Employing the most vituperative language employed so far to nix the strategy, a district judge in North Carolina affirmed Bankruptcy Judge Laura T. Beyer, who had barred secured creditors from taking haircuts so the trustee could pay his commission and make a small distribution to general creditors while cheating the debtor out of her homestead exemption.
In his March 13 opinion, Statesville, N.C.’s District Judge Kenneth D. Bell called the proposal a “backroom deal,” a “sham” and a “bastardization of the bankruptcy process.”
The chapter 7 debtor was a 72-year-old widow whose only source of income was Social Security benefits. She owned a home with a scheduled value of $125,500 and claimed a $55,000 homestead exemption under North Carolina law.
The home was subject to a $52,700 first mortgage. The IRS had a valid tax lien on the house for $113,000 alongside a valid state tax lien of almost $48,000. The total encumbrances were almost $214,000.
The trustee believed the house was actually worth $180,000 and wanted to sell. Regardless of the actual value of the house, Judge Bell said there was no equity in the home above the secured indebtedness. Under the circumstances, “This would typically prevent a sale of the Property,” he said.
The trustee hatched a deal with the IRS and the state taxing authority. (Note: The tax liens likely would be wiped out in foreclosure by the holder of the first mortgage.)
The IRS and the state taxing authority agreed to a 40% “haircut” on their liens, generating about $68,000 for the trustee. The trustee would use the leftover first to pay administrative expenses and his commission, totaling some $30,000.
From the $38,000 remainder of the carveout, $33,000 would go to the taxing authorities on their priority claims, leaving $5,000 for general unsecured creditors and $2,000 for the debtor. (Remember, her state home exemption was $55,000.)
Judge Bell said that deal would have left the debtor with “no meaningful source of income” and no home in which to live.
The trustee filed an objection to the debtor’s homestead exemption together with a motion to sell the property and implement the deal with the taxing authorities. Bankruptcy Judge Beyer denied the motion. The trustee appealed.
The trustee argued that the deal was kosher under Section 724(b), the complex provision in the Bankruptcy Code dealing with distribution of the proceeds from the sale of encumbered property when a trustee has been appointed. Basically, the section subordinates tax liens to the payment of the trustee’s administrative expenses.
Under Section 724(b), sale proceeds go to (1) the mortgage holder, (2) administrative creditors (i.e., the trustee), (3) holders of tax liens to the extent their liens exceeded administrative expenses, (4) the unpaid portion of tax liens, and (5) the estate.
Judge Bell said that Section 724(b) “allows for encumbered property to be sold.” (Respectfully, it does not. Section 365 authorizes sales. Section 724 allocates the distribution from proceeds of authorized sales.)
“Conspicuously absent from § 724(b)’s distribution scheme is any mention of exemptions,” Judge Bell said. As a result, courts have reached “inconsistent results for varying rationales.”
In North Carolina, exemptions are construed “liberally with an eye in favor of exemptions,” Judge Bell said. With “liberal construction in mind,” he found that “the carved-out funds are subject to the Debtor’s homestead exemption.” He said that the “Trustee and tax agencies cannot defeat the Debtor’s homestead exemption by agreement absent any authority from the Code or North Carolina law.”
“Put another way, once the tax agencies agree to the carve-out they cannot direct the allocation of the value created by such carve-out,” Judge Bell said.
Judge Bell found support in Law v. Siegel, 571 U.S. 415 (2014), where the Supreme Court held that exemptions can be denied only for reasons set forth in the Bankruptcy Code or state law. In the appeal before him, he said that the trustee wanted “to deprive the Debtor of her homestead exemption on a basis that is not enumerated in the Code or North Carolina law.”
“Even more to the point,” Judge Bell said, “the Trustee’s Motion must be denied because it substantially benefits no one other than himself and the tax agencies.” Citing a district judge in his own district, he said that “property may not be sold solely to benefit secured creditors or the Trustee.”
Affirming Bankruptcy Judge Beyer, Judge Bell said that the deal was “not intended to benefit the general unsecured creditors but it was concocted to allow the tax agencies to ‘tip’ the Trustee for selling the Debtor’s home.”
Employing the most vituperative language employed so far to nix the strategy, a district judge in North Carolina affirmed Bankruptcy Judge Laura T. Beyer, who had barred secured creditors from taking haircuts so the trustee could pay his commission and make a small distribution to general creditors while cheating the debtor out of her homestead exemption.
In his March 13 opinion, Statesville, N.C.’s District Judge Kenneth D. Bell called the proposal a “backroom deal,” a “sham” and a “bastardization of the bankruptcy process.”
The chapter 7 debtor was a 72-year-old widow whose only source of income was Social Security benefits. She owned a home with a scheduled value of $125,500 and claimed a $55,000 homestead exemption under North Carolina law.
The home was subject to a $52,700 first mortgage. The IRS had a valid tax lien on the house for $113,000 alongside a valid state tax lien of almost $48,000. The total encumbrances were almost $214,000.