Bankruptcy Exemptions: Pre-Bankruptcy Planning

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March 14, 2016


The rule of thumb with regard to exemption and pre-bankruptcy planning is that if you fatten the pig too much it becomes a hog and you slaughter the hog. In other words, you can undertake pre-bankruptcy planning to maximize exemptions but there is a point at which being too clever or too greedy offends the judge’s sensibilities and the exemptions or pre-bankruptcy planning activities will be disallowed. Obviously each judge has his or her own tipping point, but a survey of recent cases does provide some guidance of what pre-filing planning will be allowed.

A. Cases
In the case of In re McCarthy, 418 B.R. 745 (Bankr. E.D. Wis. 2009), the court discussed pre-bankruptcy planning and stated as follows:
Pre-bankruptcy planning is, in and of itself, not improper. As noted in Collier on bankruptcy, both the House and Senate Reports validate this approach by stating the following:

As under current law, the debtor will be permitted to convert nonexempt
property into exempt property before filing a bankruptcy petition. The practice is
not fraudulent as to creditors and permits the debtor to make full use of the
exemptions to which he is entitled under the law. 6 Collier on Bankruptcy P
727.02[3] [f] (15th ed.rev.), citing 50 H.R. Rep 595, 95th Cong, 1st Sess.
361(1977), reprinted in App.Pt. 4(d)(I) infra: S. Rep. No. 989, 95th Cong., 2d
Sess. 76 (1978), reprinted in App. Pt. 4(e)(I) infra. However, where a conversion
is made with the intent to defraud creditors, such conversion is objectionable and
may provide a basis for denial of discharge under § 727(a)(2). In re Smiley, 864
F. 2d 562 (7th Cir. 1989). Smiley also recognizes that conversions of assets from
non-exempt to exempt forms within a year preceding a petition in bankruptcy are
not necessarily fraudulent, and whether § 727(a)(2) applies depends on the facts
and circumstances of each case.

In the case of In re Wilmoth, 397 B.R. 915 (8th Cir BAP 2008) the 8th circuit BAP ruled that the use of sale proceeds from non-exempt assets to pay down the first mortgage on homestead property was not fraudulent. The trustee argued that section 522(o), which was added by BAPCPA prohibited the conversion of non-exempt assets to exempt assets. The bankruptcy  Appellate court agreed with the Bankruptcy court that the debtors did not act with an attempt to hinder, delay or defraud creditors under 522 (o). The debtors prevailed because they relied on the advice of counsel, had not liquidated all of their assets, had not sold the assets for inadequate consideration, had disclosed the payments to the mortgage company on the statement of affairs and had been forthright with the trustee.

In the case of In re Addison, 540 F.3d 805 (8th Cir. 2008) the 8th Circuit Court of Appeals likewise held that investing $4,000 of non-exempt funds into a Roth IRA and paying $11,500 of non-exempt funds on the outstanding mortgage was not fraudulent where the transfer was not substantially all of the debtor’s non-exempt property, the debtor had not borrowed funds to purchase exempt assets and had not concealed the transaction. The case of In re Graves, 396 B.R. 70 (10th Cir. BAP 2008) involved the debtor’s applying a pre-petition tax refund to their taxes for the next year prior to filing bankruptcy. The court found that the tax refund had already been spent and that the trustee could not compel the debtor to turn over funds he did not have any more than  a trustee can “squeeze blood out of a turnip”. The situation is to be distinguished from the post-petition preparation of a tax return where the anticipated tax refund is applied to next year’s taxes. Such an application constitutes conversion of estate funds and should be avoided. The moral of the story therefore is to delay the bankruptcy filing until after the tax return is prepared and any refund is either spent or redirected to next year’s taxes.

On the other hand, getting the court to allow an exemption may end up being a case where you win the battle but lose the war. In In re Lott 2011 WL 1981740 at *6, *7 (Bankr. N.D. Ala, 2011) the court held that an exclusion of 401K retirement contributions from property of the estate “does not necessarily mean that congress intended to exclude these retirement account contributions from a § 1325(a)(3) good faith inquiry.” In other words, successfully fattening the hog doesn’t mean it won’t be slaughtered.

B. Property Not Part of the Estate

Once a bankruptcy is filed an estate is created. No interest in property of the estate remains with the debtor unless it is either exempt, acquired by the debtor after the commencement of the case, or is not included as property of the estate. 11 USC § 541. Property which is not property of the estate is as fully protected from the reach of the trustee and creditors as if it were exempt. The exceptions to property of the estate are set forth in 11 USC § 541(b). Included among the exceptions are contributions to retirement funds, deferred compensation plans, and tax deferred annuities. Also excluded are education tuition plans so long as the contribution is paid more than two years before filing or less than $5,475 in the second year before filing. 11 USC §541(b)(5)(6).

