Bankruptcy: Exemptions and Exceptions
Updated: Jan 13
Property of the Estate and Exemptions
Bankruptcy allows a debtor to satisfy their debts to creditors for pennies on the dollar. These debts are satisfied, in part, by liquidating the debtor’s assets and then using those funds to pay off various creditors.
Exemptions and exceptions allow a debtor to protect certain property, or a certain amount of property, from being liquidated by creditors or the trustee during the bankruptcy process. To understand exemptions, a debtor must understand what property makes up their bankruptcy estate.
Property of the estate includes all legal and equitable title of the debtor (and their spouse in community property states such as California) as of the commencement of the case. (11 U.S. § 541(a)). For example, if the debtor files bankruptcy on January 1st, everything they legally own on that January 1st date is property of the estate. There are however various exceptions and exemptions that allow debtors to shield their assets or a portion of their assets.
Some exceptions include trusts over which the debtor is the trustee, funds placed in an education retirement account within a certain amount of time before the filing date, and certain withheld employment funds in accordance with the IRS. (11 U.S. § 541(b))
Exemptions, like exceptions, allow the debtor to shield a certain amount of their assets from creditors. Exemptions, however, are only available to individual debtors who file for bankruptcy under either Chapter 7, 11, or 13.
Common exemptions include retirement funds such as qualified plans, annuities, IRAs (which have a cap amount), ROTH IRAs, Hybrid plans, deferred compensation or deferred benefit plans, and employee contribution plans. Another common exemption is the homestead exemption which allows debtors to exempt the land and the building which make up the family residence.
Claiming an Exemption
To claim an exemption, it must be affirmatively pled by the debtor when they file a schedule of exempt assets together with a schedule of assets and liabilities. After the exemption is pled, creditors have the power to object to exemptions within the later of 30 days after the meeting of creditors or 30 days after an amendment to the debtor’s schedule is filed. If no creditor or trustee objects, then the exemption stands even if there are no grounds for the exemption.
When a debtor files for bankruptcy, they have an option of either state or federal exemptions. If the debtor is a pair of spouses, the spouses must choose the same exemption schedule. Federal exemptions are uniform across the nation whereas state exemptions vary.
To determine which state’s exemption applies, the court looks to where the debtor was domiciled for the two years before filing for bankruptcy. That means if a debtor lived their entire life in California, then moved to Nevada on December 25thand filed for bankruptcy on January 1st, their state exemption would be California, not their new domicile of Nevada even though they were living in Nevada when they filed for bankruptcy. In rare cases where the debtor has no one domicile during that preceding two-year period, the court will determine which state exemption is available based on where the debtor was domiciled for the six months before that two-year period.
Effect of Exemptions
Exemptions allow the debtor to shield a certain amount from creditors. The amount that can be shielded is in direct proportion to the amount of equity in the property. Equity exists when the property has value in excess of the encumbrances on it. For example, if the debtor owns a million-dollar home with a lien against it in the amount of $900,000, the debtor can only shield $100,000 from creditors during the bankruptcy process. Thankfully for debtors, bankruptcy allows debtors to avoid certain liens that impair the exemption, thereby increasing the equity in their property and in turn, the amount the debtor can claim as exempt and shield from creditors.
An exemption shields an asset’s monetary value from creditors during the bankruptcy process. This shield continues post-petition except in the following circumstances: to pay for domestic support obligations, exempt property that was secured by a debt that was not avoided or a tax lien that was perfected, certain debts to failed financial institutions, and debts stemming from fraudulent acts in obtaining scholarships, grants, or loans for education.
For purposes of the homestead exemption, some states have a maximum amount that can be exempted whereas others do not. California recently increased the amount debtors can shield under the homestead exemption as of January 1, 2021. Under Assembly Bill 1885, the homestead exemption can be the greater of the following:
The countywide median sale price for a single-family home in the calendar year prior to the calendar year in which the judgment debtor claims the exemption, not to exceed six hundred thousand dollars ($600,000).
Three hundred thousand dollars ($300,000).
The amounts specified in the Bill shall adjust annually for inflation, beginning on January 1, 2022, based on the change in the annual California Consumer Price Index for All Urban Consumers for the prior fiscal year, published by the Department of Industrial Relations.
Even though California increased the homestead exemption, there remain other states with no cap on the homestead exemption at all. This naturally entices debtors to “forum shop” by buying property in a state without a cap. In an effort to discourage such forum shopping, the federal bankruptcy courts have created two requirements for a debtor to claim a homestead exemption in a certain state: (1) the debtor must live in the house for two years before filing for bankruptcy in order to qualify under the exemption at all, and (2) the debtor must live in the house for at least 40 months in order to claim a homestead exemption in excess of a certain amount as determined by statute.
Another limitation on exemptions is that, under the 2005 Bankruptcy Act, amounts asserted as exempt over $160,375 are not exempt if either the debtor has been convicted of a felony under circumstances that the filing was an abuse of the bankruptcy code, or if the debtor owes a debt arising from violations of security laws or fraud while acting in a fiduciary capacity or in connection with securities transactions.
Exemption planning is when a debtor converts non-exempt assets to exempt assets before filing for bankruptcy. While exemption planning is allowed, the court maintains the power to invalidate such conversions. For example, a court can look back as far as ten years and invalidate any action that was done to defraud or delay creditors. Exemption planning by the debtor will be sustained so long as there was no fraudulent intent.
Any conveyances made with actual intent to defraud, delay, or hinder either present or future creditors will be nullified with the effect of returning conveyed property back to the estate. If you are thinking of filing for bankruptcy, contact our legal offices to discuss how you can maximize your exemptions and whether federal or state exemptions are right for you.