Fifth Circuit Finds Inherited IRAs Exempt

In a case of first impression for the Fifth Circuit or any other court of appeals, the Fifth Circuit has ruled that inherited IRA accounts may be claimed as exempt under 11 U.S.C. Sec. 522(d)(12). Matter of Chilton, No. 11-40377 (5th Cir. 3/12/12), which can be found here.

In Chilton, one of the debtors inherited an IRA account in the amount of $170,000. The debtors established an IRA account to receive distributions from the inherited account. The trustee objected that the account was not a "retirement account" and was not the type of tax exempt account identified in section 522(d)(12). The bankruptcy court sustained the objection, but was reversed by the district court.

Section 522(d)(12) allows a debtor who elects federal exemptions (an option available only to debtors in about eleven states since most states have opted out of federal exemptions), to exempt "(r)etirement funds to the extent that such funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a)of the Internal Revenue Code of 1986." Thus, there are two requirements: 1. the funds must be retirement funds and 2. they must be held in an account exempt from taxation under one of the designated sections.

The court rejected the argument that funds set aside for the retirement of another could not be "retirement funds:"

The plain meaning of the statutory language refers to money that was “set apart” for retirement. Thus, the defining characteristic of “retirement funds” is the purpose they are “set apart” for, not what happens after they are “set apart.” Here, there is no question that the funds contained in the debtors’ inherited IRA were “set apart” for retirement at the time Heil deposited them into an IRA. This reasoning finds further support from 11 U.S.C. § 522(b)(4)(C), which provides that “a direct transfer of retirement funds from 1 fund or account that is exempt from taxation under section . . . 408 . . . of the Internal Revenue Code of 1986, . . . shall not cease to qualify for exemption under . . . subsection (d)(12) by reason of such direct transfer.” In other words, the direct transfer of “retirement funds” does not alter their status as “retirement funds.” As we see no reason to interpret the statutory language differently from its plain meaning, we hold that the $170,000 contained in the inherited IRA constitute “retirement funds” as that phrase is used in section 522(d)(12).

Opinion, p. 5.

The Court also ruled that the account was held under the proper section of the Internal Revenue Code. The Trustee argued that the account was tax exempt pursuant to 26 U.S.C. Sec. 402(c)(11)(A), while the Debtor contended that section 408(e) was the relevant section. While this discussion of the Internal Revenue Code would seem arcane and of little interest to bankruptcy lawyers, the Court relied on the expansive language of section 408(e), which stated that "(a)ny individual retirement account is exempt from taxation under this subsection . . . " Because the account was an individual retirement account, it fell within the definition of "any" individual retirement account. Thus, common sense construction carried the day even thought the subject matter was the tax code.

On a final note, the Court of Appeals decided this appeal quite expeditiously. The case was argued on February 22, 2012 and decided on March 12, 2012, just nineteen days later. Judge Carl Stewart should be commended for his prompt work.

Texas Bankruptcy Courts Split Over Application of Schwab v. Reilly

The Supreme Court's decision in Schwab v. Reilly, 130 S.Ct. 2652 (2010) last term provoked a lot of concern about the finality of exemptions. Under Taylor v. Freeland & Kronz, 503 U.S. 638 (1992), a trustee's failure to timely object to an exemption, even a frivolous one, meant that the asset left the estate. However, in Schwab v. Reilly, the Supreme Court held that an exemption of a specific dollar amount in value of property exempted only the value claimed but not the asset itself, allowing a trustee to sell the asset if the value ultimately exceeded the amount of the debtor's exemption.

I have written about Schwab v. Reilly and its consequences here and here.

Now Texas Bankruptcy Judges are struggling with whether Schwab permits, or even dictates, that a debtor may claim 100% of fair market value, forcing the trustee to object within 30 days. Judge Michael Lynn and Judge Craig Gargotta have held that claiming 100% of FMV is permissible, In re Moore, 442 B.R. 865 (Bankr. N.D. Tex. 2010), In re Dominguez-Ortega, No. 10-61416 (Bankr. W.D. Tex. 5/17/11), while Judge Robert Jones has ruled the opposite way, In re Salazar, 2011 Bankr. LEXIS 1117 (Bankr. N.D. Tex. 2011).

Because Judge Gargotta's opinion is the latest word, I will start with his ruling in this post. The transcript is not yet available online. I will be happy to provide a copy to anyone who requests it.

The Permissible Approach

In the Dominguez-Ortega case, the court was faced with objections filed by the chapter 7 and chapter 13 trustees in six cases in which the debtors claimed 100% of FMV. Relying upon the Moore decision and scholarly articles from the American Bankruptcy Institute, Judge Gargotta denied the objections. He stated:

As everyone knows, in Schwab v. Reilly, the Supreme Court unequivocally says at least two things--it may say other things in addition to that.

One, that one hundred percent of fair market value on Schedule C is permissible and correct.

And second, that the trustee may not be bound by the 30 day objection period under Federal Rule of Bankruptcy Procedure 4003(b).

Transcript, pp. 6-7. He went on to adopt the reasoning of Judge Lynn of the Northern District. He stated:

(T)he judges in the (Fort Worth) division had the following observations.

First of all, fair market value of one hundred percent is the correct methodology. It puts the trustee on notice to object within 30 days. Then there can be an evidentiary hearing . . . regarding whether or not that's a fair objection.

For purposes of the proceedings here in Waco, I agree with that. I think that's exactly what the Supreme Court requires.

Second as to the discussion that we had on the record day about whether or not debtors may use a numeric amount for the interest they claim as an aid, they are free to do that, but they are not required to do that. And I will leave it up to them as to whether or not they want to do that.

Transcript, pp. 8-9.

Judge Gargotta acknowledged that his ruling would result in more work for the trustees and the court, but stated that his mandate was to follow the Supreme Court.

Now, what is the consequence to the Court? Well, the consequence to the Court is, in those situations where the trustee thinks that . . . when (the debtors) use the designation of one hundred percent of fair market value, that it may exceed the amount of the interest in an asset, the trustee is going to have to object, and I'll have to conduct a hearing on it and we'll . . . figure out how that plays out.

I recognize that, ultimately, it may increase the litigation in this Court. But, by the same token, I'm of the opinion, and I think it's unequivocally clear that what debtors are doing in that consequence is precisely what the Supreme Court ordered, and I'm not going to alter their methodology in terms of claiming it.

I apologize to both Mr. Hendren and Mr. Studensky if it increases their workload. That is not my intent. Rather, I am complying with what the Supreme Court commands.

Transcript, p. 10.

The Impermissible Approach

Writing in Salazar, Judge Robert Jones agreed that if a debtor claimed 100% of fair market value and no party objected, that "the debtor effectively reclaims the property." 2011 Bankr. LEXIS 1117 at *15. However, he disagreed with Judge Lynn about what to do if there was a timely objection. His conclusion was that an objection to 100% of fair market value was a facially valid objection and that the debtor would be required to amend his exemption to state a specific dollar amount.

He explained his reasoning as follows:

The Court will set forth its reasons for the approach it adopts. First, the Court fails to see the necessity of a hearing under the circumstances as presented. The debtors' exemption claims are limited to an interest in the property. The value of the property itself is relevant only to the extent that there is sufficient value to support the amount of the exemptible interest. If, as suggested by the Supreme Court, the debtor is trying to exempt the property in-kind rather than an interest in property, such goal may still be thwarted if, for example, the property subsequently appreciates in value. This is the very issue confronted by the Ninth Circuit in In re Gebhart, 621 F.3d 1206 (9th Cir. 2010). There the debtors made an exemption claim to the equity in their house, which amount was well within the amount they were allowed under § 522(d)(1). The trustee did not object; like the trustee in Schwab, the trustee in Gebhart had no reason to object. During the pendency of the bankruptcy case, the house appreciated in value. Two years later, after the debtors had defaulted on their mortgage payments and the mortgage company moved for stay relief, the trustee sought approval to sell the house to recover the value of the house that then well exceeded the exemption claim. The Ninth Circuit, consistent with Schwab, emphasized that the debtors' allowable exemptions did not permit the exemption of the house itself, but rather the specific dollar amount of their interest in the house.

