The Trustee’s Power to Sell the Debtor’s House when Fully Encumbered by Perfected Liens (Part Two)
By: John Lee

In Reeves v. Callaway the Fourth Circuit Court of Appeals ruled that a Trustee can sell the debtor’s real property even though it is fully encumbered by secured liens and there is a validly perfected homestead exemption. Their decision was based, in part, on Schwab v. Reilly where the U.S. Supreme Court ruled that a debtor’s exemption in property was not exempting the asset it self but rather a monetary interest in the asset. In Calloway the Fourth Circuit ruled that once the IRS allowed the trustee a “carve-out” for the unsecured creditors the Trustee could sell the fully encumbered property because the debtor’s homestead exemption only protected an interest in the property, not the property itself.

When the Reeves’ filed a Chapter 7 Bankruptcy in North Carolina they listed as an asset a piece of real estate valued at $325,000.00. The real estate was encumbered by two liens; a mortgage and an IRS tax lien, when combined, far exceeded the value of the home. Despite having no equity in the property at all, the Debtors filed for a $60,000.00 homestead exemption. The Trustee objected to the debtors’ claiming a homestead exemption in property that had no equity and the Court upheld the debtor’s asserted homestead exemption. The IRS agreed to allow the Trustee a 30% “carve-out” of their lien for administrative cost and the unsecured creditors. The Trustee filed a motion to sell the property to pay off the perfected first mortgage, the IRS lien, and have the remainder (carve-out) go to administrative expenses and unsecured creditors. The debtor’s objected to the sale on the grounds that after liens there was no equity and that their homestead exemption protected the house from sale. The bankruptcy court granted the Trustee’s motion to sell and the debtor’s appealed.

On appeal, it was undisputed that (1) the real estate became part of the bankruptcy estate upon filing and that (2) the house was fully encumbered by perfected liens leaving no equity. The debtors argued that because the equity in the property, zero, does not exceed the homestead exemption, sixty thousand, the property is fully exempted and therefore can not be sold by the trustee. The court ruled against the debtor because the exemption was for an “interest” in the property, not the property itself.

The Fourth Circuit, relying on the Supreme Court decision Schwab, determined that there are two types of exemptions, those that exempt an entire asset or the item itself; and those that only exempt a monetary interest in an asset. Some exemptions exempt an item such as a wedding ring or family pet and list no specific amount. In these cases, the whole item is exempted from the bankruptcy estate regardless of value. Other exemptions, list a dollar figure in an asset, such as the North Carolina exemption allowing a debtor to keep up $60,000.00 in real estate. When the exemption statute sets a dollar figure, the asset itself is not exempt, just a monetary interest in the asset.

Trustee’s are generally not allowed to sell properties that are fully encumbered by liens solely for the benefit of creditors that are secured lien holders. For a Trustee to sell a property, there must enough nonexempt equity after secured creditors are paid to make a distribution to unsecured creditors. In this case, the IRS gave the Trustee a carve-out of their lien for him to pay the unsecured creditors. Without this carve-out there would have been no money left for the unsecured creditors and the trustee would not have been permitted to sell the property. The carve-out was approved by the bankruptcy court, in-part, because it did not hurt the debtor because the IRS agreed to give the debtor full credit against his tax debt for the carve-out used to pay the unsecured creditors. Essentially, the debtor’s tax debt was reduced even though the money was dedicated to unsecured creditors.

Ultimately, the Court ruled that the Trustee could sell the debtor’s property because it was part of the bankruptcy estate and the fact that their exemption exceeded the value of the property did not matter. This is a Fourth Circuit decision so it is binding on the Eastern District of Virginia. In Virginia, if you have a tax lien that exceeds the value of the property and the Trustee and IRS work together, they can sell your property even if your homestead exemption exceeds any equity that may exist in the property.

The First Circuit’s Traverse decision ruled that an exemption that exceed the value of the property exempted the property itself, while the Fourth Circuit ruled that an exemption for a specific dollar amount only protected a monetary interest in the property. Both relied on Schwab, but came to different results, in one case the Trustee was allowed to sell the debtor’s real estate and the other he was not.

In next week’s blog, I will be discussing whether these two seemingly different results represent a split in the Circuits. Read my blog next week to find out.

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