Homestead Proceeds in Bankruptcy

     California's tiered homestead exemption protects a debtor's dwelling to the extent of $75,000, $100,000, or $175,000, depending upon the debtor's status, protects a like amount of proceeds of an execution sale of the homestead for six months following sale, and protects a dwelling acquired with the proceeds within the six-month period. Cal. Code Civ. Pro. §§ 704.710 – 704.730. The short six-month window seriously undermines Chapter 7 relief to a California debtor who would be willing to sacrifice non-exempt equity in a dwelling, such as a surviving spouse, recently widowed, who is burdened with unmanageable unsecured debt and can no longer afford mortgage payments.

     In the Ninth Circuit, following a Chapter 7 trustee's sale of a dwelling, the debtor's right to retain the exempt proceeds evaporates, and the right to the proceeds reverts to the trustee, if the debtor fails to reinvest the proceeds in a new dwelling within six months after receiving proceeds of the sale. Wolfe v. Jacobson (In re Jacobson) (9th Cir. 2012). The six-month window assumes a debtor's ability to purchase a replacement dwelling within the specified period. In many locations, including coastal California's urban areas, the amount of protected proceeds will be sufficient, at best, for a down payment. Unless the debtor moves to a less expensive part of the state or country, financing would be essential. But Freddie Mac and Fannie Mae will not purchase mortgage secured loans made within four years of a Chapter 7 discharge (two years with extenuating circumstances) and the FHA will not insure such loans made within two years of a Chapter 7 discharge unless the debtor qualifies under the FHA's back to work program. Some specialized lending programs targeting specific categories of debtors (e.g. veterans) may be more forgiving, but otherwise it is difficult to imagine a lender willing to finance purchase of a dwelling by a recent Chapter 7 debtor if the loan is neither insured nor salable in the secondary market.

     Absent the necessary mortgage financing, the California Chapter 7 debtor would have to return identifiable proceeds to the trustee if the case is still open. The trustee could also seek to hold the debtor liable for proceeds that have been otherwise spent. Anticipating the debtor's potential difficulty in finding mortgage financing, most trustees surely would keep cases open long enough to learn whether the debtor had or had not been able to reinvest the proceeds in another residence.

     Anecdotal evidence shared with me by two prominent consumer bankruptcy attorneys in San Jose, California, confirms this problem. They simply advise against filing a Chapter 7 petition in these circumstances.  Somewhat dated empirical evidence points in the same direction. Katherine Porter's article on the credit industry's business model for post-bankruptcy lending reported that 64.8% of a small sample of debtors filing in 2001 perceived difficulty in accessing purchase money mortgages three years post-bankruptcy. A 2009 Federal Reserve Board study, analyzing data gathered in the 1998, 2001, and 2004 Federal Reserve Board Survey of Consumer Finance, concluded among other things that "[i]t is very difficult for the most recent [bankruptcy] filers to obtain a [first-lien] mortgage" and that those filing within the preceding year were 81% less likely to obtain a first-lien mortgage than comparable non-filers. (That study included both Chapter 7 and Chapter 13 debtors.)

      In late August 2016, the California Assembly defeated Senate Bill 308 (earlier passed by the California Senate), which sought, among other things, to address the problem. The relevant language in the bill (applicable both to California's declared homestead exemption and to its non-declared homestead exemption) read:

In a case under Title 11 of the United States Code, regardless of whether the sale is voluntary or involuntary, the expiration of the six-month period . . . at any time after the filing of such case shall not terminate the exempt status of the homestead or its proceeds.

(The Ninth Circuit BAP held state specific bankruptcy exemptions constitutional in Applebaum v. Sticka (In re Applebaum) (BAP 9th Cir. 2009) (Judge Markell dissenting), as have the Fourth and Sixth Circuit Courts of Appeal.)

     The problem is not unique to California. In 2014, the Fifth Circuit limited a Chapter 7 debtor's homestead proceeds exemption to the six-month window specified in Texas law (Viegelahn v. Frost (In re Frost) (5th Cir. 2014)), as have bankruptcy courts applying a one-year protection for homestead proceeds under Massachusetts law (In re Williams, 515 B.R. 395 (Bankr. D. Mass. 2014) (collecting cases)) and Illinois law (In re Stewart (Bankr. C.D. Ill. 2011) (discussing other Illinois bankruptcy decisions to the contrary)). A sampling of exemption law from other states suggests the possibility of the same issue arising in other circuits: Michigan (Sixth Circuit) and Colorado (Tenth Circuit) protect homestead proceeds for one year; Wisconsin (Seventh Circuit) protects homestead proceeds for two years.

     The problem may even plague the debtor entering Chapter 7 with a dwelling fully protected by the homestead exemption.  If the value of a dwelling escalates enough to generate non-exempt equity, the trustee who has kept the case open anticipating that possibility may sell the dwelling.  Gebhart v. Gaughan (In re Gebhart) (9th Cir. 2010) (trustee seeks to sell home more than three years after debtor filed petition).         

     The problem is less drastic in states in which the homestead exemption is large enough to permit a debtor to purchase a replacement dwelling without financing. The Texas homestead exemption protects the entire value of a dwelling within specified acreage limits. Ohio protects a homestead in the amount of $132,900 (doubled for a married couple) and Zillow lists the median value of an Ohio home as $122,900.

     The problem may also be less drastic in those states whose exemption statutes do not specify protection for proceeds of the sale of exempt property but whose proceeds protection is likely to be implied. An Ohio bankruptcy court concluded that the proceeds from the sale of an Ohio homestead would be protected, but only if the debtor has an abiding good faith intention at the time of the sale to reinvest the proceeds in another homestead within a reasonable time. Rabin v. Meeks (In re Meeks), 2006 Bankr. LEXIS 4141 (Bankr. N.D. Ohio July 10, 2006) (collecting cases). A Florida bankruptcy court reached a similar conclusion in In re Fling (Bankr. N.D. Fla. 2011), overruling an objection to a claim of exemption in proceeds of a pre-petition sale of the debtor's residence that the debtor still held about one year after filing the petition (and about two years after the sale) because of the debtor's (unsuccessful) efforts to buy another residence.