Fifth Circuit Erodes Protection for Texas Homesteads Sold After Filing

Fifth Circuit Erodes Protection for Texas Homesteads Sold After Filing

 Expanding upon its decision in Matter of Zibman, 268 F.3d 298 (5th Cir. 2001) [an enhanced version of this opinion is available to lexis.com subscribers], the Fifth Circuit has ruled that the proceeds from sale of a Texas homestead lose their exempt character if they are not reinvested within six months--even when the sale takes place post-petition. Viegelahn v. Frost (In re Frost), No. 12-50811 (5th Cir. 3/5/14). The opinion can be found here [enhanced version]. The opinion creates a malpractice trap and arguably conflicts with this week's Supreme Court decision in Law v. Siegel.

The Problem

The Bankruptcy Code states that "property exempted under this section is not liable during or after the case for any debt of the debtor that arose . . . before the commencement of the case" except for debts for taxes and domestic support obligations, unavoided liens, debts owed by an institution-affiliated party and debts for fraud incurred in obtaining a student loan. 11 U.S.C. Sec. 523(c). Further, exempt property is not liable for administrative expenses except for the cost of recovering that property. 11 U.S.C. Sec. 522(k).

These provisions should make it pretty clear that once property is allowed as exempt, it is not liable for pre-petition debts or administrative claims with very limited exemptions. However, Texas has a vanishing exemption. While Texas has one of the most generous homestead exemptions in the country, proceeds from sale of a homestead only remain exempt so long as they are reinvested within six months. Texas Property Code Sec. 41.001(c).

In Matter of Zibman, the Fifth Circuit held that the Texas Property Code grants only a provisional exemption to homestead proceeds. Where the homestead was sold prior to bankruptcy and the debtor held proceeds on the petition date, the exemption would be allowed subject to the reinvestment provision. Zibman can be reconciled with section 522(c) and (k) for the reason that the limitation on the exemption existed on the petition date. In other words, the debtor had an exemption in a fund of money so long as he used that money to purchase a new homestead within six months. This is contrasted with the exemption in the homestead itself which was not subject to defeasance.

The Frost Facts

Mark Frost filed a chapter 13 petition on November 30, 2009. At that time, he owned a home in Cibolo, Texas. On March 26, 2010, the Bankruptcy Court entered an order allowing him to sell his home. The Trustee objected to the sale on the basis that the Debtor should be required to re-invest the proceeds within six months. The Court allowed the sale but provided that any liens or interests not specifically provided for in the Order would attach to the proceeds and that the proceeds would be deposited with the Chapter 13 Trustee "pending further orders of this Court as to the validity, priority and extent of such liens and interests." The sale closed on July 1, 2010 and resulted in net proceeds of $81,108.67.

The Debtor subsequently proposed a plan that would pay creditors 1% on their claims. On December 5, 2010, which was about seven months after the sale, the Trustee objected to the plan. The Trustee argued that the proceeds from sale of the homestead should be paid to creditors because they had not been reinvested within six months. Of course, the proceeds could NOT have been reinvested within six months because the Trustee had been holding them.

The Bankruptcy Court entered an interim order allowing the Trustee to retain sufficient funds to ensure a 100% distribution to creditors and returning $40,000 to the Debtor.

On January 27, 2011, the Court conducted a hearing on the Trustee's Objection to the Motion to Sell Property Free and Clear of Liens. This was odd because the prior order entered on March 26, 2010 did not indicate that the Court was reserving a ruling upon the Trustee's objection. At this hearing, the Court ruled that the Debtor would be given six months in which to reinvest the proceeds. Because the Trustee had been in possession of the proceeds, the Court held that the six month period would be tolled until January 27, 2011. However, the Court also ruled that because the Debtor had spent $23,000.00 of the funds previously distributed to him for purposes other than buying a new homestead, that these funds had lost their exempt character and would have to be paid to creditors under the plan. Thus, the Court gave and the Court gave away. While the Court authorized payment of $40,000.00 to the Debtor, it took back $23,000.

The Debtor appealed to the District Court which affirmed. The Court's ruling was limited to the $23,000 which was not reinvested. While the record is not clear, apparently the other funds released to the Debtor were reinvested in a homestead since they were not mentioned again.

Note: According to the Fifth Circuit, $18,000 was held in trust for the Debtor to purchase a new homestead and the remaining funds were paid to creditors. This does not appear to accurately describe what transpired below. The facts listed above are taken from my review of the Bankruptcy Court docket and orders rather than the Fifth Circuit's opinion.

The Fifth Circuit's Ruling

The Fifth Circuit affirmed. It held that Zibman applied to the post-petition sale of the homestead. The Court found that while the Debtor's exemption was fixed on the petition date under the "snapshot" rule that "it is the entire state law applicable on the filing date that is determinative.” The Fifth Circuit rejected the argument that section 522(c) rendered the homestead and its subsequent proceeds permanently exempt. The Court stated:

Frost’s homestead was exempted from the estate—when the rest of his assets were not—by virtue of its character as a homestead. As in Zibman, this “essential element of the exemption must continue in effect even during the pendency of the bankruptcy.” Id. Once Frost sold his homestead, the essential character of the homestead changed from “homestead” to “proceeds,” placing it under section 41.001(c)’s six month exemption. Because he did not reinvest those proceeds within that time period, they are removed from the protection of Texas bankruptcy law and no longer exempt from the estate.

