Beware the Living Trust! You May Lose Your Homestead

A living trust is a legal document that states who you want to manage and distribute your assets if you're unable to do so, and who receives them when you pass away. Having one helps communicate your wishes so your loved ones aren't left guessing or dealing with the courts.

This is what Legal Zoom says about Living Trusts.   What it does not say is that unless a living trust is set up properly, it can result in loss of the Texas homestead exemption as the Debtor found out in Case No.  18-50102, In re Steven Jeffrey Cyr (Bankr. W.D. Tex. 7/16/19) which can be found here.

Fifth Circuit Goes Further Down the Disappearing Exemption Rabbit Hole

In yet another blow to the finality of exemptions, the Fifth Circuit has ruled that a chapter 7 debtor who claimed an IRA as exempt but later withdrew the proceeds must pay the funds to the trustee.   Engelhart v. Hawk (Matter of Hawk), No. 16-20641 (5th Cir. 7/19/17).    The decision follows on the Court's ill-conceived Frost opinion and raises the specter that no exemption can ever be final.   (I am abandoning my usual stance of editorial neutrality to come out and say I think this is a terribly bad decision).   

What Happened

Gregory Hawk filed chapter 7 bankruptcy and Eva Engelhart was appointed trustee.   Hawk claimed an IRA account with over $133,000 in it as exempt.   No party objected to the exemption within the period allowed by the bankruptcy rules.   The Trustee filed a no-asset report.   However, a creditor objected to the Debtor's discharge.   In the course of discovery, the creditor learned that the Debtor had withdrawn most of the funds shortly after filing bankruptcy and had used them to pay living expenses.    The Trustee filed a motion for turnover.   The Bankruptcy Court ordered that all of the funds be turned over to the Trustee on the basis that they lost their exempt status when they were not reinvested into a new IRA.  The District Court affirmed.

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.

Non-Filing Spouse Suffers Another Texas Homestead Loss

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA") capped the amount of a homestead exemption which could be claimed by a debtor that acquired a homestead within 1,215 days prior to bankruptcy.    Currently, the amount of the cap, as set by 11 U.S.C. Sec. 522(p), is $160,375 in equity per debtor.  This cap has resulted in a seismic shift in Texas where the unlimited homestead exemption is part of the State Constitution.   Now debtors' attorneys must learn how to count to 1,215 and calculate the allowable equity before filing a bankruptcy petition. However, what of the case where only one spouse files?   The short answer is that all community property enters the bankruptcy estate and that the cap is based on the one spouse that filed.   This means that the non-filing spouse can be involuntarily divested of her otherwise sacrosanct homestead interest.    The Fifth Circuit has now ruled on three different variations of this scenario and in each case, including the recent decision in Wiggains v. Reed  (Matter of Wiggains), No. 15-11249 (5th Cir. 2/14/17), which can be found here, the non-filing spouse has come up short.

Current Developments in Texas Homestead Law

            For this post, I attempted to find every Texas case dealing with a homestead exemption during the period between 2010 and 2015.     Many more cases interpreting the Texas constitutional and statutory laws on homesteads are decided in bankruptcy courts than in reported state court opinions.
 

Second Western District Judge Finds Proceeds From Post-Petition Sale Can't Be Clawed Back in Chapter 7

After sorting through conflicting precedents, Judge Craig Gargotta has ruled that a chapter 7 debtor who owned a homestead property on the date of bankruptcy and claimed the property as exempt did not lose the exemption when the property was sold and proceeds were not reinvested within six months.    Lowe v. DeBerry (In re Deberry), Adv. No. 15-5054 (Bankr. W.D. Tex. 10/28/15).

Fifth Circuit Report: August-September 2015

The summer months have been slow at the Fifth Circuit.   August and September's opinions include an update on a prior opinion about abstention related to a chapter 15, judicial estoppel, mootness of an appeal of a sale order, a motion to compromise, removal of a trustee, recognition of a foreign judgment and issues relating to a homestead.
 

Texas Judges Explore State Law on Liens and Homestead Exemptions

Much state law regarding liens and property rights emerges from the Bankruptcy Courts because they are frequently the first to confront novel issues.   Two recent opinions from the Western District of Texas bankruptcy judges confirm this trend.   In one case, Judge Tony Davis found that an option to acquire a leased homestead could be claimed as exempt, No. 14-11006, James Wayne See (Bankr. W.D. Tex. 7/14/15), while in the other, Chief Judge Ronald King rejected an attempt to void a judgment creditors' lien under the Texas Property Code, Studensky v. Buttery Company, LLP,  Adv. No. 15-6001 (Bankr. W.D. Tex. 7/2/15).

Court Rejects Trustee's Unique Homestead Attack

Some of the recent decisions on Texas homesteads coming out of the courts have people wondering just what John Wayne fought and died for at the Alamo.   The sanctity of the homestead along with the prohibition against garnishment of wages are two of the pillars upon which this State was founded.  While the news for Texas debtors has generally been depressing, Texas Bankruptcy Judge Tony Davis rejected a creative argument from an aggressive trustee in the case of In re Parsons, No. 12-12649 (Bankr. W.D. Tex. 12/12/14), which can be found here.

 

What Happened

The Debtors filed chapter 11 to deal with a large IRS liability.   At the time of the filing, they owed a small balance on their mortgage but the property was subject to a sizable tax lien.  No party objected to the exemptions during the chapter 11. 

 

The Debtors converted their case to chapter 7 after proposing a chapter 11 plan which drew no votes either for or against.    By the time of the conversion, the mortgage had been paid off but the IRS lien exceeded the value of the property.   Meanwhile the Debtors had negotiated a settlement of their IRS liability for a sum which was less than the value of the homestead.

The Debtors claimed Texas exemptions.    The Trustee objected on the basis that the Debtors had no equity in the property and that under section 724(b), the Trustee could sell the property and subordinate the IRS lien to pay administrative and priority claims.