2011 Bankr. LEXIS 1117 at *17-18. The Court went on to state

The Supreme Court in Schwab predicted such claims would likely draw objections. Claiming "100% of FMV" is the debtors' way of stating that they wish to keep the asset in-kind. While this is their desire, the Court must construe that such claim has the legal effect of claiming an interest in the property up to an amount that is determined by the fair market value of the property in-kind. Accordingly, if the trustee wishes to preserve for the estate any excess value--value over the amount of the statutory limit that may exist either at the time the exemption is claimed, as was the case in Schwab, or any excess value that may exist as a result of an anticipated appreciation in the property, as happened in Gebhart--the trustee must object to the exemption claim itself. That is precisely what has been done here. The trustees' objections are facially valid. The objections do not otherwise contest the exemption claims. The Court certainly concedes that, given the items against which the exemptions were made and the claimed values of the items in-kind, it is highly unlikely that any of the items would ever achieve a value that would exceed the statutory limit for the exemption. Regardless, the Court recognizes the trustees' right to preserve this eventuality for the estates.

2011 Bankr. LEXIS 1117 at *25-26.

Reconciling the Cases

Moore, Salazar and Dominguez-Ortega all agree that if a debtor claims 100% of fair market value and no party objects, that the debtor gets to keep the property. However, where they split is in allocating the burden of proof. Under Fed.R.Bankr. P. 4003(c), the objecting party has the burden of proof on an objection to exemptions. Moore and Dominguez-Ortega require the trustee to meet the burden of proof with evidence. On the other hand, Salazar holds that the objection should be sustained as a matter of law and that the debtor has the burden of proof to state what the value of the property is. Even then, the debtor has no security. If the value of the property increases beyond the exempt amount, the trustee may sell it out from underneath the debtor.

I have mixed feelings about these opinions. Moore and Dominguez-Ortega bring order to the force by restoring the status quo under Taylor v. Freeland & Kronz. On the other hand, Salazar is more faithful to the Supreme Court's reasoning that an exemption attaches to a dollar amount rather than the thing itself. However, that is a horrible result. It allows trustees to sleep on their rights and leave estates open in the hope that an asset may appreciate. As a practical matter, it is much better to require the trustee to put up or shut up in an evidentiary hearing. This will ensure that the trustee only objects when there is a genuine basis for doing so and gives all parties certainty in dealing with assets claimed as exempt.

Post-Script

I typically do not blog about oral rulings. I chose to do so in this case because it was a very definitive ruling from one of my local judges. However, I do want to acknowledge that all of the Texas bankruptcy judges that I appear in front of put a lot of thought and hard work into their oral rulings. In most cases, the oral rulings are equivalent in force to a written opinion, just delivered in a more informal manner. In this case, it was refreshing to hear the directness of the Court’s comments.

Finally, I apologize to Judge Robert Nelms. In his ruling, Judge Gargotta referred to rulings by Judge Michael Lynn and Judge Robert Nelms. I could only find Judge Lynn's opinion. When Judge Gargotta refers to the Fort Worth judges, he is referring to both Judge Lynn and Judge Nelms.

730-Day Rule Costs Debtor Homestead Exemption

The Fifth Circuit's recent decision in Camp v. Ingalls allowed an itinerant debtor to claim federal exemptions that would not have been available to him had he remained in Florida. That was a small victory for the debtor. However, a decision released just a few days later reveals the darker side of the 730 day rule for claiming exemptions. In the case of In re Fernandez, No. 09-32896 (Bankr. W.D. Tex. 1/26/11), which can be found here, a debtor was deprived of the generous homestead exemption allowed by both Texas and Nevada law where he had gone back and forth between these states.

What Happened

Alfred Fernandez owned a home in El Paso, Texas. When he was laid off from his job in El Paso, he relocated to Nevada for seven years. All the while, he continued to make the payments on his home in El Paso and planned to return. About a year prior to bankruptcy, he did return. When he filed for bankruptcy, he claimed his home as exempt under Texas law and the trustee objected. Then he amended his exemptions to claim the home as exempt under Nevada law and the trustee objected.

Because he had not lived in Texas for 730 days before bankruptcy, the Texas exemptions were not available to him. However, the trustee contended that Nevada law could not be used to exempt property located in Texas. The Bankruptcy Court agreed.

The Court's Ruling

Judge Leif Clark engaged in an exhaustive analysis of the legal issues involved. However, at its core, the ruling followed this logic:

1. Sec. 522(b)(3)(A) instructs the court to look to the law of the state where the debtor resided for the greater portion of the 180 days prior to 730 days if the debtor has not resided in one state for 730 days.

2. This provision requires application of Nevada law.

3. Although the Nevada exemption statutes do not expressly limit their application to property located within Nevada, it is reasonably clear that Nevada would not apply its internal exemption statutes to property located within other states. Judge Clark based this conclusion, in part, in a response given by the Nevada Supreme Court to a certified question, which noted in passing that the purpose of the exemption statute was to protect "the family, its individual members, and the community and state in which the family resides." He also noted that exemption laws exist to give guidance to Sheriffs as to what property they can levy upon. Obviously, a Nevada sheriff would not be levying upon property located in Texas, so there is no reason for Nevada to design an exemption statute to apply elsewhere.

4. Because the statute says to look to property that "is" exempt under the applicable state law, the Bankruptcy Court must apply state law in the same manner as the state would have.

5. As a result, the Debtor is not entitled to a homestead exemption under Texas or Nevada law. The Debtor could claim a homestead exemption under federal exemptions, but this exemption would only cover a portion of the debtor's equity in his residence.

The Court refused to adopt a construction in which the Bankruptcy Code effectively federalized state exemption laws. Instead, the Court applied state law in the manner in which the states would have applied it.

The Court acknowledged that its decision was not very palatable, stating:

The express language of section 522(b)(3)(A) certainly generates a result that many (including this court) would perceive to be unfair. But a perceived unfair result is not necessarily an absurd result. And absent such a finding, a court is obligated to apply the plain language of the statute as written. The language of the domiciliary requirement is, to this court, unambiguous and straightforward. Though the look-back period has changed, the structure of the provision is essentially unaltered from the original version enacted in 1978, and it is plainly and easily applied (albeit with unfortunate consequences in the case of traveling debtors). If the language of a statute is plain, then it is the duty of the court to enforce them according to their terms.

Opinion, p. 30.

While this is a harsh result, it appears to be one that Congress intended. Section 522(b)(3)(A) was intended to prevent debtors from moving to enhance their exemptions. Judge Clark's ruling is consistent with what would have happened if the debtor had remained in Nevada, namely, that he could not have claimed his Texas property as a homestead.

Federalized Exemptions

Judge Clark rejected the argument that the Bankruptcy Code transformed state laws into federal rules which could be applied independently of their state law moorings. While the context was different, I made a similar argument about the Bankruptcy Code federalizing state exemption laws in the case of In re Dyke, 943 F.2d 1435 (5th Cir. 1991). (If you read the published version, it incorrectly states that my firm represented an amicus party. In fact, there were two consolidated appeals and we represented one of the debtors). In Dyke, the issue was whether ERISA preempted the Texas Property Code exemption for retirement benefits in a bankruptcy case. The correct result, as later determined by the Supreme Court, was that the anti-alienation provisions in ERISA constituted an exemption under other federal law. However, a panel of the Fifth Circuit had previously rejected this argument. This led to the seemingly absurd result that while ERISA expressly prohibited alienation of retirement plan assets, state laws which effectively said the same thing were preempted by ERISA.

