09 Oct Exemption Planning, Part 1: Selling an Asset Before Bankruptcy to Avoid Losing It
If you’re considering bankruptcy, you’re no doubt concerned about avoiding the loss of money or property to your creditors. Fortunately, although rules vary from state to state, most consumer debtors won’t lose any assets in a bankruptcy. This is because the exemptions (the laws protecting your property from loss to creditors) are liberal and usually will protect most, if not all, of your assets. However, if you own two homes, expensive vehicles, a large stock portfolio, or other valuable or unencumbered assets, you may be told by your lawyer that some of your assets cannot be claimed as exempt. In a bankruptcy, non-exempt assets are sold by the trustee to pay your creditors. Ouch!
But what if you could sell an asset you would otherwise lose, before you file the case, and use those cash proceeds to (1) obtain an asset that would be exempt, or (2) pay down a loan against an exempt asset? This is called “exemption planning.” The question is whether it is still advisable to undertake exemption planning under the new Bankruptcy Reform Act.
Before the bankruptcy laws changed in 2005, exemption planning typically went like this:
- The debtor owns a home worth $200,000 with a $150,000 mortgage. This means she has equity of $50,000. Her state’s home exemption is $100,000. Therefore, the home is protected.
- The debtor also owns a cabin worth $50,000 with no mortgage against it. There is no exemption to protect the cabin.
- The debtor sells the cabin for $50,000 before filing the bankruptcy, and she promptly pays the $50,000 to the mortgage on her home. She then files bankruptcy.
The debtor now has no cabin, but she does have an additional $50,000 equity in her home (the equity is now $100,000). Because her state has a $100,000 home exemption, she doesn’t lose any equity in her home.
The exemption planning described above results in the debtor avoiding a net loss of property value. Exemption planning was commonly and extensively used regarding all sorts of assets, usually involving non-exempt cars, boats, stock, large bank accounts, or liquid cash-type assets, all of which were turned into cash to pay down, typically, the home mortgage. This exemption planning was normally accepted by bankruptcy courts as a matter of course.
However, the 2005 Bankruptcy Reform Act contained new rules which cast a pall over exemption planning. In fact, it’s fair to say that new Sections of the Bankruptcy Code Sections 522(o), 522(p), and 522(q), have all but eliminated the practice, when it involves more than a few thousand dollars. Some bankruptcy lawyers even tell clients that exemption planning simply is no longer allowed. Indeed, the handful of court rulings interpreting Section 522(o) have disapproved the planning, with disastrous consequences to the debtors involved. The most knowledgeable lawyers will tell you that this area of law is unsettled, and that no one really knows if exemption planning can still be done with any degree of safety. As a result, exemption planning should only be considered by the most informed and motivated debtors, having access to an expert bankruptcy lawyer.
In Part 2 of this article, tomorrow, I’ll talk about when, if ever, exemption planning might be considered.
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