Understanding Exempt Asset Status

Work Smart

In one case, a California physician, operating his practice in the form of a corporation, filed a Chapter 7 (liquidation) bankruptcy proceeding. In Chapter 7, "all" of the debtor's assets are sold, with the proceeds used to pay the creditors.

The physician had accumulated nearly $2 million in a retirement plan. California, like many other states, exempts assets in a retirement plan from liquidation. (As of October 17, 2005, federal law exempts all qualified retirement funds from a creditor's reach.)

The physician's creditors challenged the $2 million exemption, on the grounds that it was unfair. While agreeing with the creditors that the exemption was unfair, the court acknowledged that it was powerless to ignore the exemption.

The result was that the physician eliminated all of his debts and, at the same time, walked away from the "liquidation" bankruptcy proceeding with $2 million.

Had the physician simply withdrawn the $2 million from the business and invested it in a personal portfolio outside of a retirement plan (as many small business owners would have done), he would have lost $2 million.

Work Smart

In one case, a Wisconsin couple moved to Florida and then, a little over a year later, filed a bankruptcy action there. They had liquidated their Wisconsin assets and invested the proceeds in a Florida home that cost over $200,000. Wisconsin recognizes only a $40,000 homestead exemption, while Florida is well known for its unlimited homestead exemption.

The bankruptcy court ruled that the conversion of nonexempt assets into exempt assets was fraudulent, as the move was really motivated only by a desire to use Florida's more generous homestead exemption. The court limited the couple to Wisconsin's $40,000 exemption. Had the move and conversion occurred much earlier, the couple would have saved over $160,000. This story should highlight the fact that timing and motive are important factors in asset exemption transfers. (As of October 17, 2005, federal law limits any state homestead exemption to $125,000, if the equity had been acquired during the previous 1,215 days before filing; equity held for longer than 1,215 days is not limited by the new law.)

Note: The case involving the Wisconsin couple may no longer represent the law in Florida. Recently, the U.S. Court of Appeals ruled that Florida's homestead exemption, which is embodied in Florida's Constitution, is absolute, and protected even when purchases or transfers are fraudulent. This decision is unique, and unlikely to be followed even in other states, such as Texas, where the homestead exemption is provided by the state constitution.

In contrast, in another case, a state judge filed a bankruptcy proceeding in his home state, which offered only a limited homestead exemption. He attributed his financial condition to large losses he suffered in the real estate market.

The value of his residence was close to $1 million, meaning that it would not be exempt in the bankruptcy proceeding. However, the judge had planned well. He had previously transferred his interest in the family residence and other property to his spouse. She was not a party to the bankruptcy proceeding.

Because the transfers occurred well before the bankruptcy proceeding (about 10 years earlier), and during a period when the debtor was financially healthy, the bankruptcy trustee could not reach these assets.

Work Smart

John Smith owns a home with a value of $110,000. He has a first mortgage on his home of $100,000.

John is starting a business. He knows his home state exempts a residence in the amount of $125,000. Because his home is worth only $110,000, he concludes that his home is an exempt asset.

Smith takes out a second mortgage in the amount of $30,000 to finance the startup costs for his new business. Because his home is an exempt asset, he believes he is not risking his home, as a creditor cannot levy on an exempt asset.

While it is true that Smith's home is an exempt asset, this exemption will not help Smith. Consensual liens, such as first and second mortgages, cannot be eliminated in state court or in a bankruptcy action even when they are secured by an exempt asset.

Essentially, the exempt status of the home is meaningless in this situation. If John does not pay his second mortgage of $30,000 and his first mortgage of $100,000, he will lose his home.

As another example, Peter Jones owns a home with a value of $300,000. The home has no mortgage.

Jones has failed to pay his real estate taxes and motor vehicle taxes for several years. Accordingly, the town in which he resides places a lien against his residence and begins foreclosure proceedings to collect the delinquent taxes.

Jones knows he enjoys an unlimited homestead exemption in his home state. Accordingly, he concludes that, because his home is an exempt asset, he can ignore the foreclosure proceeding.

However, in this case, Jones will lose his home. Statutory liens, including liens for delinquent taxes, cannot be eliminated in state court or in a bankruptcy action even when the liens are secured by an exempt asset. The exemption offers no protection whatsoever. The result is essentially the same as if the asset was not exempt.

Consider this third example: Mary Black forms an LLC to operate her new business. She contributes a car to the LLC, subject to a lien against it for a car loan. The car has a value of $9,000, and the amount owed on the loan is $8,000. Thus, there is $1,000 equity in the car.

Black concludes her car is an exempt asset, because her home state exempts the first $1,500 of equity in a car. She is confident that the car will be protected if her business experiences financial difficulties.

Black is wrong. Asset exemptions are available only to "natural persons" (i.e., real people). Corporations, LLCs and even partnerships are considered "persons" for many purposes in the law, but not for asset exemption purposes. Black's car is fully subject to the claims of the business creditors.