 

The Court's Ruling

Judge Davis put his ruling at the beginning of the opinion for those not willing to wade through eight pages of discussion:

In this case, the Court concludes that a trustee may not collect administrative expenses by forcing the sale of a Texas homestead, encumbered by IRS liens but claimed as exempt, even if there is no equity in the property.

Opinion, p. 1.

The Debtors argued that the trustee's objection was untimely.   Under prior Western District case law, conversion to chapter 7 did not trigger a new period for objecting to exemptions.   In re Halbert, 146 B.R. 185 (Bankr. W. D. Tex. 1992).   Unfortunately for the Debtors, Fed.R.Bankr.P. 1019(2)(B) was adopted in 2010.   It says that when a case converts from chapter 11, 12 or 13, there is a new period triggered for objecting to exemptions unless either:  i)  a plan was confirmed at least one year prior to conversion; or ii) the case was previously in chapter 7 and the period for objections had expired.   The rule provision is probably a wise one.   In a reorganization case, creditors and parties are generally more focused on what they will receive under a plan.  As a result, they are less likely to focus on exemption questions.    The rule amendment closes the loophole.

The Court found that the argument under section 724(b) was premature.   In order for a trustee to invoke section 724(b), the property must be property of the estate.   Therefore, section 724(b) cannot be used to bring the property into the estate.

There is some debate between the parties as to the necessity or appropriateness of this section 724(b) maneuver by the Trustee, but that debate is irrelevant; because the exemption is valid, the Homestead is not property of the estate, and section 724(b) does not apply.

Opinion, p. 4.

Finally, the Court rejected the argument that the Debtors could not claim property which lacked equity as exempt under Texas law.   The Court distinguished cases in which the exemption is limited to a specific dollar amount and under which the Debtor might arguably need to have equity in order to have an exempt interest in the property.   The Court noted that under Texas law, it is the homestead itself which is exempt, not the value of the homestead.   The Court stated:

There is no dollar limit to the exemption because it is the homestead itself, rather than the debtor’s equity, that Texas law protects. (citations omitted). Even if the Debtors had no equity to exempt, they would still have a residence that is itself exempt under Texas homestead law.

Opinion, p. 8.    The ruling that the homestead itself is of intrinsic value under Texas law, as opposed to something as transient and impermanent as value, would have brought a smile to John Wayne's face.   

Why Were the Parties Fighting Over a Home With No Equity?

One question not answered by the opinion is why the parties were arguing over a home with no equity.   For the Debtors, the answer was straightforward.   They had lived in the house since 1983, long enough to pay off the first mortgage.   This was their residence rather than simply an investment.  The trustee's motivations were more complex.   While he knew that the property had no equity on paper, he was also aware that the Debtors were negotiating with the IRS.   If the Trustee could strike the same deal with the IRS, he could generate equity for the estate.   Thus, the Trustee was seeking to object to the exemption based on no equity and then create equity by compromising the IRS lien.   

Disclosures and Other Fine Print

 

My firm represented the Debtors and I tried the homestead issue for them.

 

John Wayne did not actually fight at the Alamo.   However, he did play Davy Crockett in the 1960 film version.   He also played Texans in many other films, including The Searchers (1956), Rio Bravo (1959), The Commancheros (1962) The Sons of Katie Elder (1965) and Rio Lobo (1970). John Wayne was not actually a Texan, but he is still the iconic Texan.    

Fifth Circuit's Bankruptcy Opinions from October 2014

It's been a slow month in the Fifth Circuit, my home Circuit with just two bankruptcy-related opinions.   This month's cases involve a non-filing spouse who lost her homestead interest and a bank which provided "reasonably equivalent" value but not enough to constitute a complete defense to a fraudulent transfer claim.

Homestead Exemption; Takings Claim by Non-Filing Spouse

Thaw v. Moser (Matter of Thaw), No. 14-40108 (5th Cir. 10/9/14), which can be found here, is another case of the non-filing spouse losing her homestead interest.   Dr. Stanley Thaw filed bankruptcy while his spouse, Kernell Thaw, did not.  Because the Thaws bought their home within 1,215 days, the exemption was capped at $146,450.   However, because Dr. Thaw had liquidated non-exempt property and used it to pay down the homestead, the Bankruptcy Court reduced the homestead exemption to $0 under Sec. 522(o).   Mrs. Thaw argued that  she had a separate homestead interest in the property and that the Bankruptcy Code provisions which eliminated the homestead exemption constituted an unconstitutional taking.   The Fifth Circuit held that because the homestead was purchased after the adoption of BAPCPA, there was not a valid takings claim.    "The Thaws acquired the property after the enactment of BAPCPA, there is no 'gratuitous confiscation,' and the sale is not 'so unreasonable or onerous as to compel compensation.'”   Opinion, p. 9.

Fraudulent Conveyance; Defense for Providing "Value"

In Williams v. Federal Deposit Insurance Corporation (Matter of Positive Health Management), No. 12-20687 (5th Cir. 10/16/14), which can be found here, the Fifth Circuit required an "innocent" recipient of a fraudulent transfer to return the funds received in excess of value given.     

The Debtor occupied a building which was owned by a related party and was subject to a lien.   The Debtor made the payments on the building as "rent."    Because the Debtor was not obligated on the building loan, Trustee Randy Williams brought suit to recover the funds as fraudulent transfers.   The Bankruptcy Court, having read Stern v. Marshall, submitted proposed findings of fact and conclusions of law to the District Court  which adopted them.    

The Bankruptcy Court found that the Debtor received "reasonably equivalent value" for the payments.    The Court found that the reasonable rental value of the property was $253,333.33 while the amount of the payments received was $367,681.35.   Although these two numbers were not equal, they were "reasonably equivalent."     Nevertheless, the Bankruptcy Court found that the transfers were made with actual intent to hinder, delay or defraud.   Unfortunately for the trustee, the Bankruptcy Court also found that the bank was entitled to a defense under 11 U.S.C. Sec. 548(c) for the reason that it took the payments in good faith and gave value in return.   In determining value, the Bankruptcy Court used the same "reasonably equivalent" standard that it used in determining liability.    The Court of Appeals held that for purposes of the defense, value meant dollar for dollar value.   Because the payments received by the bank were more than the rental value received by the Debtor, the bank had to pay back the excess of $114,348.02.

