Generally speaking, in bankruptcy, property owned as a tenant by the entireties is exempt. Interpreting Section 522(b)(3) and seemingly motivated in part by policy concerns, the Fourth Circuit held that a debtor’s interest in entireties property is not exempt from tax debt.

The chapter 7 debtor was an individual who had not paid taxes. He owned a home with his wife as tenants by the entireties. The wife was not liable on the tax debt. The Internal Revenue Service filed an unsecured proof of claim.

The debtor claimed that his interest in the home was exempt under Section 522(b)(3). It exempts “any interest in property in which the debtor had . . . an interest as a tenant by the entirety . . . to the extent that such interest as a tenant by the entirety . . . is exempt from process under applicable nonbankruptcy law.”

The bankruptcy court denied the exemption claim, saying that the subsection does not apply to tax debt. The debtor appealed to the district court and lost.

District Judge Elizabeth W. Hanes sat by designation and wrote the opinion for the Fourth Circuit on April 17 affirming the lower courts.

Judge Hanes began by saying that the reference to “nonbankruptcy law” in Section 522(b)(3) refers to both state and federal law. She explained why the debtor’s entireties interest was exempt under state law.

“[T]here is no dispute,” Judge Hanes said, that North Carolina law “shields [the debtor’s] home from non-joint creditors.” She cited an intermediate state appellate court for saying that “‘it is well established that an individual creditor of either a husband or a wife has no right to levy upon property held by the couple as tenants by the entirety.’” [Citation omitted.]

However, Judge Hanes said that the debtor “does not fare as well under federal law.” To justify her conclusion, she cited United States v. Craft, 535 U.S. 274 (2002). In Craft, she said that “the Supreme Court considered whether a federal tax lien provided for in § 6321 could attach to a husband’s entireties interest when only the husband owed the debt to the IRS.”

The Supreme Court was referring to Section 6321 of the IRS Code, 26 U.S.C. § 6321, which provides:

If any person liable to pay any tax neglects or refuses to pay the same after demand, the amount . . . shall be a lien in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.

Judge Hanes described the Supreme Court as reading Section 6321 to mean that “‘each tenant [in a tenancy by the entirety] possesses individual rights in the estate sufficient to constitute “property” or “rights to property” for the purposes of [a federal tax] lien.’” Id., 535 U.S. at 276. While “state law may create the legal ‘fiction’ that each tenant in a tenancy by the entirety has no separate interest in the property,” she said, the debtor “in substance … has all the ‘most essential property rights,’ even if he does not possess the right of unilateral alienation.” Id.

Judge Hanes quoted Craft as saying that a tax lien is “‘broad and reveals on its face that Congress meant to reach every interest in property that a taxpayer might have.’” Id. at 283. “Accordingly,” she said, “the husband’s entireties interest [in Craft] constituted ‘property and rights to property’ to which a federal tax lien could properly attach, even though his wife was not personally liable for the tax debt.”

“Because a federal tax lien can attach to one spouse’s interest in an entireties property, even when the tax debt is not jointly owed,” Judge Hanes held that “the property is not ‘exempt from process’ under federal nonbankruptcy law if the IRS has the right to obtain such a lien.”

Judge Hanes found policy reasons for affirming the lower courts. “[T]o rule otherwise,” she said, “would create perverse incentives by allowing a debtor to shield his entireties property from federal tax obligations as long as the debtor files for bankruptcy before the IRS issues a demand for the taxes or a Notice of Federal Tax Lien.”

Before ending her opinion, Judge Hanes saw “[n]othing in Craft [that] limits its holding to instances where the IRS has perfected a tax lien against the property.”

Judge Hanes affirmed the lower courts, holding “that property owned as a tenancy by the entirety may not be exempted from an individual debtor’s bankruptcy estate under 11 U.S.C. § 522(b)(3)(B) to the extent of the debtor’s tax debt to the IRS.”

Observations

Factually speaking, Craft was different from the case in the Fourth Circuit because the IRS in Craft had perfected a lien, while the IRS lien in the case on appeal was not perfected. Judge Hanes did not believe that the result in Craft turned on perfection.

We leave others to ponder whether another court might disagree with the Fourth Circuit and hold that the lack of perfection means that an entireties interest is exempt from tax debt. After all, a bankruptcy filing results in a hypothetical judicial lien.