Also excluded from property of the estate are items pledged to a pawn shop. 11 USC § 541 (b)(8). While not an “exemption” this provision provides a means of sheltering family jewelry during the pendency of the bankruptcy and at the same time, perhaps, provides needed funds to finance the bankruptcy itself.

Excluded from monthly income are social security benefits, payments to victims of war  crimes, or victims of crimes against humanity 11 U.S.C. 101(10A). See also In re Carpenter, 2009 WL 2004018 (8th Cir. BAP Minn.).

In re Vogeler, 393 B.R. 240 (Bankr. D. Kansas 2008). The bankruptcy court found that under the totality of circumstances granting a discharge would be an abuse under 707(b)(3)(B) where the debtor won a lottery a month after filing in an amount sufficient to pay his unsecured debt. The debtor, however, spent his earnings and therefore having made his choice to spend it rather than pay his debt, the court felt it not appropriate to give him a discharge. Post-petition earnings can apparently sneak into the bankruptcy estate by the back door even though they are not technically property of the estate.

C. Potpourri of Issues Surrounding Homestead Exemption
Since the homestead exemption is often the largest and therefore most important exemption for debtors, the following cases help to provide definition to the breadth and scope of homestead exemptions.

The court in In re Jerew, 415 B.R. 303 (Bankr. N.D. Ohio 2009) revisited the issue of whether a debtor has to have equity in property in order to claim a homestead exemption. The court answered the question with a resounding no stating: “However there is now agreement that the 1994 amendment to § 522(f), by adding the formula set for then § 522(f)(2)(A), eliminated the need for a debtor to demonstrate the existence of equity in their property in order to avoid the fixing of a judicial lien.” See also In re Higgins, 201 B.R. 965, 967 (9th Cir. BAP 1996).

The simplistic rule regarding the calculation of exemptions is that round pegs go into round holes and square pegs go into square holes and that the exemptions must be an exact fit in order to be allowed. The classic law school case is the disallowance of an exemption of a tractor for plowing when the state’s statue provided that only a horse used for plowing could be exempt.

In practice whether exemptions are to be allowed and over what property is not always that clear cut. In In re Ford, 415 B.R. 51 (Bkrcy N.D. N.Y. 2009), the question was whether two separate but contiguous tax parcels debtor acquired under different deeds could both be claim exempt under debtor’s homestead exemption. The court granted homestead protection to both parcels when it stated: “Without compromising their homestead, debtors will be free to use their requisite discretion as to what is needed to best support themselves and their families.” The court in In re Ashcroft, 415 B.R. 428 (Bkrtcy. D. Idaho 2008), addressed the issue as to the setting aside of judicial liens which impair the debtor’s homestead rights. More specifically, the court dealt with the situation where a community judgment attached to community property which was thereafter conveyed to the debtor as her separate property in a subsequent dissolution. The court held that § 522(f) is not an operation to avoid a lien per say, but it is rather the avoidance of a fixing of lien to the exempt property. The court stated, “thus § 522(f) operates retrospectively to annul the event of fastening the judgment lien upon a property
interest.” Accordingly the fundamental question of ownership is whether the property encumbered by the subject lien was property of the debtor at the time of the fixing of that lien upon such property. The court concluded that the debtor owned the community interest of the
property at the time of the judicial lien attached to the property and therefore the lien was subject to being avoided. The court distinguished the case from Farrey v. Sandlefoot, 500 US 291, 111 S.Ct. 1825, 114 L. Ed. 2nd 337 (1991), and followed the more recent case of In re Stone King, 225 B.R. 690 (9th Cir. BAP 1998).

In the case of In re Fink, 417 B.R. 786 (Bkrtcy E.D. Wis. 2009), the court indicated it might have allowed a homestead exemption on a nonresident Chapter 7 debtor where his minor children continued to reside on the property with his ex-wife on the date his bankruptcy petition was filed. The debtor had claimed a homestead exemption under 11 USC § 522(b)(1).

Unfortunately for the debtor, his interest in the claimed homestead property was confined to a lien granted by the dissolution court and therefore the court ruled that his former homestead did not qualify as an interest subject to homestead exemption under Federal law since the debtor had neither an ownership nor possessory interest in the residence. Presumably a differently worded property agreement might have allowed the debtor to retain his homestead exemption.

In In re Green, 583 Fd3 614 (9th Cir 2009), the Ninth Circuit held that the bankruptcy code provision limiting state homestead exemption for any amount of interest in the property that the debtor acquired during the 1,215 day period preceding the date of his filing of the bankruptcy petition does not apply if the debtor owned the property before the 1,215 day period. Citing 11 USC § 522(b), the court held that perfection of a homestead exemption does not constitute acquisition of a property interest for purpose of § 522(b)(1). The court reversed the district court’s order affirming the bankruptcy court’s decision that where a debtor initiates his residency on the property and records a homestead during 1,215 day period prior to his bankruptcy petition § 522(b) places a monetary cap on the state law homestead even though the debtor purchased the property before the commencement of the 1,215 day period.


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