That's the news from the Fifth Circuit where the judges are strong, the clerks are good looking and all of the lawyers are above average.   (Apologies to Garrison Keillor).  

Kim Case KOs Homestead Interest of Non-Filing Spouse

This has not been a good year for Texas homesteads involved in bankruptcy proceedings.    In April, the Fifth Circuit ruled (after nearly two years under advisement) that the non-filing spouse does not have a separate homestead estate entitled to protection when the other spouse files bankruptcy, or, as happened in this case, has an involuntary petition brought against him.    Kim v. Dome Entertainment, Inc. (In re Kim), No. 10-10882 (5th Cir. 4/9/14), which can be found here.   While the legal reasoning of the decision is solid, it is a blow to those of us who consider the Texas homestead to be sacrosanct.

What Happened

Odes Ho Kim purchased a home in Irving, Texas for $1,048,028.36 which he occupied with his spouse Chong Ann Kim.    About two years later, Dome Entertainment Center obtained a judgment against him in California for more than $5 million.   Dome then filed an involuntary petition against Mr. Kim in Texas.   Because the home was acquired less than 1,215 days before bankruptcy, Dome objected that Mr. Kim's homestead exemption  was limited to $136,875.    The Bankruptcy Court sustained the objection.   Mr. Kim then filed a declaratory judgment seeking to determine Mrs. Kim's interest in the property.   Dome intervened.   Judge Harlin "Cooter" Hale ruled that 11 U.S.C. Sec. 522(p) preempted the unlimited Texas homestead exemption and that Mrs. Kim did not have a “separate and distinct exempt homestead interest in the property that would entitle her to compensation or to prevent the sale of the Property.”   The District Court affirmed and held that Mrs. Kim did not have a vested property right in the property.

The Fifth Circuit's Ruling

Mrs. Kim argued on appeal that under Texas law, she had a homestead interest which was independent of her husband's interest in the property and that this interest was her separate property which did not enter the bankruptcy estate.    The characterization of this interest was important because under 11 U.S.C. Sec. 541(a)(2), any interest which the debtor has in property as separate, sole management or joint management property enters the estate.   The parties stipulated that the real property fit into one of these categories which made sense since the property was purchased by Mr. Kim and was titled in his name.   

Texas law offers several unique protections to spouses:

• Under Texas Property Code Sec. 41.004, a homestead cannot be abandoned without the consent of the other spouse.
• Under Texas Family Code Sec. 5.001, regardless of whether the property is characterized as separate or community property, it cannot be conveyed without the consent of the other spouse.
• Finally, under Texas Estates Code Sec. 102.003 and 102.005, the homestead right shall descend and vest in the heirs unless the property is still occupied by a surviving spouse.  

So, were the unique rights granted to spouses under Texas law a property interest excluded from the bankruptcy estate?    The Fifth Circuit said that it didn't matter.

Even were we to accept this argument, it would not affect our analysis of the bankruptcy court’s authority to order a forced sale of the Kims’ residence. Both the United States Supreme Court and the Supreme Court of Texas have rejected arguments similar to those urged by the Kims.

Opinion, p. 9.    The Court relied on United States v. Rogers, 461 U.S. 677 (1983), which held that a Texas homestead could be sold to pay taxes owing by one spouse over the objection of the other spouse based on the federal government's superior right to collect taxes.    The court found that this ruling was analogous to 11 U.S.C. Sec. 363 which allows property to be sold free and clear of the interest of a co-owner.    The Court also relied on Texas case law that held that Texas homestead laws could not preclude enforcement of a federal statute allowing sale of the homestead.   Because the spousal rights under Texas law exist to prevent non-consensual sale or abandonment of the homestead, a superior federal law allowing sale of the property could trump these Texas rights.

Having concluded that the Bankruptcy Court had the authority to order sale of the residence, the Court turned to the issue of whether Mrs. Kim was entitled to a separate share of the proceeds from Mr. Kim.    Unfortunately, the Court had previously ruled in Matter of Rogers, 513 F.3d 212 (5th Cir. 2008) that section 522(p) only applied to "vested economic interests."    If Mrs. Kim had held a vested economic interest, she might have qualified for a share of the proceeds.

After a lengthy analysis of Texas law, the court concluded that, although the spouse's rights had been analogized to a life estate, they did not qualify as "vested economic rights."    As a result, Mrs. Kim went away empty-handed.

Dealing With Kim

The Kim case exposes a danger when dealing with Texas homesteads.    If the exemption is capped by Sec. 522, the non-filing spouse can be kicked out of the property and limited to her husband's capped exemption.    What can be done to avoid this?   I can think of three ways to mitigate the problem of varying utility.

Because the property was purchased by Mr. Kim in his sole name, it was likely his sole management community property or at least joint management community property.   If a couple purchases a high-dollar home knowing that the husband has a high risk of getting sued within the next 1,215 days, it might make sense to take title in the wife's name.   Outside of bankruptcy, Texas law would protect the husband from the wife selling the property and making off with the proceeds.   Another option would be for the couple to enter into a marital partition agreement prior to purchasing the home stating that any property acquired jointly by them would be owned as their separate property in equal shares.    If the non-filing spouse had a 50% interest in the property as separate property, that interest would not enter the estate.    Of course, a partition done on the eve of bankruptcy could be set aside as a fraud on creditors.    As a result, this would need to be done well before bankruptcy is contemplated.   

Of course, most people don't purchase property expecting to file bankruptcy within 1,215 days.   This leads to the second fix.   The Texas legislature could state that each spouse individually owns a life estate in the property.   Current law tries to give each spouse something approximating a life estate.   The legislature could make this explicit so that each spouse would have a separate vested economic interest in the property.   This wouldn't stop sale of the property, since section 363(h) would still be there.   However, it would ensure that the non-filing spouse received a financial consolation prize.

