A chapter 7 trustee sought to avoid a pre-petition partition of community property as a fraudulent transfer. The bankruptcy court ruled in favor of the trustee. After sale of the property the non-debtor’s wife moved for an award of a portion of the sale proceeds based on her homestead interest. The bankruptcy court determined that she would be limited by her debtor-husband’s capped exemption. Both decisions were appealed directly to the 5th Circuit.
Less than a year before the bankruptcy filing, the debtor and his wife bought an expensive home in an exclusive Dallas suburb and made valuable improvements as part of their strategy to increase profits from a future sale.
Shortly after they begin marketing their home they signed a contract to sell for $3.4 million. A few days before receiving the offer, (1) on advice of counsel they executed a “Partition Agreement” seeking to recharacterize their home from community property to separate property owned 50/50, and (2) within one hour after recording the Partition Agreement, the debtor filed a chapter 7 bankruptcy.
The debtor claimed a homestead exemption for his interest in the home. The exemption was subject to a cap of $155,675 under amendments enacted as part of BAPCPA in 2005 to address what was known as the “mansion loophole.” After negotiations the debtor agreed to limit his exemption to $130,675.
The family continued to live at the home until it was sold by the chapter 7 trustee for $3.4 million, which resulted in net cash proceeds of ~$570,000. The debtor’s wife claimed that she was entitled to a one- half property interest in the net proceeds (e.g. not limited by the bankruptcy cap). The trustee countered by avoiding the partition agreement as a fraudulent transfer and seeking a declaration that all of the remaining proceeds (after disbursement of the debtor’s homestead exemption) were property of the bankruptcy estate.
The debtor and his wife lost the fraudulent transfer argument based on a finding that there was actual intent “to hinder, delay, or defraud” creditors. Although actual intent is usually difficult to prove directly so that a court is forced to rely on circumstantial “badges of fraud,” the court found that this case was different. As an initial point, the court noted that the transfer could be avoided if there was an intent to hinder or delay creditors without requiring any finding of fraud.
The debtor testified that on advice of counsel they executed the Partition Agreement in an effort to exclude from the bankruptcy estate his wife’s interest in the homestead that was held as community property. They considered both filing bankruptcy, but felt that it was not necessary for the wife to file since they did not believe she was obligated on the debtor’s business debts.
Thus the “sole actual intent” was to avoid the bankruptcy cap on the homestead exemption, which the bankruptcy court interpreted as “gamesmanship for the purpose of placing reachable assets outside of creditors’ reach.” The bankruptcy court also stated that the debtor’s “articulated intent to preserve for his family as much money as possible is the same as an intent to shield as much money as possible from creditors.”
The debtor and his wife objected to what they viewed as an implication of illegitimate motivation, as opposed to merely preserving the wife’s rights. They commented that this appeared to be a matter of semantics. The 5th Circuit agreed that the issue appeared to be a matter of semantics and labeling: Preserving property for the wife was the mirror of keeping property out of the hands of creditors.
The court acknowledged that the line between legitimate pre-bankruptcy planning and impermissible intent was not clear. But in this case (1) the timing of the transfer in combination with (2) the fact that partition was one of several alternatives considered to maximize the value retained outside the bankruptcy estate tipped the scales in favor of interpreting the debtor’s testimony as showing a clear intent to hinder creditors. Thus the 5th Circuit agreed with the bankruptcy court that the partition was avoidable as a fraudulent transfer.
The debtor’s wife argued that denying her a distribution of ~$450,000 did not properly protect her separate homestead interest. The court acknowledged Texas has very strong homestead protections. Generally, a spouse has an interest that will be subject only to three state constitutionally permitted liens: i.e. liens for purchase money, taxes and home-improvement debts. However, the court concluded only the wife’s possessory interest was protected, not her economic interest. And once the property was sold, the proceeds lost their homestead characterization. With this as background, the court analyzed and rejected the argument that there had been an unconstitutional taking of property
The court also specifically addressed an argument based on section 363(j) of the Bankruptcy Code. Sections 363(g) and 363(h) allow a forced sale of an interest of the debtor’s spouse or co-owners along with the debtor’s interest a property. In that event section 363(j) provides that sale proceeds will be distributed to the spouse or co-owner based on their interests in the sold property.
Section 363(g) applies to a wife’s dower rights and section 363(h) applies to a co-owner’s undivided interest as a tenant in common, joint tenant, or tenant by the entirety that existed at the commencement of the bankruptcy case. However, the residence was community property. So, there were no dower or separate interests as a co-owner. Rather the entire interests of the debtor and his wife became part of the bankruptcy estate. So, section 363(j) was not applicable.
The court emphasized that although bankruptcy courts generally look to state law to define property interests, once they are defined federal law controls the consequences. Thus, the 5th Circuit upheld the bankruptcy court.
The court obviously had strong feelings about the legitimacy of the debtor’s pre-bankruptcy asset protection planning efforts. In affirming the bankruptcy court, the 5th Circuit stated: “Allowing [the debtor’s wife] to sidestep the statutory limits for homestead exemptions and obtain approximately $500,000 in proceeds that otherwise are for creditors would lay waste to the provisions of the Bankruptcy Code involved here.” It is not clear what asset protection planning steps might have passed muster. But it is clear that filing bankruptcy one hour after transferring or modifying interests in property is not the way to go.
Vicki R. Harding, Esq.