Proceeds of Exempt Property Retain Exempt Status in Chapter 7, District Judge Says

Expanding First Circuit authority, bankruptcy and district judges in Maine essentially followed the Fifth Circuit in holding that a chapter 7 debtor can sell exempt property after filing and permanently protect the proceeds from creditors, even if the debtor does not reinvest the proceeds in exempt property within the time limits prescribed by state law.

The facts are always important. In this case, the sequence of the facts is critical.

The Facts

The debtor owned a home in Maine, a state with a $47,500 homestead exemption. Maine has opted out of federal exemptions.

The debtor filed a chapter 13 petition and confirmed a plan under which he would retain the home and pay the mortgage. One year after confirmation, he decided to sell the home. The bankruptcy court approved the sale, which generated proceeds of almost $52,000 after paying the mortgage and closing costs.

In accord with the bankruptcy court’s order, the debtor retained $47,500, his homestead exemption. More than $4,000 went to the trustee.

Five months after closing, the debtor converted the case to chapter 7 and received his general discharge. When a homeowner sells a home, Maine law requires reinvesting the proceeds in another homestead within six months to maintain the exemption.

When the debtor did not purchase another home within six months, the chapter 7 trustee objected to the allowance of the debtor’s homestead exemption in the proceeds. Chief Bankruptcy Judge Peter G. Cary of Portland, Maine, overruled the objection, leading the trustee to appeal to District Judge John A. Woodcock, Jr.

Judge Woodcock affirmed in an opinion on September 24.

First Circuit Law

Judge Woodcock said courts around the country are divided. Some hold that an exemption, valid on the filing date, will evaporate if the debtor does not reinvest proceeds within the time prescribed by state law. Other courts employ the so-called snapshot rule to hold that proceeds of property, exempt on the filing date, will remain exempt despite any time limits in state law requiring the reinvestment of proceeds.

Judge Woodcock said there is “no specific controlling authority” from the First Circuit. However, a 2008 opinion comes close. Pasquina v. Cunningham (In re Cunningham), 513 F.3d 318 (1st Cir. 2008).

In Cunningham, the debtor was saddled with a judgment for about $250,000. The debtor owned a home protected by the $300,000 homestead exemption in Massachusetts. Using the judgment, the judgment creditor in substance obtained a judgment lien on the home.

The debtor filed a chapter 7 petition and persuaded the bankruptcy court to avoid the judgment lien as an impairment of his exemption under Section 522(f). Later, the bankruptcy court ruled that the debt was nondischargeable.

Subsequently, the debtor sold the home, generating net proceeds of $150,000. The debtor followed up with a motion under Section 522(c) for a declaration that the proceeds remained exempt. The section provides, with certain exceptions, that exempt property “is not liable during or after the case for any debt of the debtor that arose . . . before the commencement of the case.”

The bankruptcy court ruled that the proceeds remained exempt. The district court affirmed, and so did the First Circuit.

The First Circuit recited the snapshot rule “that exemptions are determined when a petition is filed.” The appeals court thus held that the bankruptcy court was correct in “permanently immunizing the homestead from pre-bankruptcy debt.”

Summarizing, the First Circuit said that the “post-petition sale” of the home “did not cause the proceeds of the sale to lose their exempt status . . . and become subject to the [creditor’s] pre-petition nondischargeable debt.”

The facts in Cunningham differ somewhat from the appeal before Judge Woodcock. In Cunningham, the debtor went directly into chapter 7. In the appeal to Judge Woodcock, the debtor had first confirmed a chapter 13 plan and sold the home after conversion to chapter 7. Should Cunningham govern even though the debtor first filed under chapter 13?

Fifth Circuit Authority

Among the appellate courts, the Fifth Circuit is home to the most thorough development of relevant issues.

In Hawk v. Engelhart (In re Hawk), 871 F.3d 287 (5th Cir. 2017), the Fifth Circuit held that an individual retirement account, exempt on the filing date, does not lose its exempt status even if it is converted to nonexempt property after the filing of a chapter 7 petition.

Six months later, the Fifth Circuit expanded Hawk to protect proceeds of a homestead sold after a chapter 7 filing, even if the debtor did not reinvest the proceeds in another home. Lowe v. DeBerry (In re DeBerry), 884 F.3d 526 (5th Cir. March 7, 2018). In DeBerry, the Fifth Circuit said that fixing the exemption once and for all on the filing date avoids “the uncertainty that the trustee’s position would inject into the large number of chapter 7 cases that bankruptcy courts confront.” Id. at 529.

In Hawk, the Fifth Circuit limited the holding of its prior opinion in In re Frost, 744 F.3d 384 (5th Cir. 2014). In Frost, a couple owned a home when they filed a chapter 13 petition. Later, they sold the home but did not reinvest the proceeds in another exempt homestead. Without saying in the opinion whether the case was in chapter 7 or 13, the Fifth Circuit held in Frost that the proceeds lost their exempt status, relying in part on Zibman, discussed below.

In Hawk, the Fifth Circuit noted that Frost was a chapter 13 case. Hawk limited Frost to chapter 13 cases. Extinguishing the exemption in proceeds in chapter 13 is arguably correct because after-acquired property comes into a chapter 13 estate.

In Hawk, the Fifth Circuit also limited the holding of In re Zibman, 268 F.3d 298 (5th Cir. 2001), a case where the debtors sold their exempt homestead two months before filing a chapter 7 petition but did not reinvest the proceeds in another home. The appeals court in Zibman held that the proceeds lost their exempt status because the Texas statute protects only a homestead, not proceeds of a homestead.

Hawk limited the holding in Zibman to cases where an exempt asset is sold before bankruptcy but not reinvested in another exempt asset within the time allowed by state law.

For ABI’s discussions of Hawk and DeBerry, click here and here.

Judge Woodcock’s Analysis

Judge Woodcock analyzed the parties’ arguments and Bankruptcy Judge Cary’s opinion in meticulous detail. He concurred with Judge Cary that ruling in favor of the debtor would foster the “practicalities of bankruptcy administration.” Were it otherwise, chapter 7 trustees could reopen cases, perhaps years later, to claw back proceeds from the sale of a home. Debtors would be left not knowing when, if ever, they could sell a homestead but not reinvest the proceeds in another home.

Upholding the exemption after the sale of the home, Judge Woodcock said, was “more in line with the ‘fresh start principle’ as well as the body of existing First Circuit and Supreme Court caselaw.”

With regard to the First Circuit, Judge Woodcock said that the principle of Cunningham “applies here.” He quoted Cunningham, where the Boston-based appeals court said that “proceeds from the sale of the home retain exempt status of the home itself.” Cunningham, 513 F.3d at 320.

Judge Woodcock thus held that the debtor had “a permanent exemption in the equity of his residence,” a result, he said, that was “consistent with the Fifth Circuit’s clarification in DeBerry.”