Many Arizona residents are aware that they are allowed a “homestead” exemption for equity in their primary residence. Many bankruptcy attorneys are aware of this fact as well. Currently, the homestead exemption in Arizona is $150,000. In the past, it was a tolerated, if not wholly supported, practice for individuals facing bankruptcy to sell assets they would otherwise lose in a bankruptcy and use the proceeds to pay down the mortgage on their home. This allowed debtors to potentially protect $150,000 in property by putting it into their home. In other states, such as Texas and Florida, the homestead protection was even more generous, allowing debtors to shield far more assets from creditors.
I recently met with a potential client that had seen three prior bankruptcy attorneys. One of these had suggested to the potential client that she sell a valuable piece of property that she owned free and clear, and use the proceeds from the sale to pay off the mortgage on her home here in Arizona. Then, he recommended she file bankruptcy and “protect” the equity in her home. As few as five years ago, this may have been an acceptable strategy, and under the right circumstances MIGHT, and I emphasize might, still be possible today.
However, the prior attorney failed to mention that major changes to the Bankruptcy Code in 2005, severely limit a debtors ability to engage in this form of “pre-bankruptcy planning.” The specific code provision in question is Section 522(o). This section limits the homestead exemption in the context of “pre-bankruptcy planning.” It requires the deduction of the value attributable to fraudulent conversions made within 10 years of filing, to the extent that such value could not have been exempted if the disposition had not been made. In plain English, if you sell an asset that you were going to lose in bankruptcy for $100,000, (like a brick of gold, vacant land you were going to build on some day, or any number of other items), and you use the money to pay down the mortgage, you are in for a rude awakening when the trustee objects to your claimed $150,000 homestead exemption.
The statute speaks of “value… attributable to… property that the debtor disposed of… with the intent to hinder, delay, or defraud a creditor.” The language is strikingly similar to that used in Section 548(a)(1)(A), which authorizes the avoidance of transfers made with actual fraudulent intent, and in Code § 727(a)(2), which bars a Chapter 7 discharge for such conduct. The similarities may suggest parallel analysis, although there is not yet a Ninth Circuit case setting forth the precise standard to be used to determine whether the transaction was done with “intent” to defraud, hinder or delay. However, there are lower court cases that state the Trustee (or objecting creditor) need only show fraud by a preponderance of evidence, rather than the higher, “clear and convincing evidence” standard that is sometimes used.
Section 727(a)(2) prohibits the grant of a discharge to a Chapter 7 debtor that engaged in fraudulent asset conversion in the year prior to filing bankruptcy. Seciton 522(o) now adds loss of the homestead exemption to the price the debtor will pay, and more troubling, extends the look back time for an astonishing 10 years. Furthermore, section 522(o) not only applies in Chapter 7 cases, but across the bankruptcy code.
While pre-bankruptcy planning, and the conversion of nonexempt property into exempt property, without more, is allowable, the intent to hinder or delay creditors is fraudulent under the code. Whether a particular transaction is fraudulent is a fact intensive question, and the objecting creditor or the Trustee bears the burden of proof. However, if you are considering bankruptcy, and you are thinking about selling, giving away, or otherwise disposing of any assets prior to filing, you should speak to a competent bankruptcy attorney first.