We argued that ERISA could not preempt state exemption laws in a bankruptcy case because the state law had become federalized when it was incorporated by the Bankruptcy Code. The Fifth Circuit adopted our reasoning but got there by a slightly different route. The Court stated:

Like Title VII, the Bankruptcy Code relies on state law to assist in the implementation and enforcement of its goals. The principal goal of the Bankruptcy Code is to ensure that a debtor comes out of bankruptcy with adequate possessions to have a "fresh start." (citation omitted). The Code adopts a federal exemption scheme which satisfies this goal; but recognizing that circumstances are different in the various states, the Code also "permits the states to set exemption levels appropriate to the locale." (citation omitted). If this Court were to interpret ERISA to preempt provisions of the state exemption schemes, the states would be unable to set enforceable exemption levels on retirement benefits. This would relegate many debtors to a federal exemption scheme which might be inappropriate to the locale. As a consequence, the enforcement scheme contemplated in the Bankruptcy Code would be modified and impaired.

Under the specific language of ERISA section 514(d), this Court cannot construe ERISA to modify or impair the policies of other federal laws. The Bankruptcy Code, in particular, is a federal law that ERISA cannot disturb. (citation omitted). The Texas legislature has created a state exemption scheme that advances the principal goal of the Bankruptcy Code. One such exemption in this state scheme, section 42.0021(a) of the Texas Property Code, permits bankrupt debtors to exempt the funds in their retirement plans. Tex. Prop.Code Ann. § 42.0021(a)(Vernon Supp.1991). If the ERISA preemption clause is enforced against section 42.0021(a), the preemption clause would impair the ability of the Bankruptcy Code to ensure -- through the Texas state exemption scheme -- that Texas debtors can get a "fresh start" after bankruptcy. Accordingly, this Court concludes that ERISA section 514(d) saves the Texas state exemption scheme from preemption. ERISA does not preempt section 42.0021(a) of the Texas Property Code.

In re Dyke, at 1449-50.

The Fifth Circuit held that the Texas Property Code advanced the policies of the Bankruptcy Code, but did not state that the Bankruptcy Code federalized state exemption laws. The nuance is important. If the state law had become federal law, it could have been interpreted as federal law. However, where it merely advanced the policies of the Bankruptcy Code, the case was weaker.

Unintended Consequences

When Congress added the 730-day residency requirement into BAPCPA, it was no doubt trying to discourage debtors from making an exemption-enhancing move, such as the one made by Bowie Kuhn. However, under Judge Clark's logic, the actual consequence of the statute is to provide that the prior state's law will never apply, since states do not design their exemption statutes to have extra-territorial application. This will mean that migrant debtors will be limited to or receive the benefit of the federal exemptions. Since most states have opted out of the federal exemption scheme, this means that a choice that would have been unavailable to most debtors becomes the only choice.

Judge Clark, in a Scalia moment, was quick to point out that just because Congress didn't think through the consequences of its wording did not give the Court license to adopt a different construction.

It seems clear that the plain language of the statute yields an unfortunate result. Here, it deprives this debtor of his home, even though outside of bankruptcy, Texas law would preserve his home against the claims of his creditors. Yet an unfortunate result is not sufficient grounds to ignore the plain language of a statute. It is certainly never grounds to simply ignore Congressional intent, nor does it ever justify simply rewriting a statute a particular judge or judicial panel does not like. And that principle of judicial restraint must cut across all ideological lines, as it is central to the nature of the judiciaryʼs role in a constitutional form of government. (citation omitted). This statute plainly directs a court to deprive the unlucky debtor who has moved to the state of filing within the two year period prior to filing of the state exemptions not only of the state in which she resides but also of the state in which she used to reside, and gives her, in return, the right to claim federal exemptions (whether on the basis this court espoused in Battle or on the basis of the failsafe provision at the end of section 522(b)(3)). The result, in this case, is that the debtor will lose his house. The court takes no pleasure in being the enforcing officer of a wrongheaded and plainly unfair statute. But it is up to Congress, not the courts, to fix this problem.

Opinion, pp. 41-42 (emphasis added).

(Note: When I wrote about Justice Scalia's dissent in Hamilton v. Lanning, I stated, "Justice Scalia is willing to be a minority of one for the proposition that when Congress passes laws that are foolish or just plain wrong, that the courts have an obligation to throw their words back at them and yield a foolish judgment." Thus, a Scalia moment is one where the Court consciously renders an absurd judgment because the statutory text demands it. It is worth noting that the Supreme Court's jurisprudence interpreting BAPCPA has taken the opposite approach and has tried to make sense of the law regardless of what a strict reading of the text would dictate.).

The Fernandez decision is a big deal. While it is heartbreaking for Mr. Fernandez personally, the larger significance is that Judge Clark has indicted Congress for legislative malpractice for constructing a statute in which one portion (applying the law of the former state) will never apply. It will be interesting to see what the higher courts do with this difficult issue.

Fifth Circuit Adopts Literal Reading of Exemption Statute

One of the reforms adopted by BAPCPA was to increase the amount of time a person had to spend in a state before he could take advantage of that state's exemptions. Under 11 U.S.C. Sec. 522(b)(3)(A), a person must live in a state for 730 days to claim that state's exemptions. If the debtor does not satisfy the 730 day requirement, the law of the state where the debtor lived for the greater portion of the 180 days prior to the 730 days applies. This provision was meant to make it harder for a debtor to enhance his exemptions by moving to a new state prior to bankruptcy. However, a new opinion from the Fifth Circuit shows that the statute can have some unintended consequences. Ingalls v. Camp, No. 09-50852 (5th Cir. 1/21/11). You can find the opinion here.

The debtor moved from Florida to Texas during the 730 days before bankruptcy. As a result, he was required to use exemptions available under Florida law. The debtor claimed federal exemptions. However, Florida law prohibits "residents" from using federal exemptions. The trustee objected, contending that the court should apply Florida law as if the debtor were still a resident of Florida. The Bankruptcy Court agreed and sustained the objection. In re Camp, 396 B.R. 194 (Bankr. W.D. Tex. 2008).

The District Court reversed and was affirmed by the Fifth Circuit. The basis for its reasoning was straightforward. "Residents" of Florida could not use federal exemptions. Camp was not a "resident" of Florida. Therefore, he could select federal exemptions even though his exemptions were determined under Florida law.

The Court of Appeals began with the canon that "courts must presume that a legislature says in a statute what it means and means in a statute what it says there." Opinion. p. 3. The Court found it to be pretty clear that the Florida legislature did not intend for non-residents to be precluded from using federal exemptions.

Therefore, Florida’s opt-out statute, by its own express terms, does not apply to nonresident debtors, who remain eligible to use the federal exemptions because nothing in Florida law specifically disallows them from doing so. (citations omitted). Here, because Camp was not a Florida resident at the time he filed his bankruptcy petition, Florida law does not restrict his access to the federal exemptions.

Opinion, p. 5.

The Fifth Circuit's analysis appears pretty clear, at least as a matter of Florida law. After all, why would Florida care if non-residents claimed federal exemptions? The difficulty with the opinion is that Sec. 522(b)(3)(A) expresses a federal policy that mobile debtors should receive the same exemptions that they would have received if they had stayed put.

States naturally draft their exemption laws to apply to their residents, since that is who they have authority over. It would be simply incomprehensible for Florida to draft an exemption statute to apply to residents of Texas. Florida could have drafted its law to refer to persons to whom Florida law applies, but why would it? Florida is interested in Floridians, while Congress has the responsibility for looking after the broader, national interest.