Finally, when faced with a bankruptcy within 1,215 days after acquiring a homestead, it might make sense for both spouses to file.   Section 522(m) says that homestead exemptions are calculated per debtor.   If two debtors file, the cap is twice as much as if one had filed.   Generally, the conventional wisdom is to keep the other spouse out of bankruptcy if she has limited exposure on the debts (such as when the husband is sued on debts from his business for which the wife is not liable).   However, if the homestead exemption is capped, then two spouses filing means 2x the exemption.    There may have been other reasons why it didn't make sense for Mrs. Kim to join her husband's filing.   However, from here on out, it is a topic that bankruptcy counsel should broach with both spouses.

 

 

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.   

Fifth Circuit Erodes Protection for Texas Homesteads Sold After Filing

Expanding upon its decision in Matter of Zibman, 268 F.3d 298 (5th Cir. 2001), the Fifth Circuit has ruled that the proceeds from sale of a Texas homestead lose their exempt character if they are not reinvested within six months--even when the sale takes place post-petition.   Viegelahn v. Frost (In re Frost), No. 12-50811 (5th Cir. 3/5/14).    The opinion can be found here.   The opinion creates a malpractice trap and arguably conflicts with this week's Supreme Court decision in Law v. Siegel.  

The Problem

The Bankruptcy Code states that "property exempted under this section is not liable during or after the case for any debt of the debtor that arose . . . before the commencement of the case" except for debts for taxes and domestic support obligations, unavoided liens, debts owed by an institution-affiliated party and debts for fraud incurred in obtaining a student loan.   11 U.S.C. Sec. 523(c).   Further, exempt property is not liable for administrative expenses except for the cost of recovering that property.   11 U.S.C. Sec. 522(k).  

These provisions should make it pretty clear that once property is allowed as exempt, it is not liable for pre-petition debts or administrative claims with very limited exemptions.   However, Texas has a vanishing exemption.    While Texas has one of the most generous homestead exemptions in the country, proceeds from sale of a homestead only remain exempt so long as they are reinvested within six months.   Texas Property Code Sec. 41.001(c).

In Matter of Zibman, the Fifth Circuit held that the Texas Property Code grants only a provisional exemption to homestead proceeds.   Where the homestead was sold prior to bankruptcy and the debtor held proceeds on the petition date, the exemption would be allowed subject to the reinvestment provision.  Zibman can be reconciled with section 522(c) and (k) for the reason that the limitation on the exemption existed on the petition date.   In other words, the debtor had an exemption in a fund of money so long as he used that money to purchase a new homestead within six months.   This is contrasted with the exemption in the homestead itself which was not subject to defeasance.  

The Frost Facts

Mark Frost filed a chapter 13 petition on November 30, 2009.   At that time, he owned a home in Cibolo, Texas.    On March 26, 2010, the Bankruptcy Court entered an order allowing him to sell his home.  The Trustee objected to the sale on the basis that the Debtor should be required to re-invest the proceeds within six months.    The Court allowed the sale but provided that any liens or interests not specifically provided for in the Order would attach to the proceeds and that the proceeds would be deposited with the Chapter 13 Trustee "pending further orders of this Court as to the validity, priority and extent of such liens and interests."    The sale closed on July 1, 2010 and resulted in net proceeds of $81,108.67.  

The Debtor subsequently proposed a plan that would pay creditors 1% on their claims.   On December 5, 2010, which was about seven months after the sale, the Trustee objected to the plan. The Trustee argued that the proceeds from sale of the homestead should be paid to creditors because they had not been reinvested within six months.   Of course, the proceeds could NOT have been reinvested within six months because the Trustee had been holding them.  

The Bankruptcy Court entered an interim order allowing the Trustee to retain sufficient funds to ensure a 100% distribution to creditors and returning $40,000 to the Debtor.  

On January 27, 2011, the Court conducted a hearing on the Trustee's Objection to the Motion to Sell Property Free and Clear of Liens.    This was odd because the prior order entered on March 26, 2010 did not indicate that the Court was reserving a ruling upon the Trustee's objection.   At this hearing, the Court ruled that the Debtor would be given six months in which to reinvest the proceeds.   Because the Trustee had been in possession of the proceeds, the Court held that the six month period would be tolled until January 27, 2011.    However, the Court also ruled that because the Debtor had spent $23,000.00 of the funds previously distributed to him for purposes other than buying a new homestead, that these funds had lost their exempt character and would have to be paid to creditors under the plan.   Thus, the Court gave and the Court gave away.   While the Court authorized payment of $40,000.00 to the Debtor, it took back $23,000.

The Debtor appealed to the District Court which affirmed.    The Court's ruling was limited to the $23,000 which was not reinvested.   While the record is not clear, apparently the other funds released to the Debtor were reinvested in a homestead since they were not mentioned again.

Note:   According to the Fifth Circuit, $18,000 was held in trust for the Debtor to purchase a new homestead and the remaining funds were paid to creditors.   This does not appear to accurately describe what transpired below.   The facts listed above are taken from my review of the Bankruptcy Court docket and orders rather than the Fifth Circuit's opinion.   

The Fifth Circuit's Ruling

The Fifth Circuit affirmed.   It held that Zibman applied to the post-petition sale of the homestead.   The Court found that while the Debtor's exemption was fixed on the petition date under the "snapshot" rule that "it is the entire state law applicable on the filing date that is determinative."   The Fifth Circuit rejected the argument that section 522(c) rendered the homestead and its subsequent proceeds permanently exempt.    The Court stated:

Frost’s homestead was exempted from the estate—when the rest of his assets were not—by virtue of its character as a homestead. As in Zibman, this “essential element of the exemption must continue in effect even during the pendency of the bankruptcy.” Id. Once Frost 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.

Opinion, pp. 5-6.

