The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:
In a case of first impression for the Circuit, the Ninth Circuit Court of Appeals (the Circuit Court) ruled in a 2-1 published opinion that a chapter 7 trustee could not use the provisions of Bankruptcy Code section 724(a) to avoid and recover for the benefit of the estate a lien against a debtor’s homestead based on tax penalties. Because the debtor had a valid homestead exemption on the property, the Circuit Court deemed it was no longer property of the estate and a trustee may not avoid a tax lien attached to exempt property. United States of America v Warfield (In re Tillman), 2022 WL 17073615 (9th Cir. Nov. 18, 2022).
To view the opinion, click here.
When Sandra J. Tillman (the “debtor”) filed a chapter 7 bankruptcy petition, she owned a home in Prescott, Arizona (the Prescott Property”). The Internal Revenue Service (“IRS” or “the government”) held a secured claim on the Prescott Property based on a tax penalty lien. In her bankruptcy schedules, the debtor claimed a $150,000 homestead exemption under Arizona law. (Arizona, as allowed under Bankruptcy Code section 522(b), has opted out of the federal exemptions, so Arizona exemptions are applicable.) Based on the debtor’s valuation, the sum of the voluntary mortgage against the Prescott Property, the tax lien, and the debtor’s homestead exemption left no available equity for administration in the bankruptcy estate.
Chapter 7 trustee Lawrence Warfield (the trustee) filed an adversary proceeding to avoid the IRS’s tax penalty lien on the Prescott Property under the provisions of section 724(a) and to recover the value of the lien for the benefit of the estate. The government objected, responding that lien avoidance and preservation under sections 724(a) and 551 did not apply to liens encumbering exempt property. The debtor also opposed. On a summary judgment motion the bankruptcy court ruled for the trustee, holding that he could avoid the portion of the tax lien securing the penalties and interest under section 724(a) and preserve the value of the lien for the estate under section 551. Among other support for its ruling, the bankruptcy court noted that under section 522(c)(2)(B) an exemption was ineffective against a tax lien, so the debtor’s homestead exemption was inapplicable against the lien which the trustee recovered for the estate’s benefit.
The IRS appealed to the district court, which affirmed, then to the Circuit Court, which reversed.
The government argued to the Circuit Court that the courts below had erred because the debtor’s homestead exemption “withdrew her exempt property from the property of the estate” and a contextual reading of the relevant sections of the Bankruptcy Code made section 724(a) avoidance only available against property of the estate. The Circuit Court agreed.
Section 724(a) provides “[t]he trustee may avoid a lien that secures a claim of a kind specified in section 726(a)(4) of this title.” Section 726(a)(4) specifies “property of the estate shall be distributed…in payment of any allowed claim, whether secured or unsecured, for any fine or forfeiture or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee…” Finally, section 551 states “[a]ny transfer avoided under section…724(a) of this title… is preserved for the benefit of the estate but only with respect to property of the estate.” Reading them together, the Circuit Court concluded that property must be property of the estate for a trustee to recover a penalty lien. And it concluded that, once exempted, the Prescott Property was no longer property of the estate.
Section 541(a) states that the filing of a bankruptcy case “creates an estate… comprised of the debtor’s specified property interests as of the commencement of the case.” The Circuit Court observed that property of the estate does not remain static after the commencement of the case, citing Owen v Owen, 500 U.S. 305 (1991) for the impact of an exemption on such property: “[a]n exemption is an interest withdrawn from the estate (and hence from the creditors) for the benefit of the debtor.” Owen, 500 U.S. at 308 (emphasis added by the Circuit Court). That exempt property is withdrawn from the estate is reinforced by Ninth Circuit law. Gebhart v Gaughan (In re Gebhart), 621 F. 3d 1206, 1210 (9th Cir. 2010).
Since the debtor’s homestead exemption withdrew the Prescott Property from the estate, the Circuit Court reasoned that section 724(a) was inapplicable here because of its reference to section 726, which in turn applies only to “property of the estate” at the time of distribution. The Circuit Court summarized: “Thus, it is clear from the express language of § 724(a) and its cross-reference to § 726(a)(4), as well as the statutory context provided by §§ 724 and 726, that § 724(a) concerns the trustee’s avoidance of qualifying liens attached to the property of the estate at the time of distribution.” (emphasis in original)
Having reached that conclusion, the Circuit Court went to great length to distinguish prior authority, reaffirming its holding here. In addition, it observed that the debtor did not escape from the federal tax lien, which was not subject to her exemption, and that she kept her interest in the property subject to that lien. However, this result avoided a potential double penalty which would result if the trustee avoided the lien and distributed $26,000 of proceeds from a sale to the creditors of the estate, not including the avoided IRS lien, yet the debtor would still owe the penalty to the government.
The strong dissent, among other things, would have defined property of the estate at the petition date and argued that an exemption merely withdraws from the estate “an interest” in property, not the property itself.
This holding will be welcome news to consumer debtors’ counsel in the Ninth Circuit. A trustee’s use of section 724(a) to subordinate a debtor’s otherwise valid homestead exemption and to sell property which appeared to be over encumbered has been a trap for unwary counsel for the last several years. Counsel have analyzed whether there is any equity beyond encumbrances (including tax liens) and a homestead exemption, determining that since there is none, a trustee would abandon the homestead back to the debtor. Instead, the trustee’s use of section 724(a) has resulted in that very property being sold out from underneath the debtor based on the recovery of the avoided tax penalty lien. And, as the Circuit Court observed, that is a double whammy for the debtor: not only does she lose her house, but she also still owes the penalty to the government. However, the dissent raises a number of valid points. I would not be surprised to see the trustee file a petition for rehearing en banc, with amicus support from the National Association of Bankruptcy Trustees. Stay tuned.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.