Congress said to look to Florida law to determine the exemptions of the debtor in this case. Congress could have been more clear and said that the debtor's exemptions would be determined under Florida law as though the debtor still resided in Florida. However, it seems pretty clear that that is what they meant.

In this particular case, the debtor received exemptions which would not have been available to him if he had remained in Florida. However, it is easy to imagine a case where state exemptions depended on residency of the state so that the peculiar wording of a state exemption law could deprive the debtor of exemptions he would otherwise have been entitled to if he had remained in the prior state.

I am a strong proponent of plain meaning analysis. However, this may well be a case where the plain meaning isn't so plain. We know what Congress was trying to accomplish. For those who are not enamored of BAPCPA it is easy to chortle at Congress for shooting for a specific result and falling short through poor drafting. However, in this particular case, the drafting was not particularly obtuse, inelegant or contradictory.

This case is somewhat ironic because of the manner in which it resolved a split between bankruptcy judges in the Western District of Texas. Judge Leif Clark articulated the position adopted by the Fifth Circuit in In re Battle, 366 B.R. 635 (Bankr. W.D. Tex. 2006). Judge Craig Gargotta wrote the opinion which was reversed in the Camp case. Judge Clark has a reputation for being a deep thinker who will go out on a limb in support of a contrarian position. Judge Gargotta has a reputation as being a straightforward by the numbers jurist. Thus, it is ironic that Judge Gargotta took the more nuanced, intellectual position, while Judge Clark said plain meaning full speed ahead. This is the nature of BAPCPA. Reasonable minds can and will disagree and sometimes the results will be surprising.

Disclosure: I represented the Trustee in this case in the appeal to the Fifth Circuit. I was the attorney who did not prevail.

While I am uneasy with the result here, I wish to commend my colleague, Robert W. Berry, who represented the debtor. Mr. Berry has a consumer bankruptcy practice. After receiving an unfavorable ruling from the bankruptcy court, it would have been easy to let the result lie. Instead, Mr. Berry stuck with his client and took the case through two levels of appellate review. That is what good lawyers do.

Schwab v. Reilly Places Homesteads at Risk Years After Filing

A new opinion from the Ninth Circuit illustrates the practical implications of Schwab v. Reilly, 130 S.Ct. 2652 (2010). In Matter of Gebhart, No. 07-16769 (9th Cir. 9/14/10), the Court held that the Trustee was entitled to reap the benefits of post-petition appreciation in the Debtor’s homestead. The opinion can be found here.

Two Homesteads Going Up Over the Years

Gebhart involved two consolidated appeals. In the first case, the Debtors filed chapter 7 in August 2003 and claimed the Arizona homestead exemption. On the petition date, the Debtor’s equity was less than the $100,000 exemption. The Trustee did not object. In November 2006, the Trustee sought to employ a broker to sell the home, contending that its value had appreciated beyond the exemption amount. In the second case, the Debtor filed bankruptcy in June 2004 and claimed the Washington homestead exemption. Two years later, the Trustee sought to sell the home, which had appreciated in value. Both Debtors cried foul. The Arizona court ruled that the property remained in the estate, while the Washington court ruled that the unopposed exemption removed the property from the estate.

It's Exempt But What Is "It"?

The Ninth Circuit acknowledged that “{q]uite simply, property that has been exempted belongs to the debtor.” However, the question is, just what was exempted and passed out of the estate? Following the Supreme Court, the Ninth Circuit stated that where an exemption was limited to a dollar amount (as was the case with both the Arizona and Washington exemption statutes):

Instead, what is removed from the estate is an “interest” in the property equal to the value of the exemption claimed at filing. (citation omitted). The implication for the cases at issue here are clear: the fact that the value of the claimed exemption plus the amount of the plus the amount of the encumbrances on the debtor’s residence was, in each case, equal to the market value of the residence at the time of filing the petition did not remove the entire asset from the estate.

Opinion, at 14071-72.

A Bad Result They Admit

The Ninth Circuit did not shy away from the implications of its decision.

The debtors argue that the result we reach today will lead to uncertainty about the status of exempt property and abuses by trustees. The facts of the Gebhart bankruptcy suggest that some of these concerns are legitimate. Gebhart remained in his home for five years after filing for bankruptcy, paying his mortgage and believing that his bankruptcy was finished when he received his discharge. Gebhart may have been mistaken in his belief, but his misapprehension was shared by his mortgage lender, which refinanced the home, apparently unaware of any claims on the property by the Trustee. A Chapter 7 debtor will not be certain about the status of a homestead property until the case is closed (something that may not happen for several years after bankruptcy filing) or the trustee abandons the property.

Opinion, at 14074.

Notwithstanding these concerns, the Court held that the Trustee was not stopped to claim the homestead property and could not be compelled to abandon the property.

Opening Pandora's Box

This case illustrates the Pandora’s box opened by Schwab v. Reilly. While that case involved a dispute over the value of property as of the petition date, these cases involved post-petition appreciation. Debtor’s attorneys cannot assume that an unobjected to exemption means that the debtor gets to keep the property. If the exemption is defined by a dollar amount, the Trustee can sit back and wait for appreciation.

How serious is the risk for Texas debtors? Texas is one of the minority of states which allow use of federal exemptions. Most of these exemptions are dollar limited. On the other hand, Texas law allows unlimited exemptions for the homestead, tax qualified retirement accounts, annuities and cash value of life insurance. Texas law allows an aggregate exemption of $60,000.00 for certain categories of personal property.

How could this issue arise in Texas? Here are a few possibilities:

1. The Debtor uses federal exemptions to claim a homestead with no equity and a business under the wildcard exemption. Subsequently, either real estate prices rebound or the debtor makes a success of the formerly languishing business. At that point, the Trustee could sell the now valuable asset.

2. The Debtor takes federal exemptions and undervalues an asset, such as tools of the trade. If the Trustee subsequently finds out that the asset had more value, he could sell it. That was the fact scenario in Schwab v. Reilly.

3. The Debtor claims Texas exemptions and claims $5,000 worth of jewelry. Subsequently, it turns out that the jewelry was worth $45,000. While that would still be under the $60,000 cap, Texas law limits the jewelry exemption to $15,000. Again, under-valuation can be remedied without a timely objection.

4. If the Debtor claims Texas exemptions, but acquired their homestead within 1,215 days, then the homestead is subject to a cap under Sec. 522(p). If the homestead subsequently appreciates, the Trustee could move to sell even though the property was under the cap on the petition date.

5. The most unlikely scenario is one where the debtor owns an asset such as artwork which has negligible value on the petition date. Post-petition, the artist dies and acquires a cult following. As a result, the total value of the Debtor’s personal property exceeds $60,000. However, in this instance, the debtor should be able to take advantage of depreciation in other personal property assets, such as vehicles, to offset the appreciation of the artwork. The challenging aspect of the Texas personal property exemption is that the cap applies to the overall group of assets. As a result, the change in value of one asset may be offset by the decline in value of another.

Supreme Court Rules for Trustee in Exemption Dispute

The Supreme Court ruled today that when claiming Federal Exemptions, the Debtor is entitled to the dollar amount claimed rather than the actual property. As a result, a trustee could sell property claimed by the debtor as exempt where it proved to be more valuable than the amount claimed by the debtor. Schwab v. Reilly, 560 U.S. ___ (6/17/10).

The majority opinion was written by Justice Thomas and joined by Justices Stevens, Scalia, Kennedy, Alito and Sotomayor. Justice Ginsberg wrote a dissent which was joined by Chief Justice Roberts and Justice Breyer. This was another case of strange judicial bedfellows as conservative and liberal justices signed on to both opinions. The competing opinions each parsed the legislative language to arrive at their conclusions.