The Fifth Circuit also ruled that the timing of the sale, whether pre or post-petition did not affect the analysis.  

This temporal distinction is insufficient to escape the holding of Zibman. The court’s insistence that an “essential element of the exemption must continue in effect even during the pendency of the bankruptcy case” indicates that a change in the character of the property that eliminates an element required for the exemption voids the exemption, even if the bankruptcy proceedings have already begun. Under this court’s precedent, (i) the sale of the homestead voided the homestead exemption and (ii) the failure to reinvest the proceeds within six months voided the proceeds exemption, regardless of whether the sale occurred pre- or post-petition.

Opinion, p. 6.   

The Court also rejected the argument that Schwab v. Reilly, 560 U.S. 770 (2010) preempted the Texas law.  Schwab v. Reilly divided exemptions into those which consist of a dollar amount versus those which attach to the thing itself. The Debtor argued that because the thing was exempt that it remained exempt.   As stated by the Debtor, Schwab held that "exempt is exempt."   The Fifth Circuit stated that "The rationale of Schwab simply does not apply to this case."    However, its stated rationale suggests that the Court did not understand the Debtor's argument.   The Court said that Schwab did not apply because Schwab involved an exemption limited by dollar amount and the Texas exemption was unlimited.   However, that really misses the Debtor's point that under Schwab, the thing itself was exempt and therefore could not return to the estate.

The Need for Reconsideration

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.

I also think the Court was incorrect on the temporal issue.  When the Debtor filed bankruptcy on November 30, 2009, he owned a homestead.   By the time that he filed the Motion to Sell Property Free and Clear of Liens, the exemption on that property was final.   As a result, the property left the estate.   In the words of Neil Young, "once you're gone, you can't come back."   That applies to property of the estate as well.    Would the court hold that property sold free and clear of liens or abandoned could revert back to the estate after the debtor and third parties had acted in reliance?  I don't think so.

 

Additionally, the factual application of the case is contrary to Texas law.   Under Texas law, proceeds from a homestead remain exempt for six months.  The Debtor can do whatever he wants with the money during those six months.   If the Debtor spends the proceeds of the homestead on fine dining and poor investments, creditors can't get the money back.   However, the Bankruptcy Court held (and the reviewing courts agreed) that spending part of the homestead proceeds during the six month exemption period meant that a similar portion of the unexpended homestead proceeds lost their exempt character.   Huh?  That does not seem to make sense.   I think that the Debtor was on the right track.   Exempt is exempt with one caveat.   I would agree that if a debtor sells a homestead during a chapter 13 and has proceeds left over six months later, that the unexpended money would constitute property of the estate.   However, if the Debtor uses the money to buy a new home or spends it on wild living, it is simply not there to become property of the estate. 

The Court might also want to think about how Law v. Siegel affects this case.    In Law, the Ninth Circuit held that a Bankruptcy Court could surcharge a debtor's exempt property based on bad behavior.    The Supreme Court reversed, holding that the clear language of section 522(k) prevented the Court from using exempt property to pay administrative expenses regardless of the reason.   Section 522(c) says the same thing with regard to pre-petition claims.    Granted, Law v. Siegel was about the abuse of section 105 to override a clear statutory provision while the Court did not rely on section 105 in this case.   However, the result of undermining the statutory protection is the same and should make a difference.  

Proceed With Caution If This Opinion Remains the Law

If the Frost case remains good law, the only good advice to a debtor with a Texas homestead is plan to hold on to it indefinitely or be ready to buy a new homestead within six months.   Any other advice will place your client and your malpractice insurance at risk.   The other take away is never let the trustee hold the money from sale of your homestead.   Here, the trustee held on to the funds for six months and then tried to claim that the debtor had forfeited his exemption altogether.   Then when the Bankruptcy Court allowed some of the funds to be released to the Debtor without stating any conditions, the Court clawed that money back when it wasn't used for purchase of a homestead.   What the Debtor should have done in this case was to file his bankruptcy to get the benefit of the automatic stay and then dismissed or converted the case once the sale went through.   While this may seem like an abuse of chapter 13, it is a rational response to an irrational result.

Wife's Homestead Claim Remains in Limbo With No Answer From Fifth Circuit

The plight of the non-filing spouse who stands to lose an interest in the homestead is a trap that is easy to overlook.   Under 11 U.S.C. Sec. 541(a)(2), when one spouse files bankruptcy, all joint management community property enters the bankruptcy estate.    This means that if the filing spouse elects not to claim the homestead as exempt in favor of selecting other property or is subject to a cap, the non-filing spouse may lose her interest in the property without having any say in the matter.     

I have previously written about the Odes Ho Kim case here.   In the Kim case, an involuntary petition was filed against Mr. Kim.    The creditors then sought to impose a cap upon his homestead exemption.  Mrs. Kim intervened asserting that she had an independent interest in the homestead.   The Bankruptcy Court and the District Court ruled that Mr. Kim was subject to a cap on the homestead exemption and that Mrs. Kim had no separate interest in the property.    If both spouses had filed, they would have been entitled to two times the amount of the cap.   However, with Mrs. Kim sitting outside of bankruptcy, her interest in the homestead was completely divested by the bankruptcy filing.

Up until this point, the result of the case illustrated an unfair result for the non-filing spouse, but one which was based on an arguable reading of the code.    However, things got interesting after the case was appealed to the Fifth Circuit.    On September 10, 2010, Pronske & Patel and Andrews & Kurth appealed the District Court ruling on behalf of the Kims.    The case was argued to Judges Higginbotham, Owens and Haynes on July 8, 2011.   Now, almost two years have passed since oral argument without a ruling.   According to the Bar Association for the Fifth Circuit, the case is the oldest bankruptcy case still under advisement and is the second oldest case of any kind under advisement.    

