Exclusions and Exemptions

<p>Almost invariably, a consumer debtor will ask "what do I get to keep?" or "what do I lose?" Unlike
dischargeability questions, which arise in relatively few consumer cases, the question of what property the debtor
will retain arises in all cases. In perhaps a majority of consumer cases, the answer to the question is more likely
than not that the debtor keeps everything—the classic "no-asset" case. One of the three most important functions
that counsel for the individual debtor performs is the proper identification and selection of exemptions. (The other
two, in my opinion, are selection of the appropriate chapter and completion of the schedules.) Debtor's counsel is
responsible for advising the debtor in a manner that maximizes the property retained. On the other side of the coin,
it is the obligation of trustees and trustees' counsel to ensure that the debtor does not retain property that the debtor
is not entitled to retain.

</p><p>Property, or perhaps more accurately, interests in property, may be either excluded from the estate under §541 of
the Bankruptcy Code or be exempt under §522. In some instances, a particular asset may be both excluded from the
estate and exempt under the exemption law applicable—<i>e.g.,</i> qualified pension plans. There is, however, a
fundamental difference: Property that is excluded from the estate never becomes property of the estate, whereas
exempt property is part of the estate but is not subject to liquidation by the trustee for eventual use to satisfy the
claims of creditors. In addition, property that is excluded from the estate is universal and beyond the reach of the
trustee irrespective of whether or not it is exempt under the applicable exemption statutes. Finally, most exemption
statutes have value limitations restricting the amount that may be claimed as exempt; property that is excluded is
unlimited in amount. This can be a very important factor in non-opt-out states in choosing between federal and state
exemptions.

</p><h4>Excluded Property</h4>

<p>Section 541 specifically excludes certain property from the estate. From the consumer debtor's standpoint,
the exemptions most likely to apply are those future earnings derived from personal services—<i>i.e.,</i> future
wages—under §541(a)(6) and the beneficial interest in spendthrift trusts under §541(c)(2). With respect to
§541(a)(6), it is important to keep in mind that the earnings that are exempt are those resulting from services
performed post-petition; earnings that have accrued (<i>i.e.,</i> earned but unpaid) at the time the petition was filed are not
excluded. Thus, if a debtor files at the midpoint of a pay period, half the earnings would be excluded but the other
half would be included in the bankruptcy estate and subject to being turned over to the trustee unless otherwise
exempt under the applicable exemption law.

</p><p>The "spendthrift" trust exclusion of §541(c)(2) includes pension and profit-sharing plans containing
anti-alienation provisions. These include ERISA-qualified plans (26 U.S.C. §401, <i>et seq.</i>); Civil Service
Retirement (5 U.S.C. §8346(a)); Federal Employees Retirement System (FERS) (5 U.S.C. §8470(a)); Federal
Thrift Plans (5 U.S.C. §8437(e)(2)); Military Survivor Annuities (10 U.S.C. §1450); and qualified pension plans of
states or political subdivisions of the states (<i>e.g.,</i> borough, municipality, county or city) (26 U.S.C. §457).
Individual Retirement Accounts (IRAs) and Simplified Employee Plans (SEPs) established in accordance with 26
U.S.C. §408, and Roth IRAs established under 26 U.S.C. §408A, are not "spendthrift" trusts within the scope of
§541(c)(2). However, some state and local retirement plans that do not fall within the scope of 26 U.S.C. §457 may
be excluded depending on the provisions of the statutes establishing the plan and the plan instruments. In the
absence of a controlling judicial decision, both the enabling statute and the plan documents should be reviewed to
make this determination.

</p><p>Although not too common, there are other provisions outside the Bankruptcy Code that create exclusions
from the bankruptcy estate. For example, if the debtor is an Native American, he or she may have an interest in
property that is specifically excluded from the bankruptcy estate. Examples of this include the exclusion of interests
in Alaska Native Corporations [43 U.S.C. §§1606, 1607], restricted allotments under chapter 9, title 25, U.S. Code
[25 U.S.C. §§334, <i>et seq.</i>], and money from the sale of land held in trust for an Native American [42 U.S.C.
§410]. There are several other trust provisions contained in title 25, <i>e.g.,</i> §543, and if the debtor is an Native
American, the nature of the entitlement, in particular its status as part of a trust or under other restrictions, should
be carefully examined and researched.

</p><p>Although excluded from the estate, excluded property must nonetheless be included in the schedules of
assets. There is no need for the debtor to claim an exemption for excluded property, but it is good practice to note
the claim of exclusion as a note in the description of the property in Schedule A or B of Official Form 6.

