Bankruptcy: Homestead Exemptions and IRS Secured Claims

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Bankruptcy: Homestead Exemptions and IRS Secured Claims

In In re Kresock, Jr., Case No. 16-08631 (Bankr., Dist. of Arizona, November 24, 2020), bankruptcy case out of the Bankruptcy Court of the District of Arizona, the Court was faced with the interplay between the Debtor’s homestead exemption on the one hand and IRS claims – both secured and priority – on the other.

The Debtor in the case, which was filed on July 27, 2016, claimed a homestead exemption in certain real property in Parker Arizona under Arizona law.  No objections were filed to the exemptions.  For reasons that are not described in the case, the Trustee sold the Parker, AZ, property (in many state, including Texas, a Trustee would typically not be allowed to force the sale of a Debtor’s homestead).  Pursuant to the Court’s order approving the sale, after certain secured creditors were paid from the sales proceeds, the remaining $197,415.57 was held by the Trustee pending further order of the Court.

On September 6, 2017, the Court approved a settlement agreement that authorized the Trustee to pay the Debtor’s ex-wife $100,000 from the remaining proceeds in full satisfaction of her claims against the estate, leaving $97,415.57 (the “Net Sale Proceeds”).

On May 17, 2018, the IRS filed an amended proof of claim in the amount of $2,293,059.32.  Of that amount, $21,844.52 was asserted as a secured claim, and $650,850.47 was asserted as a priority claim pursuant to §507(a)(8).  On February 6, 2019, the Bankruptcy Court issued an opinion allowing the IRS’s amended proof of claim as filed.

Pursuant to the Amended Final Report and the Trustee’s Summary of the Amended Final Report, the Trustee proposed to provide for a distribution to the IRS on its remaining allowed secured claim. Thereafter, the Trustee proposes to distribute the remaining Net Sale Proceeds pursuant to the priority scheme set forth in the Bankruptcy Code, which would ultimately pay all the proceeds to the IRS and the Arizona Dept. of Revenue.

The Debtor argued that he was entitled to the Net Sale Proceeds pursuant to his claimed homestead exemption, to which no objection was timely filed. The Trustee and IRS both took the position that the Debtor could not use the homestead exemption  as a shield against nondischargeable pre-petition priority tax debt, like that owed to the IRS.

In analyzing the Bankruptcy Code statutory scheme, the Court first looked at §522 (c)(2)(B) with respect to the secured portion of the IRS claim, which states that

“property exempted … is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 [of the Bankruptcy Code] as if such debt had arisen, before the commencement of the case, except – a debt secured by a lien that is – a tax lien, notice of which is properly filed[.]” In other words, “exempt property remains liable for a properly noticed tax lien.”

Pursuant to a final judgment issued by this Court, the IRS had an allowed secured claim in the amount of $21,844.52 (the “Secured Claim”).  The Secured Claim represented the balance owing on the recorded IRS Tax Lien, encumbered “all property and rights to property belonging to the Debtor,” and attached to the Net Sale Proceeds being held by the Trustee pursuant to the Bankruptcy Court’s Sale Order.  Based on that finding, the Court held that the IRS was entitled to payment of the remainder owing on the IRS Tax Lien from the Net Sale Proceeds pursuant to § 522(c)(2)(B) and the Sale Order.

After deduction of the balance owing on the IRS Tax Lien, $75,571.05 in Net Sale Proceeds remained. The IRS took the position that the IRS and the Arizona DOR were entitled to the remainder of the Net Sale Proceeds pursuant to  § 522(c)(1).

In analyzing the Bankruptcy Code with respect to the Priority Claims, the Court turned to §522 (c)(1), which sets forth another exception to the general rule that exempt property is not liable for pre-petition debt.  Section 522(c)(1) provides in relevant part:

[P]roperty exempted … is not liable during or after [a bankruptcy] case for any debt of the debtor that arose, or that is determined under section 502 of [the Bankruptcy Code] as if such debt had arisen, before the commencement of the case, except – a debt of a kind specified in paragraph (1) … of  section 523(a) (in which case, notwithstanding any provision of applicable nonbankruptcy law to the contrary, such property shall be liable for a debt of a kind specified in such paragraph)[.]

In other words, the Court believed that the remaining Net Sale Proceeds were liable for debt of a kind set forth in § 523(a)(1).  The Court went on to find that debt “for a tax … of the kind and for the periods specified in section … 507(a)(8) of [the Bankruptcy Code], whether or not a claim for such tax was filed or allowed” is debt of a kind set forth in  § 523(a)(1).

Accordingly, the Priority Claims were found to be debt of a kind specified in § 523(a)(1), and therefore, the Net Sale Proceeds were liable for the Priority Claims pursuant to  § 522(c)(1).  After applying these conclusions of law, nothing remained of the Net Sale Proceeds that would inure to the Debtor for application to the homestead exemption.

This result would likely be different in other states, but it serves as a cautionary tale of assuming that a homestead exemption always prevails.  When it comes to the IRS and other taxing entities, that is often not the case.

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