While speculation about the reason for the long gestation of the opinion is not worth much, I will engage in some anyway.   Both Judges Owens and Haynes sat on Texas state benches before being named to the Fifth Circuit.   (Indeed, Judge Owens was on the Texas Supreme Court).   Texas has a long tradition of protecting homestead rights.   Additionally, according to a recent book on the history of the Texas Supreme Court (Haley,The Texas Supreme Court: A Narrative History 1836-1986, University of Texas Press 2013),  Texas also was also the first state to recognize property rights for married women.    It may be that the judges are struggling with how to reconcile these strong Texas state law protections with the Bankruptcy law applicable here.   It will be interesting to see how the case is finally resolved.

A Warning Against Do It Yourself Legal Forms

A debtor avoided losing her home in a recent case illustrating the perils of do it yourself legal forms.    Lowe v. Vazquez, No. SA-12-CV-00399-DAE (W.D. Tex. 3/28/13).    

The Debtor paid $10 to download a living trust form while she was living in Nevada.   When she moved to Texas, she conveyed her homestead to the trust.   Her stated reason for setting up the trust was:

 The one and only reason I created the Living Trust after my divorce was to be sure my son could have access to any assets I owned at the time I die and to avoid probate, so I named my son as Successor Trustee. Probate proceedings in Nevada are lengthy and costly and I only wanted to make things easier for him when I die.

When she filed bankruptcy in Texas, the trustee objected to her exemption on the basis that title to the home was vested in the trust.   The Bankruptcy Court denied the objection.    In re Vazquez, 2012 Bankr. LEXIS 642 (Bankr. W.D. Tex. 2012).    

On appeal, the Court found that notwithstanding some confusing language in the pre-printed form, that the Debtor was the sole beneficiary of the trust.   As the sole trustee and sole beneficiary, a valid trust had not formed as of the petition date and the property remained vested in the Debtor.

U.S. District Judge David Ezra had some insightful words for individuals who might want to save money by creating their own legal documents.

This case is a poster child for the proposition that one should not rely on prepaid legal forms with boilerplate language for important legal matters. Had Debtor passed away, it is clear to the Court that the document would not have accomplished what she hoped; indeed, all of the tax consequences she hoped to avoid would have been visited upon her son. It is also clear that a properly drafted trust prepared by a competent lawyer would have accomplished the goal she sought in the first instance.

Opinion, p. 8, n. 2.

I cannot say it any better than Judge Ezra.    If you own a Texas homestead, do not EVER convey it to a trust.   You may place your homestead exemption at risk for no good reason.    The Debtor in this case did not lose her homestead.   However, she had to defend an objection to exemption and an appeal at her own expense.
 

Disclosure:   My firm represented Karen Vazquez in the appeal.    

Judge Rules That Home is Where the Heart Is

In 2000, Natalie Portman starred in "Where the Heart Is," a movie about a pregnant 17 year old girl who makes her home in a Walmart. Judge Stacey Jernigan recently had to decide a quite different case about home and the heart. The case involved whether a modern day cowpoke's heart was down on the ranch or in town in his wife's bedroom. Fortunately, like a character in a John Wayne movie, the Debtor fended off every attack and saved the ranch. In re Tinsley, No. 09-36036 (Bankr. N.D. Tex. 11/16/10). The opinion can be found here.

The Story

Our story goes back to 1979, when the Debtor's father purchased 116 acres located in Kaufman, Texas. In 2004, the Debtor moved into the Kaufman property to take care of his father. From 2004 to 2008, the Debtor stayed at the property full time and operated his own business, which consisted of running cattle and growing hay.

On September 24, 2008, the Debtor's father passed away and left the ranch to the Debtor. under his will A few days later on October 14, 2008, the Debtor married. After marriage, he d spent his days at the Kaufman property and his nights at his wife's home. The Debtor generously allowed his adult son and his family to live at the Kaufman property.

On September 10, 2009, the Debtor filed bankruptcy. Title to the Kaufman property remained in the name of his deceased father because the probate case had not been concluded. The Debtor used his wife's address as his address on the bankruptcy petition, but claimed the Kaufman property as his homestead.

The Objections

The Trustee and a creditor objected to the claimed homestead exemption on the grounds that:

a. The Kaufman property was not his homestead under Texas law; and
b. The homestead exemption was capped at $136,875 because the Debtor acquired his interest within 1,215 days before bankruptcy.

Texas Homestead Exemption

In order to establish a Texas homestead, a person must show that he has a present possessory interest in the property and must show a combination of both overt acts and intent to make the property his homestead.

The objecting parties claimed that the Debtor did not have a present possessory interest in the property because he did not hold legal title. The Court rejected this argument, finding that legal title was not necessary. The Court found that the Debtor was a tenant at will of the probate estate. While his continued possession of the property "depends upon the will and whim of the fee simple owner (i.e., the probate estate of his father)," the fact that he was the devisee under the will made it unlikely that he would lose his possessory interest.

The next issue was thornier. The homestead "is a possessory right which inures to the benefit of a family unit." The Debtor and his wife occupied two separate properties. Therefore, the Court had to determine whether the Debtor showed sufficient overt acts and intent to make the Kaufman property his homestead. The Court noted the possibility that the couple could claim both properties as a noncontiguous rural homestead, but found that this theory had not been pled.

The court found that in a dual residence scenario, the first step is to determine whether one residence was objectively the only homestead. If the usage is sufficiently ambiguous, then the court may honor the Debtor's subjective intent.

While finding that the case was extremely close, the Court found enough ambiguity to take the Debtor's subjective intent into account.

1. The Debtor spent almost every day at the Kaufman property.
2. The Debtor intended to move his bride onto the Kaufman property once it was renovated.
3. "While his new bride is eight miles down the road, the Debtor's horses, boots, tools, livelihood the past 17 years and now extended family are at the Kaufman property 365 days a year." Judge Jernigan shows real discernment here. The real test of a cowboy's residence is where he keeps his boots.

Homestead Cap

However, the ranch was not out danger yet. The creditors argued that because the Debtor acquired his interest in the Kaufman property under his father's will and his father passed away less than 1,215 days before bankruptcy, that the exemption was capped at $136,875.