What Happened

Nadejda Reilly filed a petition for chapter 7 and claimed equipment from her catering business as exempt. She valued the property at $10,718. She claimed an exemption of $1,850 for tools of the trade under Sec. 522(d)(6) and $8,868 under the wildcard exemption under Sec. 522(d)(5). Thus, the debtor claimed the entire scheduled value as exempt. During the time for filing objections to exemptions, the Trustee obtained an appraisal valuing the equipment at $17,200. However, the Trustee did not object. Instead, the Trustee subsequently filed a motion to auction off the equipment and pay the Debtor the amount claimed as exempt.

The Trustee's request was rebuffed by the Bankruptcy Court, the District Court and the Third Circuit, but not the Supreme Court.

The Statutory Language

Both the majority and the dissent focus on the language of Sec. 522(l) which states that "Unless a party in interest objects, the property claimed on such list is exempt." However, they disagreed about what "the property claimed on such list" referred to.

The dissent contended that "the property claimed on such list" referred to the actual items listed on Schedule C and that when a Debtor claimed the full value as exempt, that the property would be exempt absent a timely objection.

The majority required several more steps to parse the language.

1. Section 522(l) allows the debtor to "file a list of property that the debtor claims as exempt under subsection b of this section."

2. Section 522(b) allows the debtor to claim property exempt under state law or other applicable law or under Section 522(d).

3. If the Debtor claims Federal Exemptions under Section 522(d), the exemptions in Sec. 522(d)(1)-(8) and 11(C) are defined in terms of "the debtor's aggregate interest, not to exceed $____ in value." On the other hand, the exemptions in Sec. 522(d)(9), (10), (11)(A)-(C) and 12 are not defined in terms of value.

4. If the Debtor claims a value limited exemption, the Debtor's exemption is in the value, not the property.

5. So long as the Debtor claims a dollar amount which is within the statutory limits, the Trustee is not required to object, because the Debtor has claimed a value allowed by law and only the value.

The majority rejected the Third Circuit's contention that "an unstated premise" of Taylor v. Freeland & Kronz was that a debtor who claims the full value of an item of property claims the property itself.

What It Means

In her dissent, Justice Ginsberg stated that:

In addition to departing from the prevailing understanding and practice, the Court's decision exposes debtors to protracted uncertainty concerning their right to to retain exempt property, thereby impeding the "fresh start" exemptions are designed to foster.

While the majority claims that its decision did not do violence to its prior holding in Taylor v. Freeland & Kronz, the practical problems are clear.

Under Section 541 of the Bankruptcy Code, all of the debtor's interests in property enter the estate. Under Section 522(b)and(l), property successfully claimed as exempt is no longer property of the estate. However, if the exemption applies to property subject to a dollar value limitation, the property doesn't leave the estate, merely the value. This means that the property (the res, as opposed to the value) remains property of the estate until it is abandoned under Section 552.

Under Section 552(a), the Trustee can voluntarily abandon a piece of property which is burdensome or of inconsequential value. If the property is properly scheduled and the court does not order otherwise, the property is automatically abandoned to the debtor when the case is closed. Furthermore, the debtor may request that the trustee be ordered to abandon the property under Section 552(b). Thus, the practical import is that if a debtor claims a value limited item of property as exempt and wants to dispose of the property, the debtor would need to file a motion to compel abandonment.

The new rule creates possibilities for mischief and malpractice. Assume that the debtor files bankruptcy and claims federal exemptions with regard to their homestead. At the time that they file, they believe that the value of the homestead is within the exemption limit. The trustee neither objects to the exemption nor closes the case. Two years later, the trustee files a motion to sell the debtor's home because values have gone up dramatically. Has the debtor's attorney committed malpractice by not filing a motion to compel abandonment? The trustee's gambit shouldn't work because Section 522(a)(2) defines value in terms of the petition date. However, if the debtor has an appraisal from a year prior to bankruptcy and the trustee has one from a year after the bankruptcy, how certain can the parties be about what the value was on the petition date. Will it be necessary to get an appraisal as of the petition date to protect the debtor?

Here is another facet. Under 11 U.S.C. Section 363(b), the trustee can lease property of the estate. If the homestead remains as property of the estate, could the trustee evict the debtors and lease the property out even if the value of the exemption exceeded the value of the property? If the exemption is in the value rather than the property, does the debtor have to be compensated for use of the property by the trustee?

Taking it further, let's assume that the house burns down without either the debtor or the trustee having insured it. Is the trustee subject to a claim on his bond?

As a practical matter, trustees will likely be motivated to close questionable value estates in order to receive their commission. However, the potential for trouble is tremendous.

Lawyers, Guns and Money

"Send lawyers, guns and money."--Warren Zevon (1978).

A new opinion out of San Antonio (home to the Alamo) contains the elements of lawyers, guns and money in a decision about exempting firearms. In re Wilkinson, No. 07-50189 (Bankr. W.D. Tex. 4/10/09). While I enjoyed the analysis, I don't think I would have arrived at the same conclusion. (Of course, I don't wear a black robe, so whether I agree or disagree is somewhat academic).

Dr. Wilkinson had guns. Lots of guns. Some of them could shoot. Others were mounted on the wall with brass plates describing them. The Debtor sought to keep two guns under the firearms exemption, but also sought to keep the mounted guns as home furnishings. The trustee cried foul, arguing that "firearms are firearms and cannot be claimed under another category such as 'home furnishings.'"

The Debtor's first shot (pun intended) was to point to a statute which said that antique or curio guns manufactured before 1899 were not guns. Texas Penal Code Sec. 46.01. This was a nice try, since the creative debtor's lawyer found a statute which said that the mounted guns were not legally firearms. However, this shot was easily deflected by the judge. The Penal Code dealt with guns which could not be possessed by felons. Since guns which cannot go bang are not inherently dangerous in the hands of a felon, their possession should not be criminalized. However, the statute didn't really answer the question of whether antique firearms mounted on plaques should be excluded from the definition of firearms under an exemption statute.

Next, the court considered the definition of firearm in common parlance. The court noted that:

Notably, none of these definitions excludes antique firearms or guns from the definition of what constitutes a firearm. None of these definitions requires that the item be in working order to constitute a firearm.

Opinion, p. 11.

The Court then went on an interesting historical analysis which demonstrated that guns have not always been sancrosanct in Texas. The Court noted that in Choate v. Redding, 18 Tex. 579 (1857), the Texas Supreme Court bemoaned the fact that there was no exemption for guns in Texas. This was especially troubling because Texas law required that every able-bodied man bring a gun in connection with their militia service. (This was back in the good old days when gun ownership was not only allowed but mandated!) Thus, if a creditor levied upon a debtor's non-exempt gun and he was called up for militia service, the debtor could be punished for showing up disarmed.

The lackadaisical legislature did not allow a gun to be exempted until 1870 and tardily expanded this exemption to two guns in 1973. The court concluded that because the legislature had to be dragged kicking and screaming to allow even two guns to be exempted that it would not allow more than that to be exempted under the guise of home furnishings.

I find the historical analysis interesting. I had always thought that the exemption for two guns was meant to allow Pa to shoot one gun out the front door while Ma defended the back of the house. Since the exemption for two guns did not come around until 1973 when the risk of marauding indians was substantially diminished, this assumption was probably incorrect. Hopefully none of my clients who I told this story to will ask for their money back.

