The debtors sought to recover a federal tax refund that the United States Department of Treasury set off prebankruptcy in partial satisfaction of a foreclosure deficiency the debtors owed to HUD. The debtors argued that the refund should be turned over to the bankruptcy estate under section 542 of the Code since the setoff was a preference under section 547.
The debtors obtained a loan from HUD to buy a manufactured home. In connection with the loan a debtor executed a notice that a payment default could result in an offset of federal payments due to the debtors, including income tax refunds. The timeline is as follows:
- The debtors defaulted on the loan. So, in August 2016, HUD sent a notice of intent to collect by Treasury offset.
- By February 2017 the debtors had filed their income tax return, and because they overpaid, Treasury owed them a tax refund of ~$5,300. Around that time the debtors owed HUD almost $20,000.
- Treasury processed HUD’s offset request on February 23, 2017.
- The debtors filed a chapter 7 bankruptcy on March 3, 2017.
The debtors listed the tax refund as exempt property in their bankruptcy schedules. They also identified “Dpt Treasury” as a creditor and listed HUD as a party to be notified about the Treasury debt. In April 2017 each debtor filed a Homestead Deed claiming exempt property, including the income tax refunds. The debtors’ list of the debt to HUD showed $26,600 from a “foreclosure deficiency on a home.” HUD records showed a balance of ~$14,500 as of the filing date.
Against this backdrop the debtors argued that they were eligible to recover the tax refund pursuant to sections 522 (regarding exemptions) and 542 (requiring turnover of property that debtors can exempt. They contended that the application of the tax refunds to the loan constituted a preference that the trustee was entitled to avoid and recover, at which time the debtors could exempt property.
The court rejected this argument because there must be a “transfer” of property for there to be a voidable preference. However, transfer is a term of art defined in section 101(54) of the Code. The legislative history states that “setoff” was intentionally omitted with the effect that it cannot be set aside as a preference, but instead is subject to special rules.
The special rules are found in section 553, which provides that the Code does not affect a creditor’s right to setoff mutual debts with certain exceptions. The list of exceptions does not include section 547. So, the debtors’ only recourse was under the setoff provisions in section 553. Section 553 sets forth several circumstances in which a trustee may avoid a setoff.
The court addressed section 553(b), which includes an “improvement in position” test. If a creditor sets off a mutual debt within 90 days before a bankruptcy filing, then the trustee may recover the amount of the setoff to the extent that the “insufficiency” is less at the time of setoff than on the date that is the later of (1) 90 days before the filing, and (2) the first date during the 90-day period on which an insufficiency exists. Insufficiency is defined as the “amount, if any, by which a claim against the debtor exceeds a mutual debt owing to the debtor by the holder of such claim.”
The court determined that the debtors’ right to recover the tax overpayment arose on December 31, 2016. This was within the 90 days prior to the bankruptcy filing. So, the court decided that the insufficiency arose on that date because that was the first date on which there were mutual debts. On December 31, the difference between the amount owed by the debtors on the loan and the amount owed to the debtors for the tax refund was ~$14,400. When the offset was processed in February, the insufficiency was at least that amount (and in fact probably increased due to the accrual of interest).
Using December 31st as the applicable test date, there was no improvement of HUD’s position as of the setoff date. Thus, the trustee was not permitted to recover any portion of the setoff amount.
A key part of the court’s decision was the conclusion that there was no insufficiency within the meaning of section 553 until there were mutual debts. An alternate view (which has been adopted by some other courts) is that the insufficiency existed 90 days before the bankruptcy filing since the debtors already owed HUD on that date. Under that view the deficiency 90 days before the filing would be compared to the deficiency immediately after the setoff. This would mean the full amount of the outstanding loan would be compared to the loan minus the tax refund, which would result in an improvement in position – giving the trustee the right to recover an amount roughly equal to the tax refund.
Vicki R Harding, Esq.