Turning Non-Exempt Property into Exempt Property

The Bankruptcy Code is full of traps for the unwary. For instance, Section 522(o) of the Bankruptcy Code reduces the value of a debtor’s homestead exemption when funds from nonexempt assets are applied to the homestead within 10 years of the bankruptcy filing with the actual intent to hinder, delay, or defraud a creditor. To illustrate, let’s look at an often cited case out of the Eighth Circuit Bankruptcy Appellate Panel (BAP), In re Wilmoth, 397 B.R. 915 (8th Cir. BAP 2008). In this case the debtors sold non-exempt business equipment that was in danger of repossession, and used over $140,000 of the proceeds to pay down a personal mortgage. All this pre-bankruptcy planning was done at the direction and advice of their bankruptcy attorney. The bankruptcy trustee went bananas and challenged the transactions as fraudulent.

The bankruptcy court and BAP agreed that while there were was evidence of “badges of fraud,” there was no extrinsic evidence that the debtors acted with intent to defraud. It was pointed out that the debtors were “forthcoming with the trustee, received fair value for the equipment, and acted upon the advice of counsel.” The bankruptcy court noted that the equipment sold would have continued to depreciate or even been repossessed, so the sale of the equipment actually benefited the estate.

In another Eighth Circuit case, In re Addison, 540 F.3d 805 (8th Cir. 2008), shortly before filing a bankruptcy petition the debtor transferred nonexempt funds to an IRA and used nonexempt funds to make a voluntary payment on a home mortgage to take advantage of a state homestead exemption. Even those these transfers were made for the obvious purpose of taking these funds out of the reach of creditors, the Eighth Circuit Court of Appeals upheld the transfers as there was no “extrinsic evidence of fraud”, finding that the “mere conversion of nonexempt assets to exempt assets is not in itself fraudulent”, and “it is well established that a debtor’s conversion of nonexempt property to exempt property on the eve of bankruptcy for the express purpose of placing that property beyond the reach of creditors, without more, will not deprive the debtor of the exemption to which he otherwise would be entitled.” See In re Addison, 540 F.3d 805 (8th Cir. 2008).

In yet another case, In re Coates, 242 B.R. 901, (Bankr. N.D. Tex. 2000), the debtors used $45,000 of non-exempt funds to pay off the debt on their homestead only 18 days before filing a Chapter 7 bankruptcy. The Chapter 7 trustee objected to the homestead exemption contending the debtors’ action constituted a fraud on the creditors. The bankruptcy court disagreed with the trustee and stated, “A disposition of property subject to execution for the purpose of procuring a homestead would not be deemed a fraud upon creditors. The head of a family has the right to invest his property in a homestead, and creditors without lien cannot complain that in doing so he uses property that could be levied on for debt, even though he is in failing circumstances.”

One might ask, how is Section 522(o) a trap if all of the case law is pro-debtor? Well, the analysis under 522(o) or 727 is very fact specific, and the interpretation of the facts and the Bankruptcy Code are subject to the whim and whimsy of the bankruptcy court. Consequently, the debtor should consider the well-worn path of pre-bankruptcy planning as crossing over a frozen pond, so tread carefully.

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