However, I think that the court was asking the wrong question. The Debtor sought to exempt the mounted firearms as home furnishings rather than as firearms. Thus, the relevant question should be whether a mounted gun which doesn't go bang could be considered to be a home furnishing. A home furnishing is something that is used to furnish a home. (While I don't have any authority for this proposition, it is based on the close proximity between home and furnishing in the statute). Texans are granted great leeway in deciding how they will furnish their homes. They may decide to decorate their homes with tasteful artwork bought in galleries in Santa Fe and Taos or they may decide to build elaborate displays of Lone Star beer bottles and photographs of road kill. Likewise, both a display case containing pre-Columbian pottery and a collection of sweatstained tshirts from the Capital 10,000 neatly mounted in a shadow box could be a home furnishing. How you furnish your home is largely in the eyes of the beholder.

In my mind, whether a gun is exempt as a gun or a home furnishing depends on how it is actually used. If it is kept in a gun safe with suitable ammunition nearby, it is only exempt as a firearm or possibly as a tool of the trade in the case of a law enforcement officer. On the other hand, if it is mounted and the wall and doesn't go bang, then it is probably being used as an adornment or decoration and thus would fit the definition of a home furnishing. Just because the same item could potentially be exempted under one category should not prohibit it from being claimed under another applicable provision. Function, not origin, should determine the appropriate category for exemption. The mounted firearms seem an easy case to me. The harder case would be the debtor who decorated the inside of his closet with $60,000 worth of gold bullion. If the interest in decorating with gold arose on the eve of bankruptcy and the gold was not prominently displayed to visitors, that would probably not be a real home furnishing.

Exemption Cases Take a Campy Turn

When Bankruptcy Judge Craig Gargotta decided In re Camp, 396 B.R. 194 (Bankr. W.D. Tex. 2008), he staked out a unique position on how exemption laws should be applied when Sec. 522(b)(3)(A) requires application of the law of another state. Judge Gargotta concluded that Sec. 522(b)(3)(A) was a choice of law provision so that the law chosen should be applied to the debtor as though the state where he currently resided was the state whose law was being applied. As a result, Judge Gargotta concluded that where a Florida resident living in Florida would be prevented from using the federal exemption scheme that a Texas resident subject to Florida law could not claim federal exemptions either. In reaching this decision, Judge Gargotta disagreed with In re Battle, 366 B.R. 635 (Bankr. W.D. Tex. 2006), a decision by his Western District colleague Judge Leif Clark. Indeed, Judge Gargotta's analysis appeared to be unique to him. Now two additional courts have considered the Camp analysis, reaching differing results.

Camp Followed

The Camp choice of law approach has now been applied by a second judge. In re Morgan C. Smith, No. 07-20614 (Bankr. S.D. Tex. 3/12/09) is a decision by Judge Richard Schmidt which applies Louisiana law to a Texas resident. The Debtors lived in Louisiana from 1991 to 2007. During that time, his parents conveyed 245 acres in San Patricio County to the debtor and his siblings. After the property was partitioned, the Debtor received 81.79 acres solely in his name. Later in 2007, the Debtors filed under Chapter 12 and claimed Texas exemptions. Under these facts, the exemption allowed to the Debtor would be:

Unlimited as to 81.79 acres if Texas law applied;
Limited to $40,400 if federal exemptions could be claimed; or
Limited to $25,000 if Louisiana law applied.

The Court concluded that because the Debtors had only been domiciled in Texas for 230 days prior to filing that Texas law did not apply.

The Court then concluded that under the Camp decision, because Louisiana law did not allow debtors to choose federal exemptions, that this choice was not available either.

As a result, the Court found that Louisiana law was the only choice available for the Debtors and limited the exemption to $25,000. The Louisiana statute did not specify that only land in Louisiana could be claimed as homestead. However, if the Court followed the Camp opinion to its logical conclusion, the Debtor would be able to claim the full Louisiana exemption on a Texas property for the reason that the Court would be required to apply the law as if the Texas property were really in Louisiana.

Camp Rejected

While Smith followed Camp to allow extra-terratorial application of the Louisiana law, the 10th Circuit BAP rejected Camp but still allowed extra-terratorial application of the Iowas homestead law. In In re Stephens, 2009 Bankr. LEXIS 305 (10th Cir. BAP 3/9/09), a debtor sold his Iowa homestead and moved to Oklahoma. Iowa law allowed an exemption in proceeds of a homestead sale for a "reasonable" time. The Court rejected the Camp choice of law analysis, which would have held that restrictions on applying Iowa law to property outside of Iowa were preempted. However, the court reached the same result by concluding that nothing in the Iowa law prevented it from being applied to homestead proceeds taken to another state. As a result, the Court concluded that Iowa could have chosen to prevent its homestead exemption from being applied to property located in another state, but had not done so.

I have one final comment after reading these cases: Does your head hurt yet? Mine does.

Bankruptcy Court Limbers Up to Tackle Mental Gymnastics of Lien Avoidance

A Texas bankruptcy judge had to engage in some mental gymnastics to decide whether to avoid a lien on property exempted under the federal wildcard in In re Melissa Catherine Powell, No. 08-60204 (Bankr. W.D. Tex. 11/6/08). Powell presented some interesting facts. The debtor owned four tracts of real property. However, those properties were encumbered with a $1.1 million judgment lien. Ms. Powell had apparently been up to no good, since the judgment creditor subsequently obtained a non-dischargeable judgment against her. In the absence of bankruptcy, the debtor would have lost the three non-homestead properties. However, the debtor filed bankruptcy, claimed the property as exempt under Sec. 522(d)(1) and (5) and then sought to avoid the judgment lien as a lien impairing an exemption. While the result may raise a few eyebrows, the court faithfully followed the code sections.

The debtor was able to claim four properties as exempt because Texas allows use of the federal exemptions and each property had minimal equity. The debtor claimed total exempt equity of $7,406.43 between the four properties. The exempt values were determined based on the difference between the scheduled values and the non-judgment liens. No party objected to the exemptions, so that they became final. The debtor then moved to avoid the judgment lien as a non-purchase money lien impairing an exemption under Sec. 522(f). The creditor tried to hold the debtor to its scheduled exemption, arguing that the debtor had claimed $7,406.43 in exempt property and could not avoid the judgment lien to the extent that the equity in the properties exceeded this amount.

The Bankruptcy Court framed two issues for decision:

1. Exactly what was claimed and allowed as exempt?

2. Are the creditors, in defense of a lien avoidance motion under Sec. 522(f), foreclosed from challenging the exempt nature of the properties in question due to their failure to timely object to the Debtor's exemption claims?

The creditor's defense to the lien avoidance motion raised the question of what the debtor had claimed as exempt. Was it the property or was it a specific dollar value in equity? The court dryly noted, "Remarkably, this is an issue about which there has been some controversy."

The court pointed out that when a debtor claims an unknown amount as exempt or lists the exempt value at $1, she is putting creditors on notice that the entire value of the asset is claimed as exempt. On the other hand, when the debtor listed a specific dollar amount calculated as the difference between the scheduled value and the scheduled liens, creditors were not on notice that the debtor might claim a greater value. The court noted that there was a difference between "in kind" exemptions which apply to the entire asset and "not to exceed" exemptions which are limited to a dollar value.

The Court stated:

Section 522(d)(1) and (5) allow the Debtor to exempt her aggregate interest in the real property in question. There are not "in kind" statutes. However, when the Debtor places a value on her exemption under (d)(1) and (5) which is less than the monetary amount allowable under the statute and such value was reached by deducting the amount of debt from the value of each such listed property as set forth on Schedule A; it is clear, at least to this Court, that the Debtor's intention was to exempt the maximum allowable under the federal exemption statute. There is no intent to exempt the Properties in their entirety. Even so, this is not determinative of the issue at had as discussed below.

Slip op. at 8.