The Court found that the Debtor had acquired a "vested economic interest" under the will. While noting that she "had grave doubts whether section 522(p) should apply at all in the context of a homestead 'acquired' by devise in a will within 1,215 days of the debtor filing for bankruptcy," she found that the Fifth Circuit had assumed without discussion that an inherited property was acquired. She also noted that Black's Law Dictionary defined "acquire" to mean "to gain by any means."

While it looked like a bad result, the Court was willing to hold her nose and apply the cap. However, there is an exception to the cap for the principal residence of a family farmer. After an exhaustive analysis, the Court found that: the Kaufman property was the Debtor's principal residence; that the Debtor was engaged in farming operations even though he no longer grew crops and didn't have any cattle on the property at the time of the filing (the Court found it compelling that he had operated a ranching operation on the property since 1993 and had resumed his ranching operation after recovering from a heart attack), the Debtor's debts were less than $3,544,525 and that the Debtor received more than 50% of his gross income from farming during the three years prior to bankruptcy.

The end result was that the Debtor got to keep the ranch without being subject to a cap.

Conclusion

In conclusion, Judge Jernigan remarked:

The court would conclude with the old saying that “home is where the heart is,” and, although the Debtor may have spent his nights with his new bride at the Kemp Property, rather than the Kaufman Property, the facts and circumstances in this case certainly show that the Kaufman Property is the Debtor’s true home and where his “heart” is. This case is certainly unique in that it implicates section 522(p)(1) for reasons not originally contemplated by Congress (i.e., this is hardly a case of letting a debtor get through a “mansion loophole,” in that no non-exempt property was put in a large, luxurious mansion on the eve of bankruptcy). Fortunately, for this Debtor, even though he “acquired” property which he used as his homestead within 1,215 days of filing bankruptcy, Congress anticipated certain situations to which they did not want section 522(p)(1) to apply and drafted section 522(p)(2)(A).

Opinion, p. 35. In the final analysis, a bad unintended consequence was avoided due to the fortuitous intervention of an exception that happened to fit the Debtor to a t.

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.

Court Protects Homestead Proceeds But Leaves Open Question on Tardy Objections

Texas has one of the most generous homestead exemptions in the country. However, a quirk in the law allows an exemption in homestead proceeds to be lost due to the passage of time. San Antonio Bankruptcy Judge Leif Clark recently found a creative solution to the problem created by an obstreperous creditor seeking to outlast the debtor and preclude reinvestment of the proceeds from sale of a homestead. In re Bading, No. 06-52750 (Bankr. W.D. Tex. 9/22/07). However, the opinion raises the question of why Judge Clark had to work so hard when Supreme Court precedent provided a simpler alternative.

The Vanishing Exemption and Absolute Protection of Exempted Property

Most exemption statutes are limited by the type and value of the property to be claimed as exempt, but are not limited as to time. Thus, exempt property will keep its status so long as it retains its exempt character. However, a sale or other transformation of the exempt property will usually cause it to lose its exempt character. The Texas homestead exemption extends not only to a homestead owned and occupied by the debtor, but to the proceeds from sale of a homestead as well. Tex. Prop. Code §41.001(c). The proceeds exemption is one which is limited by time. It lasts for the lesser of six months or until the debtor acquires another homestead. The purpose of the proceeds exemption is to give the debtor a limited period of time in which to acquire a new homestead. As a result, the statute creates a vanishing exemption. Homestead proceeds which were fully protected five months and 29 days after sale of the home become cash subject to claims of creditors after six months and one day.

This vanishing exemption creates a potential conflict between state and federal law in the bankruptcy context. According to 11 U.S.C. §522(c), “property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case” (with certain exceptions). Thus, the Bankruptcy Code gives exempted property absolute protection from pre-petition claims.

This absolute protection is implemented in two ways. First, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure provide a limited time in which to object to exempt property. 11 U.S.C. §522(l); Fed.R.Bankr.P. 4003(b). If the property is claimed as exempt and the exemption is not timely challenged, the property remains exempt regardless of whether it would have been subject to a valid objection. Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). Second, the property’s exempt status is determined as of the petition date using the “snapshot” approach. Matter of Zibman, 268 F.3d 298 (5th Cir. 2001).

A Fading Snapshot

While the Zibman decision recognized the “snapshot” approach, it also noted that like a bad Polaroid, the picture could fade. According to the Fifth Circuit:

“(T)he law and facts existing on the date of filing the bankruptcy petition determine the existence of available exemptions but . . . it is the entire state law applicable on the filing date that is determinative. Courts cannot apply a juridical airbrush to excise offending images necessarily picture in the petition-date snapshot.”

Zibman at 304.

Thus, Zibman teaches that where conditions exist on the petition date which would limit the exemption, the snapshot approach does not eliminate those limitations. However, it seems important to the Fifth Circuit’s analysis that the condition must exist as of the petition date. In the Zibman case, the debtors had sold their homestead approximately two months prior to bankruptcy. Thus, the snapshot on the petition date revealed an exemption which had just four months remaining in the absence of reinvestment. Since the debtors had moved to another state, reinvestment was not a possibility.

In the Zibman case, the Trustee obtained an order extending the time to object to exemptions until after the six month reinvestment period expired. When the debtor failed to purchase a new homestead, the trustee objected and was sustained by the Fifth Circuit. Thus, although the exemption was still valid on the petition date, it was a limited exemption and was defeated by the timely filed objection.

Although the Trustee benefitted from an extension of time in Zibman, the court noted that the debtor could benefit from one as well. In a footnote, the Court noted that although the debtors could have requested tolling of the six month period, they failed to do so.