</p><h4>Exemptions</h4>

<p>Debtors face two potential situations. If domiciled in an "opt-out" state, there is no choice; the debtor must
use state exemptions. In other states, the debtor has a choice between two exemption laws, the federal exemptions
under §522(d) or the law of the domiciliary state. In those states, it is generally necessary to examine the debtor's
assets and compare the outcome using both the federal and applicable state exemptions. The debtor may use the
exemption laws that are the most beneficial to the debtor. One must note, however, that in the case of a husband
and wife whose estates are jointly administered they may not "split" the exemptions: both must claim either state or
federal exemptions. However, if federal exemptions are available and elected, the exemption amounts apply to each
debtor so that a husband and wife have the advantage of two exemption amounts. Most states also permit each
debtor to utilize a full exemption with some exceptions applicable to particular exemptions. In opt-out states (there
being no choice), the process, while easier, may not result in a better outcome for the debtor.

</p><p>There are certain basic principles governing the application of exemptions in bankruptcy that must be kept
in mind:
</p><ul>
<li>Exemptions can only be applied to the equity in the exempt property. They do not protect against liens—<i>i.e.,</i> only where the property has equity (value in excess of encumbrances) is an exemption of any benefit in bankruptcy.

</li><li>Exemptions may be applied only to the interest of the debtor in the property. If property is jointly owned with
a non-spouse or a non-filing spouse, only that interest that the debtor has is exempt. The interest of the
non-spouse or non-filing spouse is not part of the debtor's estate.

</li><li>Eligibility to claim and the amount of an exemption is determined as of the date the bankruptcy petition is
filed. For example, a person may not claim a federal homestead exemption in a dwelling unless the debtor
resided in that dwelling on the date the petition was filed.

</li><li>Most exemptions have value limitations, and only the value of the property to the extent it does not exceed
the value limitation is exempt. Consequently, the trustee may sell "exempt property" and retain the proceeds in
excess of the exempt amount for the benefit of the estate.

</li><li>Under §522(k), if the property subject to the exemption is sold by the trustee, the debtor's exempt interest is not
liable for the payment of administrative expenses except for the expenses incurred in avoiding transfers of the
property or interests in the property, <i>e.g.,</i> avoidance on nonconsensual preferential transfer that the debtor claims as
exempt under §522(g).

</li></ul>

<p>Another point to remember is that although property may be exempt, that does not mean that the property
is protected from all creditors. One major exception applicable to consumer cases involves spousal or child support
obligations. Section 522(c) excludes support obligations from the prohibition against satisfaction of pre-petition
obligations from property claimed as exempt under §522. In addition, several exemption statutes also exclude
family support obligations from their operation.

</p><p>Space limitations preclude a discussion of the process in those states that have not opted out. For a
complete discussion of state and federal exemption laws, one should refer to Thomson West's <i>Bankruptcy Exemption Manual,</i> which is updated annually. Instead, this column focuses on the §522(b)(2)(A) provision: "any
property that is exempt under federal law, other than subsection (d) of this section." That provision is important to
practitioners in both states that have elected to opt out and those states that have not. In the opt-out states, it
provides exemptions in addition to those allowed under state law. In other states, recognition of the availability of
those exemptions under state law may be important in assessing which exemption law, state or federal, is the most
advantageous for the debtor. Only too frequently, practitioners overlook the additional exemptions that may be
available under non-bankruptcy federal law when state exemptions are elected or mandated.

</p><p>The legislative history of the 1978 Bankruptcy Code lists some of the federal exemptions, other than those
contained in §522, that are available. In addition, changes to federal law since 1978 have added exemptions not
included in the listing contained in the legislative history. The following list includes some of the items
exempt under non-bankruptcy federal law in addition to those permitted under state law. Some of these are also
exempt under §522(d) and choosing federal exemptions will not result in their loss. This should be kept in
mind when determining which exemption law, state or federal, is the most advantageous to the debtor.

</p><ul>
<li>Foreign Service Retirement and Disability payments (22 U.S.C. §4060).
</li><li>Social Security benefits (42 U.S.C. §407).
</li><li>Compensation paid for war injuries (42 U.S.C. §1717).
</li><li>Wages of fishermen, seamen and apprentices (46 U.S.C. §601) (unlike the future wages excluded by
§341(a)(6), this exemption may be applied to accrued but unpaid wages).
</li><li>Civil service retirement benefits (5 U.S.C. §8346) (in a district that does treat these as excluded, they may be
claimed as exempt).
</li><li>Longshoreman's and Harbor Worker's Compensation Act death and disability payments (33 U.S.C. §916).
</li><li>Railroad Retirement Act annuities and benefits (45 U.S.C. §228(L)).
</li><li>Medal of Honor pensions (38 U.S.C. §1562(c)).

