Debtors Exempt Interest in Home Did Not Remove It from Bankruptcy Estate.
(Parker Tax Publishing January 2014)

A debtor couple's claimed exemption of an interest in their home did not remove the property from the bankruptcy estate; thus, the bankruptcy trustee had the authority to sell the property and use the proceeds to pay an IRS tax lien and unsecured creditors. Reeves v. Comm'r, 2013 PTC 364 (4th Cir. 11/20/13).

In March 2010, Garon and Diane Reeves filed a joint Chapter 7 bankruptcy petition. On the real property schedule of their petition, Schedule A, the couple listed their home in North Carolina. At a bankruptcy hearing in July 2010, the parties stipulated that the fair market value of the couple's home was $325,000. There was no dispute that the property was encumbered by a mortgage of $195,500 and by a federal tax lien of approximately $382,300. The couple had no equity in the home over and above the mortgage and federal tax lien. Under North Carolina law, married debtors can exempt an aggregate interest in real property used as a residence, not to exceed $70,000, from a bankruptcy estate.

On Schedule C of their bankruptcy petition, Garon and Diane claimed an exemption of $60,000 as the value of their entire interest in their home, acknowledging that they had no equity in the property. The bankruptcy trustee objected. The bankruptcy court denied the trustee's objection on the grounds that the debtors could assert and reserve their exemption in the home notwithstanding their lack of equity. Subsequently, the trustee sought the authority to sell the couple's home to generate funds the majority of which would be applied to satisfy the federal tax lien and the balance to pay unsecured creditors. The bankruptcy court approved the trustee's motion and a district court affirmed the bankruptcy court order.

Bankruptcy Code Section 522(b) provides a list of property a debtor can seek to exempt from the bankruptcy estate. The property that a debtor is authorized to exempt is defined as an interest, the value of which may not exceed a certain dollar amount, in a particular asset under Bankruptcy Code Section 522(d)(9).

Garon and Diane acknowledged that upon filing their bankruptcy petition, their interest in the home became the property of the bankruptcy estate. They also acknowledged that the amount of the liens on their home exceeded its actual value, thereby eliminating any equity interest they may have had.

The couple argued that they were entitled to exempt their interest in the property even though they had no equity in it. The couple argued that, since their actual interest in the home (i.e., zero) did not exceed the amount of aggregate interest for which they were entitled to claim as exempt (i.e., $60,000) under state law, the bankruptcy court's granting of their exemption removed the property from the bankruptcy estate and, as a result, the trustee had no authority to sell it.

The Fourth Circuit affirmed the district court and concluded that the bankruptcy trustee could sell the couple's home as part of the bankruptcy estate. The court rejected as without merit the couple's argument that the property had been removed from the bankruptcy estate. The court cited Schwab v. Reilly, 130 S. Ct. 2652 (2010), which distinguished between exempting an asset itself from the bankruptcy estate and exempting an interest in such asset from the bankruptcy estate. Under Bankruptcy Code Section 522(d)(9), the property claimed as exempt was an interest in a particular asset, not the asset itself. Thus, the effect of the bankruptcy court allowing Garon and Diane's exemption in the home was to exempt their interest in the home from the estate, not in the home itself, the court noted.

The couple's home remained part of the bankruptcy estate even though the bankruptcy court allowed them to reserve an exemption of $60,000 as their aggregate interest in the home, which was subordinate to the mortgage and federal tax lien.

For a discussion of IRS procedures in jeopardy, receiverships, and bankruptcies, see Parker Tax ¶262,500. (Staff Contributor Parker Tax Publishing)

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