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The Federal Tax Lien and the Homestead Exemption

Posted on Dec. 13, 2018

The case of In re Selander, No. 16-43505 (Bankr. W.D. Wash. Oct. 19, 2018) pits the bankruptcy trustee against the IRS. The trustee attempts to use a provision in Chapter 7 to take from property secured by the federal tax lien in order to pay his fees and other administrative costs. The IRS argues that when its lien attaches to property claimed by the debtor as a homestead, the provision allowing the trustee to use an asset secured by the federal tax lien does not apply. The case allows for an explanation of B.C. 724(b), in which Congress allows the use of money that would otherwise come to the government because of its secured position to pay unsecured priority creditors, and the interplay between the federal tax lien and the homestead exemption. The bankruptcy court here gets the law right and does a good job of explaining it.

Mr. Selander filed a Chapter 7 petition on August 22, 2016. The Umpqua Bank filed a claim for over $5 million and the IRS filed one for over $700,000. The bank had liens against the debtor that predated the IRS’s federal tax lien. The debtor owned a ½ interest as a tenant in common of a home in the Seattle area. Other assets may have existed, but the house occupied the attention of the court.

The trustee of the bankruptcy estate found a buyer for the house for a gross sales price of $825,000. After paying off the mortgage, closing costs and the other owner, about $200,000 came to the bankruptcy estate. Washington is one of the states that allows debtors to choose between the federal bankruptcy exemptions in B.C. 522, or its own state-level exemptions, including a pretty generous homestead exemption of $125,000. The debtor elected to receive that amount as his homestead exemption.

The homestead exemption seeks to allow debtors something to get going after bankruptcy as part of their fresh start. While some states provide generous homestead exemptions and other states provide very little, the exemption in all states comes to the debtor subject to the federal tax lien. So, debtors owing federal taxes do not get the benefit of the homestead exemption that the state might intend since the state homestead law lacks the ability to pass property to the debtor in a way that overrides federal law. The operation of the federal tax lien vis-à-vis the homestead exemption has frustrated many debtors and provides one of many reasons to pay down federal tax debt prior to bankruptcy rather than to pay ordinary creditors.

The trustee ordinarily cannot use the homestead amount to pay his fees or to pay the claims of creditors of the estate. B.C. 522 carves the homestead amount out of the estate and gives it to the debtor as property exempt from the estate.

B.C. 724(b) allows the trustee to take an amount that would ordinarily go to the IRS because of the federal tax lien and use that amount to pay unsecured creditors of the bankruptcy estate entitled to priority status. The trustee is one of the creditors entitled to priority status. In the B.C. 724 analysis of Mr. Selander’s bankruptcy estate, nothing would go to the IRS because of the higher priority lien of Umpqua. That higher priority lien and the value of the assets in the estate prevents the IRS from having a secured claim against the estate. Without a secured claim held by the IRS, the trustee could not use B.C. 724(b) to carve out money to pay priority claimants.

Even though the IRS could not take from the estate, it stood to receive the homestead amount. The trustee argued that the payment of the homestead amount should allow the B.C. 724(b) carve out to occur even though the basis for the payment occurred from money not a part of the bankruptcy estate.

The court rejects the trustee’s argument, citing to relevant case law and finding:

There is no conflict between § 724(b) and § 522(k) because those two sections speak to different kinds of property. Section 724(b) involves property of the estate where the IRS holds a valid lien. In this scenario, Congress has made the decision that the bankruptcy trustee may subordinate the secured tax claim to pay administrative expenses. What § 724(b) does not address is the property a debtor removes from the estate by exemption, but still subject to a continuing lien of the IRS. This property is not covered by the plain language of § 724(b), which provides that it only applies to property ‘in which the estate has an interest….’ Exemptions remove property, or a certain value of that property, from the estate. Alsberg v. Robertson (In re Alsberg), 68 F.3d 312, 315 (9th Cir. 1995). Debtor’s Homestead Exemption removed the value of $125,000 from the estate but such exemption was powerless to eliminate the interest of the IRS in those funds claimed with the exemption.

The court noted that in the absence of the federal tax lien, the trustee’s attempt here would be a naked effort to take exempt funds to pay his fees, and that B.C. 522(k) prohibits that action. The bankruptcy court found that by claiming the homestead exemption, the debtor removed the property from both the estate and the application of B.C. 724(b).   It further found that the IRS need not bring a separate action to seize the money in the debtor’s bank account, but that the trustee should remit the $125,000 to the IRS. This victory by the IRS may benefit the debtor if the taxes were excepted from discharge. If the taxes would have been discharged by the bankruptcy, the debtor loses as well as the trustee since the debtor’s homestead exemption turns out to provide him with no benefit. Prior to filing bankruptcy, debtors should check the impact of a federal tax lien if they hope that bankruptcy will allow them to take certain assets with them. Mr. Selander’s case leaves him with a bankruptcy discharge but no major asset to take with him as he leaves bankruptcy.

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