In a case where prebankruptcy exemption planning backfired disastrously, the Fifth Circuit held that a nonfiling spouse had no homestead exemption rights because the husband’s bankruptcy trustee sold the home the couple owned for fewer than 1,215 days.
In substance, the wife was worse off financially because she did not file a petition herself, although she had no debt to discharge.
The Feb. 14 opinion by Circuit Judge Leslie Southwick stands for the proposition that the bankrupt husband’s estate included all community property, leaving the wife with no rights under Section 363(j) or otherwise to receive any proceeds from the sale of the couple’s home, despite her homestead exemption rights under Texas law.
Unless the opinion is set aside on rehearing en banc, couples in Texas who are subject to the Section 522(p) limitation on a homestead exemption must both file petitions to receive the double exemption, which is now about $320,000. The Fifth Circuit’s interpretation of the statute would appear to apply to any state with community property.
Gerrit M. Pronske told ABI in a phone interview that he will file a petition for rehearing en banc. Pronske, of Dallas, is counsel for the wife who lost in the Fifth Circuit.
The Facts
A husband and wife purchased an expensive Texas home they improved and intended to flip for a profit, living there in the meantime as their homestead. Attempting to maximize their profit on the home despite the husband’s impending bankruptcy on account of his business debt, the couple recorded a partition agreement where they recharacterized their community property interest in the home into separate property, with each owning half. The husband alone filed a chapter 7 petition hours after recording the partition agreement, which had been executed on the advice of counsel.
Without objection from the couple, the trustee sold the home, generating almost $570,000 after payment of liens.
Because the couple had owned the home for fewer than 1,215 days, Section 522(p) limited the homestead exemption to $155,675, which became $160,375 in April 2016. The husband agreed to limit his homestead exemption to about $130,000.
The Fraudulent Transfer
After payment of the liens, expenses and the husband’s homestead exemption, the wife claimed $450,000 of the remaining sale proceeds as her separate property under the partition agreement. In response, the trustee sued to set aside the partition agreement as a fraudulent transfer.
The bankruptcy judge set aside the agreement as a fraudulent transfer with actual intent to hinder or delay creditors. The lower court also held that the wife was entitled to no compensation under Section 363(j). The Fifth Circuit granted a direct appeal and affirmed.
Judge Southwick upheld the ruling that the partition agreement was a fraudulent transfer. Even so, the wife argued on appeal that she was entitled to some or all of the remaining net sale proceeds in view of her Texas homestead exemption rights.
Judge Southwick didn’t buy her arguments under either the Bankruptcy Code or the Constitution.
The Statute
In addition to Section 522(p), several other provisions in the Bankruptcy Code were pivotal.
Section 541, defining property of the estate, provides in subsection (a)(2) that the estate includes “all interest of the debtor and the debtor’s spouse in community property.”
Section 363(h) allows a trustee to sell both the interest of the debtor and “any co-owner in property in which the debtor had . . . an undivided interest as a tenant in common, joint tenant, or tenant by the entirety.”
Following a sale under Section 363(h), Section 363(j) requires the trustee to distribute net proceeds “to the debtor’s spouse or co-owners” and to the estate according to “the interests of such spouse or co-owners, and of the estate.”
In a sale under Section 363(h), Section 363(i) gives the debtor’s spouse a right of first refusal with regard to “property of the estate what was community property.”
Notwithstanding avoidance of the partition agreement, the wife asserted her homestead exemption rights and claimed $450,000 under Section 363(j).
The Circuit Court’s Analysis
Citing Texas cases, Judge Southwick said that the Texas exemption grants only a possessory interest, not an economic interest. He posed the question as to whether the wife was entitled to any compensation for her homestead interest “beyond the [$130,000] her husband elected” under Section 522(p). He answered the question in the negative.
Judge Southwick held that Section 363(h) did not apply because the community property became property of the bankrupt estate under Section 541(a)(2) when the husband filed bankruptcy, even though the wife was not bankrupt.
Judge Southwick concluded that Section 363(h) gave the wife no protection because it did not refer to “community property,” as did Section 363(i). He said that if Congress intended to protect community property in Section 363(h), it would have said so.
Because “the entire homestead property is brought in[to]” the bankrupt estate, the judge said that the “voluntary sale of a homestead” did not give the wife a right to compensation.
Judge Southwick rejected several constitutional attacks to his interpretation of the Code. Although homestead rights are constitutionally protected, he said that the Supremacy Clause allowed Congress to limit the dollar amount of the exemption.
Implications of the Decision
In similar circumstances, a husband and wife should both file bankruptcy, even if only one has debt to be discharged. Judge Southwick so much as said so himself when he observed that the couple would have enjoyed a $311,500 exemption had both filed.
Pronske said the result is “worse in divorce”: If a couple separate and one files bankruptcy, the nonfiling spouse could end up with no distribution from the sale of a home owned for fewer than 1,215 days. Consequently, one spouse could use the threat of bankruptcy as leverage in matrimonial negotiations.
Thankfully, the untoward results do not befall a couple who have owned a homestead for more than 1,215 days. In those situations, the bankrupt spouse could exempt the entire property in Texas.
In other words, the Fifth Circuit’s interpretation of Section 541(a)(2) results in giving a nonfiling spouse no exemption at all, not even the $160,375 perhaps intended by Section 522(p).
Residents of states without community property laws but in an identical circumstance would not realize the same loss of homestead rights, because the Fifth Circuit’s opinion is based on the notion that the community property rights of both spouses are brought into the bankrupt estate under Section 541(a)(2) even though only one spouse has filed.
In short, Texas is great place to live if you’ve owned your expensive home for more than 1,215 days. Otherwise, watch out!
In a case where prebankruptcy exemption planning backfired disastrously, the Fifth Circuit held that a nonfiling spouse had no homestead exemption rights because the husband’s bankruptcy trustee sold the home the couple owned for fewer than 1,215 days.