Affirming the bankruptcy court, a district judge in Brooklyn identified a loophole allowing chapter 13 debtors in some states to assert a homestead exemption without having the exemption prevent the debtor from setting aside a tax-lien foreclosure of a homestead.

In his May 29 opinion, District Judge Eric N. Vitaliano found an escape hatch for debtors living in New York State. It’s an open question whether the same escape hatch or another is available for debtors who live in states that prohibit their citizens from claiming federal exemptions.

The Tax Foreclosure

The debtor had not paid real estate taxes on her home for years. The tax lien was purchased at auction for less than $2,000 by an outfit we shall call the purchaser. After the redemption period ran out, the purchaser obtained a deed and filed a quiet title action in state court. The purchaser won a default judgment declaring its ownership of the home and employed the sheriff to serve an eviction notice.

Before eviction, the debtor filed a chapter 13 petition and a complaint to avoid the tax foreclosure as a fraudulent transfer under Sections 548(a)(1)(B) and Section 522(h).

Chief Bankruptcy Judge Alan S. Trust of Cental Islip, N.Y., granted the debtor’s motion for summary judgment and set aside the transfer of the home. He also denied the purchaser’s motion for summary judgment seeking dismissal of the complaint. The purchaser appealed.

Debtor Saved by a Hypothetical

Following the footsteps of Tyler v. Hennepin County, 598 U.S. 631 (2023), both sides agreed that the chapter 13 trustee could have avoided the transfer as a constructively fraudulent transfer for lack of reasonably equivalent value under Section 548(a)(1)(B). In Tyler, the Supreme Court held that a real estate tax foreclosure can violate the Takings Clause of the Fifth Amendment when a municipality takes title but doesn’t give the owner the difference between the unpaid taxes and the value of the property. To read ABI’s report on Tyler, click here.

While the text of Section 548(a)(1) provides that the “trustee may avoid” the transfer, the debtor ostensibly was given standing by Section 522(h). If the “trustee does not attempt to avoid such transfer,” the subsection provides that the “debtor may avoid a transfer of property of the debtor . . . to the extent that the debtor could have exempted such property under subsection (g)(1) of this section if the trustee had avoided such transfer, if — (1) such transfer is avoidable by the trustee under” Section 548, among others.

Similarly, Section 522(g) allows the debtor to “exempt . . . property that the trustee recovers . . . to the extent that the debtor could have exempted such property . . . if such property had not been transferred, if — (1) (A) such transfer was not a voluntary transfer of such property by the debtor. . . .”

New York allows debtors to elect between state and federal exemptions. In her petition, the debtor had taken the homestead exemption under New York law. The purchaser therefore challenged the debtor’s standing by referencing Section 5206(a) of the New York Civil Practice Law and Rules, which provides that “no homestead shall be exempt from taxation or from sale for non-payment of taxes or assessments.”

As Judge Vitaliano put it, the purchaser contended that “CPLR 5206 precludes [the debtor] from taking advantage of the New York state homestead exemption because the Property was subject to sale for nonpayment of taxes.” He characterized Bankruptcy Judge Trust as having ruled in favor of the debtor by taking “a more exemption-friendly view of the ‘could have’ language in § 522(g)(1) and (h).”

Judge Vitaliano said that Judge Trust’s “interpretation of Section 522(g)(1) is not only more exemption friendly than that adduced by [the purchaser], but it is also more consistent with the statute’s plain language regarding its temporal setting.”

The “interpretation of the ‘could have’ language of Section 522(g)(1),” Judge Vitaliano said, “returns the debtor to the position it would have been in ‘if such property had not been transferred.’” Next, he said that the court asks, “What exemptions could the debtor have claimed?”

Because the transfer occurred more than one year before the chapter 13 filing, Judge Vitaliano said that “Section 522(g)(1) therefore contemplates a hypothetical world prior to Debtor’s bankruptcy filing” when the “Debtor faced no statutory impediments to exempting her Property pursuant to” the federal homestead or wildcard exemptions.

“Because Debtor ‘could have’ exempted her Property at the time such property was transferred,” Judge Vitaliano agreed with Bankruptcy Judge Trust and held that the “Debtor has standing to bring this fraudulent transfer action under Section 522(g)(1) and (h).”

Because standing was the only issue on appeal, Judge Vitaliano affirmed the bankruptcy court’s judgment avoiding the transfer. In addition, Bankruptcy Judge Trust had required the debtor to reimburse the purchaser for the price paid for the deed, plus interest at 9% in satisfaction of the tax lien.

Observations

In a footnote, Judge Vitaliano cited a case where the debtor was in a state prohibiting assertion of the homestead exemption for tax liens and also prohibiting the debtor from claiming federal exemption. In that case, the debtor was held to lack standing. Is a debtor in a state like that unable to set aside a fraudulent transfer of a tax-lien foreclosure?

The hypothetical is a step beyond the holding in Tyler. However, Tyler held that a state law depriving the debtor of the equity in a tax-lien foreclosure violates the Takings Clause of the U.S. Constitution.

Does Tyler mean that a debtor in any state can set aside a fraudulent tax-lien foreclosure? Is there a uniformity problem if a debtor were barred from avoiding a transfer in some states? If a debtor could set aside a tax-lien foreclosure outside of bankruptcy, is there a circumstance where the same debtor would be prohibited from avoiding the transfer in bankruptcy? Does the constitutional right established in Tyler mean that a state law prohibition of standing must fall to the wayside in bankruptcy under the Supremacy Clause?