The issue is thornier because Sec. 522(f) allows the debtor to avoid a lien "to the extent that such lien impairs an exemption to which the debtor would have been entitled under subsection (b) of this section . . ." Thus, for purposes of lien avoidance, the issue is not what amount was exempted by the debtor, but what amount the debtor would have been entitled to. "For purposes of Sec. 522(f), the issue starts with the inquiry of whether we are dealing with property the debtor would have bene entitled to exempt not whether the debtor has scheduled them as such." Slip op. at 11.

Based on the "would have been entitled" language of Sec. 522(f), a debtor who under-exempts his property would be entitled to avoid the lien based on the full amount he was entitled to, while a debtor who over-exempted or claimed property which should not have been exempt at all could not resort to use of Sec. 522(f).

In the specific case, the amount actually claimed as exempt by the Debtor was $7,406.43. However, the Debtor was entitled to claim exemptions of $21,275.00 based on Sec. 522(d)(1) and (5). The lien would impair the exemption to the extent that it prevented the Debtor from realizing the value of $21,275 that she "would have been entitled" to. If there was less equity in the property than the maximum which could be claimed as exempt, then the lien "should be avoided in its entirety as the Debtor's claimed exemption is totally impaired." On the other hand, if the properties were worth more than the value of the unavoidable liens plus the Debtor's maximum exemption, then the "judicial lien would be preserved to the extent of such excess value." Although the Debtor's schedules indicated that there would not be any excess value for the lien to attach to, the court gamely offered that, "if the (creditors) would like to offer such proof, the court is amenable to holding a hearing for such purpose."

There are a number of important points to take away from this opinion.

1. Just because the Debtor is a bad person does not prevent them from using the tools available under the Code. While we frequently say that the Bankruptcy Court is a court of equity and that litigants must do equity to receive equity, that will not overcome a statutory command. In this case, the court, in discussing the creditors' claim, dropped a footnote stating, "There is no indication in the Complaint as to whether the Debtor was prosecuted for her alleged misdeeds; but, if they are true, prosecution would seem most appropriate." Where else but Bankruptcy Court would a party for whom "prosecution would seem most appropriate" prevail against the wronged party?

2. There are two types of exemptions: in-kind and not to exceed. An in-kind exemption exempts the entire property, while a not to exceed exemption just protects a dollar amount. As a result, failure to object to a "not to exceed" exemption does not make the entire property exempt unless the debtor clearly stated an intent to claim the entire asset or the asset was worth less than the allowable exemption. Therefore, if the debtor claims a $5,000 wildcard exemption on a million dollar asset, the debtor gets to keep $5,000 rather than $1,000,000.

3. Lien avoidance under Sec. 522(f) is based on what the debtor should have been entitled to exempt rather than what she actually claimed as exempt. Therefore, every lien avoidance hearing is also a hearing to determine what the exemption should have been.

Bankruptcy Court Stakes Out Unique Position on Sec. 522(b)(3)(A) as Choice of Law Rule, Relies on Former State's Law Without Regard to Actual Residenc

A new decision from Bankruptcy Judge Craig Gargotta is likely to prompt discussion as the court held that a debtor could be prohibited from using federal exemptions based on the law of his prior residence even though that state's law only prohibited "residents" of the state from using the federal exemptions. In re Camp, No. 08-11056 (Bankr. W.D. Tex. 9/25/08). In so ruling, Judge Gargotta disagreed with the opinion in In re Battle, 366 B.R. 636 (Bankr. W.D. Tex. 2006) from his Western District colleague Leif Clark.

The Facts

Melvin Camp moved to Texas from Florida. Under 11 U.S.C. Sec. 522(b)(3)(A), his choice of exemptions was governed by the law of Florida because he had not resided in Texas for the requisite 730 days. Mr. Camp was a prime candidate to use the federal exemptions. His paltry possessions added up to only $24,205, but included cash of $3,100, a lot which was not his homestead valued at $4,500 and a pickup truck worth $13,750. Under the federal exemptions, he would be able to keep all of these assets.

The Debtor's lawyer had no doubt read In re Battle, which held that Sec. 522(b)(3)(A)'s mandate to apply Florida law meant to apply it exactly as written. Since Florida law prohibited residents of Florida from using the federal exemptions and Mr. Camp was NOT a resident of Florida, he should be able to claim federal exemptions and keep his property.

The Trustee objected to the Debtor's exemptions claiming that In re Battle was incorrectly decided. The Bankruptcy Court agreed with the Trustee and denied the exemption.

When Does A Statute Not Mean What It Says? When It is a Choice of Law Provision.

The Florida statute appears clear. It states that "residents of this state shall not be entitled to the federal exemptions provided in s. 522(d) of the Bankruptcy Code of 1978." Based on this language, Judge Clark's Battle opinion held that where Florida had adopted a limitation applicable to residents of Florida and Congress had deemed that the statute apply to persons who no longer resided in Florida, that the statute should be applied exactly as written--in other words, that Texans subject to Florida exemption law were not prohibited from using the federal exemptions.

Judge Gargotta acknowledged that, "At first blush, these courts' reasoning appears sound. It relies exclusively on the language of the applicable opt-out statute." Opinion, p. 4.

However, Judge Gargotta went on to consider Congress's intent in adopting these provisions and how they should be applied.

Florida has thus expressed its judgment that its residents who file bankruptcy should be restricted to claiming Florida exemptions. Congress decided when it enacted the 1978 Bankruptcy Code to honor such decisions by the states that have made them, by expressly incorporating such "opt-out" provisions by reference in Sec. 522(b)(2).

Residency restrictions in a state's exemption laws, including residency restrictions applicable to its opt-out statute, are equivalent to choice of law provisions--they address the question of what state's laws should determine the exemptions of a debtor who has moved from one state to another. (citation omitted). However, by adopting Sec. 522(b)(2) and (3)(A), congress expressed its own judgment that, in instances where a debtor moves from one state to another within 730 days before filing bankruptcy, his exemptions should be determined by the laws (including any opt-out law) of his former domiciliary state. Thus, the issue in this case (and in Battle and similar cases) arises because of the conflict between a state law choice of law provision and the federal choice of law provision contained in Sec. 522(b)(2) and (3)(A). Such conflicts are traditionally resolved by applying the doctrine of preemption. (citations omitted).

The courts deciding Battle and similar cases, however, did not address this conflict between the applicable state opt-out statute and the federal statute, Sec. 522(b)(3)(A), or the question of preemption. Instead, those courts assumed, without discussion, that Sec. 522(b)'s incorporation of each state's substantive exemption laws also incorporated the state law choice of law provisions that each state applies to its exemption laws outside of bankruptcy (e.g., the residency restriction in its opt-out statute). In doing so, those courts have effectively written out of Sec. 522(b)(3)(A) Congress's own considered policy judgment on which state's law should apply when a debtor moves before filing bankruptcy.

Opinion, pp. 4-5.

The resourceful Judge Gargotta came up with an interesting example to make his point about how literally following a state's laws could frustrate the intent of Congress. Idaho law provides that residents of Idaho are entitled to use the Idaho exemptions and that nonresidents are entitled to use the law of the state of their residence. If this provision were applied literally, a debtor who moved from Idaho to another state would automatically be allowed to use the law of the new state despite Congress's mandate to apply Idaho law.

Judge Gargotta ultimately concluded that the proper approach was to apply the laws of the prior state "as if he had not moved for purposes of determining what property he may claim as exempt." Opinion, p. 8. Indeed, he adopted the position that in applying Sec. 522(b)(3)(A), the court must disregard the reality that the debtor actually resides in the state where he lives.