Bading Determines Calculation of Six Month Period

In Judge Clark’s Bading decision, the court examined how to calculate the six month period in the face of creditor obstruction. The debtor owned two contiguous lots which made up her homestead. Prior to bankruptcy, Gulfside Supply, Inc. recorded an abstract of judgment against the debtor. Under Texas law, an abstract of judgment creates a lien against all real estate owned by the debtor in the county, but does not attach to a homestead. Since the debtor only owned a homestead, the abstract of judgment should have been a nullity. However, as noted by the Bankruptcy Court, “title companies are notorious cowards.” When the creditor refused to release the lien, the debtor was put to a Hobson’s choice to either pay off the invalid lien or risk losing the ability to sell the property.

In this case, the debtor found a middle ground. It reached an agreement with the creditor to release its lien from one of the two tracts. The sale of the first lot closed on December 4, 2006 and the debtor received proceeds of approximately $142,000. The debtor did not reinvest these proceeds out of fear that acquiring a new homestead would void the exemption on the second tract.

Instead, the debtor then filed bankruptcy on December 29, 2006 and filed a motion to avoid lien on the second tract. The motion to avoid lien was granted. However, at this point, the debtor was faced with a timing dilemma. The creditor, which had not objected to the debtor’s exemptions, contended that it was not required to file an objection until after the property lost its exempt character and that the six month clock had begun to run on the sale of the first tract. Under the creditor’s position, there was only one month in which to complete the sale of the second tract and invest the proceeds from both tracts in a new homestead. To avoid this problem, the debtor, relying on the Zibman dicta, filed a motion to toll the reinvestment period.

After a hearing, the Bankruptcy Court came to three important conclusions:

1) The fact that Gulfside failed to file a timely objection to exemption was irrelevant. The court stated:

“Gulfside responds that a creditor should not be required to file a ‘conditional objection’ based on what might happen after the close of the time allowed for objection to exemptions, on pain of those exemptions being allowed as a matter of law under section 522(l). The court agrees with Gulfside on this issue. Were the rule otherwise, then trustees and creditors alike would have a duty to object in every proceeds case, just to make sure they preserved their rights. That strikes the court as an unnecessary formality, and one that is difficult to square with the rationale employed by the Fifth Circuit in Zibman to reach its result.”

Bading, slip op., p. 6, n. 5.

2) The six month clock did not begin to run until the second tract was sold.

The six month clock is triggered by sale of “a” homestead, not part of the homestead. Here, the debtor had a single purchaser for both parts of the homestead. The closing of the sale of the complete homestead was delayed by the creditor’s unjustified refusal to release its lien. As a result, there was not a sale of “a” homestead until the second closing, so that the six month clock did not begin to run until that date.

3) If the single sale theory did not work, the court found that equitable tolling would apply.

The court noted that both Texas law and the Zibman opinion held open the possibility that the six month period to reinvest could be tolled. Tolling is an equitable principle. Where, as here, the creditor delayed the debtor’s ability to sell through its refusal to release an invalid lien, there were sufficient grounds to toll the six month reinvestment period.

Thus, the net result was that the debtor was able to sell her homestead free of the offending judgment lien and the creditor’s stall tactics failed to achieve their desired result.

Invoking Avril Lavigne

Judge Clark’s reasoning is elegant and avoided an obvious injustice. However, it raises an obvious question: “Why do you have to make things so complicated?”* Judge Clark would never have had to reach the issues of unitary homestead sales or equitable tolling if he had simply followed Taylor v. Freeland & Kronz and ruled that failure to timely object to the claimed exemption ended the inquiry.

Judge Clark justified his failure to deem the objection waived on two grounds:

1) Practicality; and
2) Fealty to the Fifth Circuit’s reasoning in Zibman.

The practical argument questions the reasonableness of requiring conditional objections in cases involving homestead proceeds. The most reasonable response to this argument is: So what? Cases involving exemptions of homestead proceeds are relatively rare. In order to have a case involving proceeds, the sale must have taken place pre-petition. The deadline to object to exemptions occurs 30 days after the conclusion of the first meeting of creditors. Fed.R.Bankr.P. 4003(b). While the creditors’ meeting must be commenced 20-40 days after the filing of the petition, Fed.R.Bankr.P. 2003(a), there is no rule as to when the meeting must be concluded. As a result, the trustee may simply continue the meeting to a date after the conclusion of the six month reinvestment period. If that isn’t satisfactory, a creditor could move to extend the time to object or could file a conditional objection. All of these solutions are easy to accomplish. Since proceeds cases are unusual, it is reasonable to require trustees and creditors to take these nominal steps to preserve their rights rather than to argue that Supreme Court precedent should be disregarded.

The rationale of the Zibman opinion offers offers little support to the tardy creditor. In that case, the trustee obtained an order extending the time to object to exemptions. The trustee filed his objection within that time period. As a result, Zibman should not be construed as authorizing out of time objections. Indeed, the Zibman rationale simply recognizes that the debtor’s right to exempt proceeds may depend on events happening after the petition date. This is not an invitation to ignore the rules requiring timely objections to exemptions.

Finally, allowing untimely objections to exemptions based on events occurring after the petition date would lead to absurd results. Under Taylor v. Freeland & Kronz, which is an intellectual cousin to Republic Supply Co. v. Shoaf, 815 F.2d 1046 (5th Cir. 1987), failure to file a timely objection to exemption allows the debtor to retain the claimed property regardless of whether the debtor had a colorable claim of exemptions in the first place. If Zibman is read as allowing untimely objections, it means that a conditional claim to exemption of homestead proceeds would receive less protection than a debtor’s attempt to exempt a stack of gold bullion or a herd of Ethiopian hog-nosed goats** as his homestead. The legal system would be seriously out of joint if it accorded greater rights to the frivolous than the conditionally correct. The entire concept of statutes of limitation assumes that creditors must be diligent to protect their rights. If a creditor is unable to focus its attention on a claim which will be resolved in less than six months, the court should not create a judicial do-over for it.

*--This is the refrain from a recent song by semi-punk songstress Avril Lavigne.
**--A rare form of livestock found only in Bastrop County. Apologies to Joe Martinec and Eric Borsheim. For the full story of the Ethiopian hog-nosed goats, write to me at ssather@bnpclaw.com.