Special Lien Elimination Situations

April 13, 2006

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In a bankruptcy proceeding, it is possible to eliminate a non-purchase-money, non-possessory security interest lien in exempt property, if the property consists of:

household furnishings, household goods, wearing apparel, appliances, books, animals, crops, musical instruments, or jewelry held primarily for the personal, family or household use of the debtor or a dependent of the debtor
implements, professional books, or tools of the trade of the debtor or a dependent of the debtor
professionally prescribed health aids for the debtor or a dependent of the debtor

Remember, a non-purchase-money security interest lien arises where the proceeds from the debt were not used to purchase the property. Loans involving purchase-money security interests are more common. This fact means lien elimination will not apply to very many loans.

The requirement that the lien must be on a specific and narrow class of property also means that this exemption will not apply to many cases.

And the lien must also be non-possessory. This means that the debtor, as opposed to the creditor, must retain possession of the property. This condition will not usually be difficult to meet, except, for example, in the case of a loan from a pawn broker.

The bankruptcy code imposes one other condition on this rule: If the debtor uses the state's exemptions, rather than the federal bankruptcy code exemptions, and the property exempted consists of implements, professional books, or tools of the trade of the debtor or a dependent of the debtor, or farm animals or crops of the debtor or a dependent of the debtor, then the lien cannot be eliminated to the extent the value of such implements, professional books, tools of the trade, animals, and crops exceeds $5,000.

The cap exists because, while the federal exemptions for the property covered by the rule are not that generous, the analogous state exemptions can be significant.

It's important to note that the courts have typically interpreted this $5,000 limitation as a cap on the amount of the lien that can be eliminated. However, a Texas bankruptcy court has ruled that this limitation actually means the debtor must be left with a minimum equity in the property of $5,000.

The difference between the two interpretations can be significant, when the loan exceeds the value of the property.

In addition, a mechanic's lien that is filed within the 90 days before the bankruptcy action commences (or is for rent owed) can be eliminated as a "preference" under the bankruptcy code.

John Smith personally owns office furniture valued at $20,000 with a non-purchase-money, non-possessory lien against it in the amount of $80,000. Thus, Smith has no equity in the furniture.

Smith files a bankruptcy action and elects his state's exemptions, so that the $5,000 limitation applies (due to the federal cap). Further, Smith's state exemption for the office equipment makes it completely exempt.

Under the most common interpretation, Smith can eliminate $5,000 of the lien, and he still owes $75,000. He still will have no equity in the furniture.

Under the recent interpretation by a Texas bankruptcy court, the balance of the loan will be reduced to the difference between the value of the property, $20,000, and the $5,000 limitation. Here, that amount is $15,000. In this way, the debtor is left with a minimum equity of $5,000 in the property.

Thus, in this example, under the second interpretation, Smith's loan is reduced to $15,000, and he has $5,000 equity in the furniture ($20,000 less $15,000).

Under this second interpretation, Smith saves $60,000 (lien of $75,000 vs. lien of $15,000).