For example, if thirty days before filing bankruptcy a debtor moved from Texas to Louisiana and purchased a home, Sec. 522(b)(3)(A) requires the bankruptcy court to "disregard the element of reality" of the actual state of the debtor's residence (Louisiana), and instead engage in the fiction of considering the state of his or her former residence (Texas) to be the state where he or she currently resides. If the debtor chooses state exemptions, Texas exemption laws would apply to the debtor's home and other property located within the state--in this case, within "Louisiana qua Texas." This is not, however, the extraterritorial application of Texas's exemption laws. It is not under the authority of the State of Texas that its exemption laws are being applied to property outside Texas. Rather, it is a federal choice of law statute--Sec. 522(b)(3)(A)--that has expressly provided that the exemption laws of a particular state--Texas--are applicable to a debtor who, by definition, is no longer a domiciliary of that state and so whose property is almost certainly no longer located within that state.

Opinion, p. 11.

What Does It All Mean?
This is a difficult opinion to digest. It will likely result in the death of many trees (or perhaps the consumption of many electrons) as law professors try to sort this out. Judge Gargotta acknowledged that, "(N)o other court has yet expressly held that a state residency restriction in an opt-out statute is a choice of law provision that is preempted by Sec. 522(b)(3)(A)." Opinion, p. 7.

However, despite the density of the reasoning, there is a simple logic to the result--namely, that a debtor should neither be advantaged or disadvantaged by a move within 730 days before bankruptcy. While Sec. 522(b)(3)(A) has often been viewed as a measure designed to punish debtors who move to exemption friendly states, it can also have the reverse effect. If a debtor moves from Texas with its unlimited exemption to Maryland which has no homestead exemption, the Debtor could enjoy the benefits of the Texas exemption in Maryland.

Judge Clark Protects the Brooklyn Bridge

The prolific Judge Leif Clark, who has written many memorable footnotes, including one quoted here yesterday, has written another one which is both quotable and addresses an important point. In In re Rendon, No. 06-52501 (Bankr. W.D. Tex. 3/15/07), a party who claimed to be purchasing a home from the debtors filed a Motion to Create Equitable Lien/Motion for Expedited or Emergency Hearing. The court found that the motion requested three forms of relief: an order quieting title, an injunction and an objection to the debtors’ claim of exemption. The court found that the first two forms of relief must be brought in an adversary proceeding and dismissed the motion without prejudice. The court found that the objection to exemptions was untimely and must be denied. Even though the purchasers were not listed as creditors in the bankruptcy, they admitted that they had actual knowledge of the bankruptcy case prior to the 341 meeting.

The court noted that the mere fact that the debtors had successfully claimed the property as exempt did not establish their ownership of the property. In a footnote, the court added the following comment:

"Just in case there is any confusion, let’s suppose I claim an exemption on the Brooklyn Bridge, and you fail to timely object to my exemption claim. Is the sainted bridge thus exempt? Technically, section 522(l) says it is. But of course, what difference does my exemption claim make if Hizzoner, Mayor Bloomberg, comes to court and successfully establishes that, in fact, the Brooklyn Bridge is not my bridge to claim, but is safely still the property of the City of New York, safely untarnished by my exercise in hubris? None at all you correctly reply, none whatsoever.”

It is important to note that an exemption merely determines whether property is excluded from the estate. However, it does not operate to grant title to the property. Mayor Bloomberg will no doubt sleep more soundly.

Exemptions and the Mobile Debtor

Most states do not allow their residents to choose federal exemptions. However, a new opinion from Judge Leif Clark points out that BAPCPA may have expanded the reach of federal exemptions for a limited number of mobile debtors. In re Battle, No. 06-50545 (Bankr. W.D. Tex. 12/12/06).

Exemptions were a major concern for Congress when it passed the Bankruptcy Abuse and Consumer Protection Act of 2005 (BAPCPA). Among other things, Congress was worried about wealthy debtors moving to states with generous exemptions, such as Texas and Florida, for the purpose of filing bankruptcy. One provision enacted to limit this practice imposed a residency requirement of 730 days before an individual could claim under a state's exemption laws. If the person had not resided in one state for the entire 730 day period, then exemptions would be determined under the law of the state where the debtor had resided for the greater portion of the 180 days prior to the 730 days. See 11 U.S.C. Sec. 522(b)(3)(A). If the effect of Sec. 522(b)(3)(A) is that no exemption law applies (for example, if the person resided out of the country during the relevant time period), then the person would be allowed to take federal exemptions under 11 U.S.C. Sec. 522(d). The application of Sec. 522(d) as exemption of last resort is of little solace, since it only applies in the case where no exemptions whatsoever would be allowed.

While the legislation may guard against abuse, it also operates as a trap for the unwary. Each year, about 3% of the population changes states. See Allison Stone Wellner, "The Mobility Myth," Reason Magazine (April 2006). If these individuals wind up in bankruptcy court, they may find their property rights defined by the laws of a state they had long left behind and which are unfamiliar to their counsel. This extraterratorial application of exemption laws may lead to strange results. For example, the Texas homestead exemption applies to "all homesteads in this state whenever created." Tex. Prop. Code Sec. 41.002(d). Thus, if a Texas resident moves to Florida (both states with high homestead exemptions), purchases a Florida homestead and files bankruptcy 729 days later, then the debtor would arguably not be able to claim a homestead exemption under either law. Sec. 522(b)(3)(A) would mandate application of Texas law. However, the Texas law appears to apply only to homesteads within the state of Texas. Thus, even though both states allowed comparable homestead exemptions, a move for a legitimate reason, such as to take a new job, may lead to loss of the exemption.

The federal exemption option under Sec. 522(d) offers limited protection to some debtors. It allows each debtor to exempt $18,450 of equity in a home and includes a wild card provision as well. One problem is that when Congress created the federal exemption scheme, it also allowed states to opt out. See 11 U.S.C. Sec. 522(b)(2). Thirty-six states prohibit their residents from claiming federal exemptions.

In the case of In re Battle, No. 06-50454 (Bankr. W.D. Tex. 12/12/06), Judge Clark considered whether a former Floridian filing bankruptcy in Texas could claim federal exemptions. Because the debtor had lived in Texas for less than 730 days and had lived in Florida during the 180 days prior to the 730 days, the parties agreed that Florida law would apply. Florida is an opt out state. As a result, the Trustee argued that federal exemptions were not available under Florida law. However, Judge Clark noted that the relevant Florida statute provided that "residents of this state shall not be entitled to the federal exemptions." On the date of filing bankruptcy, the Debtor was not a Florida resident. Although the choice of law was determined by where the Debtor resided during the 180 days prior to 730 days, the facts of the exemption were determined as of the petition date. Because the Debtor was not a resident of Florida on the petition date, the opt-out provision did not apply and the Debtor was able to use the federal exemptions.

This is a case of two restrictive statutes canceling each other out. Both Sec. 522(b)(3)(A) and Sec. 522(b)(2)'s opt-out language restrict debtors' exemption choices. However, it appears that an unintended consequence of Sec. 522(b)(3)(A) is to allow most debtors whose exemption choices are governed by the law of another state to choose federal exemptions regardless of whether they could have chosen federal exemptions in either the original state or the new state. Thus, if a debtor moves from one opt-out state to another opt-out state and files bankruptcy less than 730 days later, the result may be to make federal exemptions available where they would not otherwise have been. If State A's exemption laws prohibit its residents from choosing federal exemptions, but the debtor is no longer a resident of State A, State A's prohibition does not apply. If State B's exemption laws prohibit its residents from choosing federal exemptions, but exemptions are determined under State A's law, then State B's prohibition is inapplicable. Thus, the result is to frustrate the policies of both states and make the federal exemption available. This would be little consolation to a debtor with a million dollar homestead who moves between high exemption states. However, it was enough to protect the Debtor in Battle.