Opinion, pp. 5-6.

The Fifth Circuit also ruled that the timing of the sale, whether pre or post-petition did not affect the analysis.

This temporal distinction is insufficient to escape the holding of Zibman. The court’s insistence that an “essential element of the exemption must continue in effect even during the pendency of the bankruptcy case” indicates that a change in the character of the property that eliminates an element required for the exemption voids the exemption, even if the bankruptcy proceedings have already begun. Under this court’s precedent, (i) the sale of the homestead voided the homestead exemption and (ii) the failure to reinvest the proceeds within six months voided the proceeds exemption, regardless of whether the sale occurred pre- or post-petition.

Opinion, p. 6.

The Court also rejected the argument that Schwab v. Reilly, 560 U.S. 770 (2010) [enhanced version] preempted the Texas law. Schwab v. Reilly divided exemptions into those which consist of a dollar amount versus those which attach to the thing itself. The Debtor argued that because the thing was exempt that it remained exempt. As stated by the Debtor, Schwab held that "exempt is exempt.” The Fifth Circuit stated that "The rationale of Schwab simply does not apply to this case." However, its stated rationale suggests that the Court did not understand the Debtor's argument. The Court said that Schwab did not apply because Schwab involved an exemption limited by dollar amount and the Texas exemption was unlimited. However, that really misses the Debtor's point that under Schwab, the thing itself was exempt and therefore could not return to the estate.

The Need for Reconsideration

The Fifth Circuit might want to take another look at this one. For one thing, the opinion completely fails to appreciate the case's unique procedural posture which could have provided a more coherent basis for the Court's ruling. It also seems to fumble the intersection between the Bankruptcy Code and Texas exemption law. This could result in major mayhem in future cases.

This was a chapter 13 case. As a result, property acquired post-petition is included in the estate. 11 U.S.C. Sec. 1306. The proceeds from sale of the homestead could have been analogized to property acquired post-petition which would only be exempt if re-invested in a new homestead within six months. As a result, the timing that would matter is whether the homestead was sold during the case or subsequently. However, under the Court's ruling, if a debtor files chapter 7 bankruptcy and sells his homestead many years later, the Trustee could reopen the case and seek to administer the proceeds if they were not reinvested. Judge Tony Davis rejected the application of Zibman to a post-petition sale of a homestead in a chapter 7 case in a well-reasoned opinion in In re D'Avila, No. 13-11173 (Bankr. W. D. Tex. 8/21/13), which can be found here [enhanced version]. The Frost opinion suggests that it would be equally applicable in a chapter 7 or a chapter 13 case. That would be bad.

I also think the Court was incorrect on the temporal issue. When the Debtor filed bankruptcy on November 30, 2009, he owned a homestead. By the time that he filed the Motion to Sell Property Free and Clear of Liens, the exemption on that property was final. As a result, the property left the estate. In the words of Neil Young, "once you're gone, you can't come back.” That applies to property of the estate as well. Would the court hold that property sold free and clear of liens or abandoned could revert back to the estate after the debtor and third parties had acted in reliance?  I don't think so.

Additionally, the factual application of the case is contrary to Texas law. Under Texas law, proceeds from a homestead remain exempt for six months. The Debtor can do whatever he wants with the money during those six months. If the Debtor spends the proceeds of the homestead on fine dining and poor investments, creditors can't get the money back. However, the Bankruptcy Court held (and the reviewing courts agreed) that spending part of the homestead proceeds during the six month exemption period meant that a similar portion of the unexpended homestead proceeds lost their exempt character. Huh?  That does not seem to make sense. I think that the Debtor was on the right track. Exempt is exempt with one caveat. I would agree that if a debtor sells a homestead during a chapter 13 and has proceeds left over six months later, that the unexpended money would constitute property of the estate. However, if the Debtor uses the money to buy a new home or spends it on wild living, it is simply not there to become property of the estate.

The Court might also want to think about how Law v. Siegel affects this case. In Law, the Ninth Circuit held that a Bankruptcy Court could surcharge a debtor's exempt property based on bad behavior [enhanced version]. The Supreme Court reversed, holding that the clear language of section 522(k) prevented the Court from using exempt property to pay administrative expenses regardless of the reason. Section 522(c) says the same thing with regard to pre-petition claims. Granted, Law v. Siegel was about the abuse of section 105 to override a clear statutory provision while the Court did not rely on section 105 in this case. However, the result of undermining the statutory protection is the same and should make a difference.

Proceed With Caution If This Opinion Remains the Law

If the Frost case remains good law, the only good advice to a debtor with a Texas homestead is plan to hold on to it indefinitely or be ready to buy a new homestead within six months. Any other advice will place your client and your malpractice insurance at risk. The other take away is never let the trustee hold the money from sale of your homestead. Here, the trustee held on to the funds for six months and then tried to claim that the debtor had forfeited his exemption altogether. Then when the Bankruptcy Court allowed some of the funds to be released to the Debtor without stating any conditions, the Court clawed that money back when it wasn't used for purchase of a homestead. What the Debtor should have done in this case was to file his bankruptcy to get the benefit of the automatic stay and then dismissed or converted the case once the sale went through. While this may seem like an abuse of chapter 13, it is a rational response to an irrational result.

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