the six month sale proceeds limitation. As the Smith court found, "on the date of the filing of the [d]ebtor's Chapter 7 petition, the property of his bankruptcy estate included a non-exempt asset that was both prospective and contingent; namely, all proceeds from any future sale of [his homestead] that the [d]ebtor did not use within six months of the sale to purchase a new homestead." Smith, 514 B.R. at 848 (emphasis added).

Finally, the Court finds that the policy goals underlying the Texas statute direct this result. Although the Texas homestead exemption seeks to prevent homelessness, the six month period during which the proceeds remain exempt is meant "solely to allow the claimant to invest the proceeds in another homestead, not to protect the proceeds, in and of themselves." England, 975 F.2d at 1174-75  emphasis added). The termination of exemption after six months thus "reflects the Texas legislature's attempt to balance two competing public policies the need to minimize homelessness versus the need to afford creditors the opportunity to collect on their debts." Smith, 514 B .R. at 843. Allowing a Chapter 7 debtor to retain the proceeds of a homestead sale in direct contravention of Section 41.001(c) would defeat such a policy and produce inequitable results, particularly when Chapter 13 debtors in identical situations are not permitted to retain such proceeds. It would effectively read the six month limitation out of the statute in Chapter 7 cases.

For these reasons, the Court finds that Frost applies to Chapter 7 cases and that where a debtor claims his homestead as exempt under Section 41.001 of the Texas Property Code, then sells that homestead post-petition and fails to reinvest the proceeds in another homestead within six months, the homestead proceeds lose their exempt status and become part of the bankruptcy estate reachable by the trustee. The Court therefore finds that the Bankruptcy Court erred in holding otherwise and will reverse the decision of the Bankruptcy Court. 

Opinion, pp. 17-20.

Why I Think the Court Got It Wrong

Generally, I try to explain decisions and how they fit within the law without editorializing.   I make an exception when I think that a case has gone terribly wrong and this is one such case.   I will start by deconstructing the District Court's reasoning.    

1.    Frost never says that it only applies to chapter 13 cases.   The Court is absolutely correct here.  However, the Frost decision only makes sense in light of Section 1306 which provides that after-acquired property becomes property of the Bankruptcy Estate.   In chapter 7 cases, there is a clean break between pre-petition and post-petition.   Property acquired post-petition can never be property of the estate unless it is an inheritance acquired within 180 days after the petition or proceeds from property of the estate.

So, why wouldn't proceeds from sale of a homestead fit within the exception for proceeds from property of the estate?   This is because when property is exempted, it is no longer property of the estate.  See Law v. Siegel, 134 S.Ct. 1188, 1192 (2014); Rousey v. Jacoway, 544 U.S. 320, 325 (U.S. 2005);  Taylor v. Freeland & Kronz, 503 U.S. 638, 645 (U.S. 1992).   Section 541(a)(6) does not apply to proceeds from exempt property.   Once property becomes exempt, it can't come back into the estate.   Or, in the words of Neil Young, "once you're gone, you can't come back, when you're out of the blue, and into the black."     

2.   When proceeds are not re-invested within six months, they are removed from the protection of Texas bankruptcy law.  No.  In is in and out is out.   Once an asset leaves the estate, it can't be yanked back in.   Let's look at other ways that property can leave the estate.   If the Trustee abandons an asset and the notice becomes final and non-appealable, the Trustee cannot say King's X, I made a mistake.  The Trustee could possibly move to set the abandonment aside under Rule 60(b).   However, that is not available with exemptions because of the 30 day period to exempt.    If property is sold under section 363, the Trustee can't change his mind and claw the property back.   Why should exempt property be any different?

3.   Under Texas law, proceeds are only exempt on a temporary basis.   This argument really misunderstands the Texas exemption.   The exemption for proceeds is an expansion of the homestead exemption, not a limitation.   Most exempt assets lose that status immediately when they are converted into another form.   For example, my paycheck is exempt as current wages until the moment it is deposited into my bank account.   At that point, it becomes non-exempt cash.   If I sell my car instead of trading it in, the proceeds are not exempt.   Proceeds from sale of a homestead receive extra protection under Texas law.  Further, the asset that was exempted here was the homestead and not its proceeds.  If the asset claimed as exempt was proceeds, as in the Zibman case,  I think it's appropriate to apply the limitation.   However, if the asset claimed as exempt was the homestead itself, this asset is not time limited and is forever removed from the estate. 

The DeBerry Court and the Smith Court make two fundamental errors here.  First, they ignore the fact that once an exemption is final, the property leaves the estate for all purposes.   Second, they construe an expansion of an exemption as a limitation.    Under their rationale, a chapter 7 trustee could demand that a debtor turn over every paycheck received for the rest of his life because the paychecks ceased to be exempt once they were received.  

4.  The policy underlying Texas law supports this result.   The policy may, but the law does not.  The Texas Proceeds Rule allows a debtor who is not in bankruptcy carte blanche to use the proceeds for six months or until he acquires a new homestead.   If the debtor deposits the proceeds into the bank and does nothing for six months, then his creditors could attach them.   However, let's say the debtor spends the money on lottery tickets and a round the world cruise.  Those funds do not become non-exempt at the end of six months; they are simply gone.    Texas could have written a law that that proceeds from sale of a homestead are exempt, but only if they are invested in another homestead, but they did not.  Instead, it said that the proceeds themselves were exempt for six months or until the debtor acquired a new homestead.   This is an important distinction.

What Happens Next?

The District Court's order reversed and remanded the case.   If the defendants wish to appeal further, they will need to request permission for an interlocutory appeal.   I hope that they do so because the Fifth Circuit needs to clean up the mess that it has made of Texas exemption law.  If the Fifth Circuit finds that it cannot distinguish Frost, then it needs to reverse the decision on the en banc level because it is just wrong when applied outside of the chapter 13 context.    If the case goes up to the Fifth Circuit, I suspect there will be multiple amici willing to help them sort through the issues.

UPDATE:

There were in fact amici willing to weigh in on this issue.   Prof. Christopher Bradley, Michael Baumer, retired Judge Leif Clark and I filed an amicus brief.   The Fifth Circuit reversed the District Court and reinstated Judge Gargotta's decision.