Exemption Planning, Part 2: Selling an Asset Before Bankruptcy to Avoid Losing It

11 Oct Exemption Planning, Part 2: Selling an Asset Before Bankruptcy to Avoid Losing It

Even before the 2005 Bankruptcy Reform Act’s addition of Sections 522(o), 522(p), and 522(q) to the bankruptcy law, lawyers were careful when advising clients about exemption planning. Under the old law, it was still possible for the client to lose his or her discharge if exemption planning was not done “right.” A lawyer typically would have the client sign an acknowledgement that he or she had been informed of the risk of losing the discharge, and that the client proceeded with the exemption planning at his or her own risk.

Under the new bankruptcy law, the debtor not only can lose his or her discharge under section 727 for transferring property solely to hinder, delay or defraud creditors, but the following sections apply:

  • Section 522(o): the debtor could lose the ability to claim as exempt the increased homestead equity created by the exemption planning, if such planning runs afoul of Section 727.
  • Section 522(p): the debtor’s homestead exemption is capped at $125,000 if the debtor increases his home equity by more than that amount, in the 1215 days before the bankruptcy is filed, by employing some type of exemption planning, unless the debtor has simply rolled over home equity into a new residence in the same state.
  • Section 522(q): the debtor’s homestead exemption is capped at $125,000 if the debtor has committed securities fraud, fraud, other fraudulent conduct listed in that section, or caused serious physical injury or death to another in the preceeding five years.

Got it? Now you can see why lawyers have become reluctant to counsel clients to engage in any degree of exemption planning under the new bankruptcy law. However, there are some situations where a debtor should at least consider exemption planning, even if the debtor decides not to actually do it.

The situation below was described by a Minnesota chapter 7 trustee, who might fairly be described as the “dean” of the Minnesota trustee panel, while he delivered a brief CLE speech in April 2007. I have added a few inconsequential details of my own. The trustee described this as an example of exemption planning which he believed would be approved by the court, even under the new bankruptcy law.

  • The debtor owns a home worth $350,000 subject to a first mortgage with a balance of $275,000 with 6% interest. The monthly payment is about $1,800 including taxes and insurance.
  • The home has a second mortgage with a balance of $50,000 at 15% interest. The monthly payment is over $700.
  • The two mortgages total $325,000; therefore the home has equity of $25,000. The state’s home exemption is $200,000.
  • The debtor has $50,000 in his stock portfolio. This could not be claimed exempt and would be lost in a bankruptcy.
  • The debtor’s income and household expenses are such that it is difficult, or maybe impossible, to pay the second mortgage.
  • The debtor therefore elects to cash in the $50,000 worth of stock and uses it to pay off the second mortgage. A few months later the debtor files bankruptcy.

There is now $75,000 equity in the home, rather than $25,000 equity existing before the stock sale. This is probably as safe an example of exemption planning as can be imagined under the new bankruptcy law. If the debtor testifies that the motive for paying down and eliminating the second mortgage was that he doubted his ability to continue the payments on it, thereby ensuring he could keep his home, and if the court gives credit to this testimony, then the trustee cannot successfully challenge the exemption planning. This is because the motive for paying down the second mortgage was to avoid possible foreclosure, rather than to hinder, delay, or defraud creditors.

Sections 522(o), 522(p), and 522(q) apply only when state exemptions are used. They do not apply to federal exemption cases, but remember that section 727 always applies in chapter 7 cases.

Got it now? Don’t feel bad; exemption planning is complicated; it was once famously described by a bankruptcy judge as, “a pig gets fat, but a hog gets slaughtered.” Consequently, few debtors are choosing to engage in exemption planning today. If you think you should consider it, consult an experienced bankruptcy lawyer. However, until there is some case law to rely on, don’t feel bad if you decide to take the safe route and hand over an asset to the the trustee.

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Craig W. Andresen is a consumer bankruptcy lawyer in Bloomington, Minnesota, with 22 years’ experience in consumer and small business bankruptcy cases. He is the Minnesota chair of the National Association of Consumer Bankruptcy Attorneys, and is a member of the Minnesota State Bar Association’s Bankruptcy Section. Mr. Andresen lectures often on the topic of consumer bankruptcy at local and national legal seminars.
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