Homeowners See Win in Ruling Keeping Sale Proceeds From Creditors

A recent appeals court decision on how to treat home sale proceeds during bankruptcy is a homeowner-friendly decision for those cashing out in the robust real estate market.

In Rodriguez v. Barrera, the U.S. Court of Appeals for the Tenth Circuit found that federal bankruptcy law allowed a bankrupt Colorado couple to keep home sale proceeds that were realized after their Chapter 13 plan was confirmed by a bankruptcy court, but before they converted the case to Chapter 7.

The court ruled that the proceeds weren’t automatically part of their Chapter 7 bankruptcy estate. That meant the couple could shield the extra money from their creditors, as long as they didn’t act in bad faith.

The opinion only binds a handful of states and addresses a particular set of circumstances. But it still provides valuable guidance to judges, bankrupt individuals, and their attorneys dealing with a murky legal issue during a time of increasing home sale values.

“With the rise in real property values over the past decade, this has become a hotly contested issue in many jurisdictions,” said attorney Erik Atzbach, who represented the couple in the case. “This is the first circuit court decision on this issue in the nation.”

The decision sticks closer to what some courts and practitioners say was Congress’ intent—to incentivize debtors to favor Chapter 13 over Chapter 7.

Chapter 13 allows debtors to use disposable income earned after they file for bankruptcy to pay off their creditors over a period of time. Chapter 7, on the other hand, appoints an independent trustee who would liquidate debtors’ assets and pay creditor, subject to some exemptions.

Debtors can convert to Chapter 7 from Chapter 13 if they can’t make their payments, as long as they do so in good faith.

Although a boon to debtors, the Tenth Circuit’s decision has negative implications for creditors in Chapter 7 cases that started out in Chapter 13. Less assets in the bankruptcy estate will mean lower recoveries for creditors.

Proceeds vs. Appreciation

The substantial increase in home prices over the last two years makes the decision “exceedingly important,” said Bill Rochelle, editor-at-large at the American Bankruptcy Institute.

After a debtor converts from Chapter 13 to Chapter 7, the bankruptcy estate that creditors can access generally includes the same property that would have been included in the estate had the debtor filed for Chapter 7 in the first place, provided the debtor still owns the property.

The Tenth Circuit ruling specifically addresses home sale proceeds. But it also provides a blueprint for how to treat a home’s appreciation in value during bankruptcy proceedings, a more common scenario.

Bankruptcy courts are split on how to treat appreciation in the value of existing property when its owner converts the bankruptcy case to Chapter 7, said bankruptcy attorney Stanley A. Zlotoff.

Some courts say the law doesn’t treat appreciation as a separate asset, but rather a characteristic of an asset the debtor owned at the time of the bankruptcy. Therefore, any appreciation becomes part of a Chapter 7 bankruptcy estate that the trustee can access to pay creditors.

Others argue the legislative history clearly says that post-petition appreciation stays with the debtor and not the estate, Zlotoff said. The rationale was to incentivize debtors to initially opt for Chapter 13. That way, a debtor could pay creditors with money they’re earning, and creditors would receive at least as much as they would receive under a Chapter 7, if not more. If a debtor can’t keep up with the Chapter 13 plan payments and has to convert to Chapter 7 liquidation, the debtor wouldn’t be penalized for converting since the appreciation stays with the debtor.

The lower courts in the Rodriguez case ruled in favor of the couple after finding that their home’s appreciation didn’t go into their Chapter 7 bankruptcy estate.

But the Tenth Circuit affirmed on the separate ground that “proceeds” from the home’s sale are a different kind of asset than the home itself, Zlotoff said.

Other Implications

Because the Tenth Circuit ruled only on proceeds, the ruling leaves the appreciation question open for now. But the decision has other implications, Rochelle said.

For example, many states, including Colorado, have homestead exemptions that protect a certain amount of equity in a debtor’s home from creditors’ reach.

If a Chapter 13 debtor’s home value appreciates beyond the allowed exemption, Rodriguez would also generally discourage a trustee the bankruptcy case from trying to push for the home to be sold to pay creditors from that appreciation, Rochelle said.

“Bankruptcy is not punitive. It’s not supposed to have a ‘gotcha’ effect’ where three years later a decision pops up and bites you in the rear end with something you never contemplated at the time you filed bankruptcy,” said Rochelle, a former bankruptcy attorney.

The Tenth Circuit’s underlying interpretation of the law also gives a glimpse into how the court would deal with appreciation rather than sale proceeds, Rochelle said.

“I think the judges are being very careful in pointing out what the facts were in the case before them,” he said. “I mean, to me, it would be astonishing if the court were to rule differently in a case that did not involve proceeds.”

Some local bankruptcy rules prevent the Rodriguez decision from applying outside the Tenth Circuit’s jurisdiction.

For instance, the rules of the U.S. Bankruptcy Court for the Western District of Washington—which falls within the Ninth Circuit—contain Chapter 13 plan language that requires court approval before the sale or disposal of personal property above a certain dollar amount.

Bankruptcy attorney Eric M. Boeing said the Tenth Circuit’s ruling could influence jurisdictions that don’t yet have clear guidance.

In Oakland, Calif.—where Boeing practices—there are Chapter 7 trustees awaiting cases where they can test how courts will rule on the treatment of appreciation, he said.

“I don’t believe there is clear binding precedent on this issue in the Ninth Circuit, so this case might be helpful to the extent to which it is persuasive,” Boeing said.