Homestead Exemption in Bankruptcy – 9th Circuit Pitfalls

Home equity you thought was safe from creditors may become vulnerable during the course of a bankruptcy if the value of a home increases. In some states, cash proceeds from a pre-petition home sale can lose their exempt status if not reinvested promptly. These are the lessons of two recent Ninth Circuit decisions. Klein v. Chappell and Ford v. Konnoff.

Suppose you, as debtor, own a home with a hefty mortgage obligation. You decide to keep the house and are able to negotiate and adhere to an affordable schedule of payments, which gets you off the hook as far as the secured debt is concerned. The small difference between the house’s market value and the secured debt falls comfortably within the state or federal homestead exemption, so the bankruptcy trustee cannot sell it as an asset to pay off unsecured creditors. At least you hope the trustee will not be able to do so.

In a rapidly appreciating housing market, the market value of a house can increase substantially during the time a Chapter 7 bankruptcy estate is open. Now the house is an asset with net value in excess of the secured debt and homestead exemption, and the bankruptcy trustee has the power to either sell the house or require you to redeem the non-exempt portion of the value to pay off unsecured creditors. The United States Trustee for Region 18 recently sent a letter to bankruptcy trustees in the Ninth Circuit advising them of this and urging them to investigate and pursue suspected cases where increased equity could be liquidated for the benefit of the estate. All your earlier efforts to keep the house come to naught, and the unsecured creditors reap the benefits of your post-petition house payments.

Of course, this situation will rarely arise in a stagnant or depreciating housing market. However, if the difference between market value and mortgage obligation is very close to the maximum homestead exemption, a bankruptcy debtor must be aware of this potential pitfall.

This brings us to the second booby-trap: time limits on the exemption of money realized from the sale of a home. Does the homestead exemption apply to such funds deposited in a money-market account for application to a future home purchase?  Yes, in some states such as Oregon, but with an important qualification.  In Oregon, for example, a person has one year in which to use the funds to buy another primary residence. After that, the money reverts to the estate according to the 9th Circuit Bankruptcy Appellate Panel in Konneff. If that time limit clock is ticking, be aware of it. The bankruptcy trustee certainly will be.

Bankruptcy attorneys in the 9th Circuit must be alert to file a Motion To Abandon real property if the case fails to close promptly for one reason or another and a homestead is subject to potential appreciation. If cash proceeds are exempted as a homestead, they must be properly spent within the time allowed or they could be lost.

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