</li><li>Federal homestead lands on debts contracted before issuance of the patent (43 U.S.C. §175).
</li><li>Disability and death benefits paid to federal employees (5 U.S.C. §8130).
</li><li>Veterans' benefits (38 U.S.C. §5301(a)).
</li><li>Servicemen's and veterans' life insurance benefits (38 U.S.C. §1970(g)).
</li><li>Benefits paid surviving spouses of lighthouse service personnel (33 U.S.C. §775).
</li><li>Military retirement pay (10 U.S.C. §1440).
</li><li>Judicial survivor's annuity (28 U.S.C. §376(n)).
</li><li>Service members' deposits in savings institutions while serving outside the United States (10 U.S.C.
§1035(d)).
</li></ul>

<h4>The Exemption Process</h4>

<p>Section 522(l) requires the debtor to file a list of the property that is claimed as exempt. This is
accomplished by completing Schedule C of Official Form 6. The trustee and creditors have 30 days after the
meeting of creditors is concluded within which to object to the exemptions claimed, unless the court for cause
extends the time upon motion made before the 30-day period expires (F.R.Bank.P. 4003(b)). If no objection to the
claimed exemptions is filed within the 30-day period, exemptions are allowed as claimed. One exception to the
30-day rule that has been recognized is that an objection to the value of the property claimed as exempt may be filed
at any time. Another recognized exception is that a creditor in defending against a lien avoidance action (discussed
further below) may raise the validity of the claimed exemption.

</p><p>It should also be noted that in most districts, even property that is claimed as exempt remains property of
the estate until such time as it is abandoned by the trustee. Also, most circuit courts that have ruled on the issue
have ruled that appreciation in the value of property claimed as exempt inures to the benefit of the estate to the
extent that the increase in value exceeds the exemption amount. This has even been held to apply when the increase
is an increase in the equity as a result of payments made on the underlying indebtedness secured by the property or
improvements to the property paid for by the debtor. Debtors too frequently believe that because they have claimed
the property as exempt they may utilize it or dispose of it as they see fit. Unpleasant consequences can result if the
debtor disposes of the property before the case is closed and the property abandoned under §554(c). Counsel for
debtors should make debtors aware of the status of exempt property and the limitations on its use or disposition.

</p><p>Although there is authority that abandonment of property, simply because it is exempt, is impermissible
under §554(b), in those cases where the case is expected to remain open for an appreciable period of time, it may be
in the best interests of the debtor to move for an order compelling the trustee to abandon exempt property. This is
particularly true where the homestead exemption is involved. Frequently, debtors are forced to alter lifestyles and
reduce expenses post-petition—<i>i.e.,</i> the debtor simply cannot afford to continue to make the house payments. In
those cases, the debtor will want to sell. As long as the property remains property of the estate, only the trustee is
empowered to sell it after notice and a hearing. If there is no excess equity that will enure to the benefit of the
estate, the trustee, quite understandably, will not be particularly interested in getting involved in the sale. On the
other hand, in those cases where the equity is borderline between being totally exempt and excess equity, the trustee
and the courts should be wary of abandonment. In those cases, it may be beneficial for the trustee and the debtor to
agree that the debtor proceed with the sale with a specific provision in the abandonment order that the trustee be
provided a copy of the seller's closing statement and all net proceeds in excess of the exemption amount be paid to
the trustee. One should also bear in mind that frequently sale of a residence requires some measure of repair or
restoration, either functional or cosmetic. These should be taken into consideration so that those costs are treated as
costs of sale and not charged against the exemption.

</p><h4>"Creating" Equity</h4>

<p>Although, as noted above, only the equity in property may be exempted, it is possible to "create" equity
by avoidance of certain liens against the property. Section 522(f) permits debtors to avoid judicial liens (other than a
lien for spousal or child support) and nonpossessory, nonpurchase-money security interests in specified personal
property to the extent such liens impair an exemption. This right extends to household furnishings and goods,
wearing apparel, appliances, books, animals, crops, musical instruments, jewelry, implements, professional
books—or tools—of trade, and professionally prescribed health aids. Under this provision, a lien is considered to
impair an exemption when the sum of the liens on the property plus the amount that would otherwise be exempt
exceeds the value of the debtor's interest in the property. However, a lien that has been avoided is not considered in
this determination. In opt-out states or states that permit a debtor to waive exemptions under §522(d), the lien in
implements, professional books, or tools of trade or farm animals and crops may not be avoided to the extent the
value exceeds $5,000.

</p><p>When the debtor avoids a lien under §522(f), the debtor's exemption replaces the position of the holder of
the avoided lien. Thus, the holder of an unavoided or unavoidable lien junior to that of the avoided lien does not
move up in priority: The debtor's exemption trumps the interest of that lienholder to the extent of the avoided lien
or the exemption amount, whichever is less.

</p><hr>
<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> Board Certified in Consumer Bankruptcy Law and Business Bankruptcy Law by the American Board of Certification. <a href="#1a">Return to article</a>

</p>