Interviewer: When I hear or read about bankruptcy, I often come across the term “exemption.” Can you tell me the purpose of exemptions in bankruptcy and why they should be important to me if I am filing for bankruptcy?
John’s Answer: First of all, let me say that in most bankruptcy cases whether Chapter 7 or Chapter 13, my clients tend to keep all their assets. Determination needs to be made at the time of the filing of the petition as to which exemptions to claim, whether federal or state and those exemptions are then identified on Schedule C to the bankruptcy petition.
Now let me address your question specifically. Exemptions have a very important function in both Chapter 7 and Chapter 13 cases. When filing for bankruptcy, the property you own becomes, at least for some time, “property of the estate”. A Trustee is appointed to review the property noted on your petition in order to determine its significance as far as what creditors can expect to receive from the bankruptcy case. Each particular item of property is identified on schedules A and B, to the petition.
The Trustee also looks to see if any of the this property has one or more liens, The liens against the property are identified on Schedule D to the petition. What the Trustee is looking for in reviewing these schedules is whether or not there is equity in any item of property that isn’t considered protected equity. This type of equity is called “non-exempt” equity. Of course, the person filing for bankruptcy would want there to be as little non-exempt equity as possible. If, for example, the non-exempt equity turns out to be $7,000.00, then that means that a Chapter 7 Trustee would want to see you make an offer of about the same amount, i.e. $7,000.00 to pay generally in equal installments over a one year period if you wish to avoid a Trustee auction of that property. Any funds received by the Trustee would be used to pay your unsecured creditors on a “pro rata” basis. In a Chapter 13 case, the Trustee would not auction the items but you would need to pay at least this $7,000.00 to unsecured creditor under the Chapter 13 plan you are seeking to have confirmed by the Court. The rest of the equity in property and property would be protected and not at issue. Not all bankruptcy cases involve an issue with “non-exempt” equity.
Interviewer: How do the exemptions work in practice. Can you give us some examples?
John’s Answer: Yes, of course.
Example 1: There is a house worth $100,000. with a mortgage of $120,000. In this example there is no “non-exempt” equity for a Trustee at all, even without looking at exemptions. That is because there is no equity at all on the property as the lien takes up the entire house value.
Example 2: Let’s say the house is worth $100,000 with a mortgage lien of $60,000. In this case the house has about $40,000 of equity (not counting any expected cost of sale). This situation would be a problem for you, were it not for exemptions. Now, state or federal exemptions will allow you to assert some or all of this equity as protected, depending upon which law you choose to assert the protection. Given that there is about $40,000 of equity in this property, the state exemption rule which allows exemption of a house up to $75,000 per owner (who is in bankruptcy) would make sense if this property is owned only by one person. If it is owned by two people, then the federal exemption in the amount of $26,500 per person would be equally sufficient to protect all of the equity in this property.
If this were the only item of property you own, then it would be better to assert the federal exemption, rather than the state exemption to protect this house. Of course, in real life, most people have more than one item of property so, therefore, the attorney needs to look at all of their items of property that exist to determine which exemptions (state or federal) provide the more favorable protection for the client.
It is possible that either state or federal exemptions will provide full protection for any equity that’s non-exempt. However, in many cases there is a clear choice to be made as to whether federal or state exemptions will better maximize the debtor’s exemptions such that the non-exempt equity is minimized to the greatest extent possible.
Interview: Can you tell us about two or three of the most important exemptions that you’ve come across in your practice?
John’s Answer: Yes. Perhaps the most important is the homestead exemption which covers a house, condo, co-op, or mobile home. Under federal rules the exemption amount is $26,500 per debtor and under state rules it’s $75,000 per debtor that can be protected from a Trustee.
A second very important exemption is the vehicle exemption. Under federal rules, $3,450. can be protected and under state rules $4,000. can be protected.
The third most important I would say is the federal wild card exemption which allows a client to protect $1,150. plus an additional $10,825. of the unused federal homestead exemption up to $11,000 on any piece of property that they have.
Sometimes we see a combining of the vehicle and wildcard federal exemptions. For example, let’s say you have a vehicle worth $10,000 and asserts a federal exemption of $3,450, the maximum that the federal law will allow for one person. Well, if you asserted no house protection, then you have up to $11,975. to additionally place on whatever assets property you like, including on the vehicle. This would mean that you could protect all of the equity in your vehicle by asserting the federal vehicle exemption of $3,450 and, in addition, a wildcard exemption of $6,550. to have the combined exemption reach the full value of your vehicle. So, therefore, the entire $10,000. of value in the vehicle is protected.
Interviewer: I understand about the non-exempt equity in the Chapter 7 cases and I can see the fairness argument as to why creditors should be able to get at some of my property. But what if I want to keep the property, is there a way to do so? If not, what will happen to the property?
John’s Answer: Where there is non-exempt equity, the Chapter 7 Trustee will need to make a determination as to whether or not the property is worth selling. For example, if one or more items combined have exempt equity, in the amount is $2,000 or less, many Trustees would exercise their discretion to simply do nothing further with the property and close the case as a “no-asset” case. The reason they would do this is because the little amount of money that would be received from an auction of the property does not justify selling the property, as the distribution to general creditors would be very small or insignificant, after subtracting out what would be the Trustee’s fees the cost of obtaining an auctioneer to sell the property.
In the event that the Trustee makes a determination that there is non-exempt value that is significant enough to warrant a sale, then you can request the Trustee to accept an offer to buy back from the Trustee the particular property.
This situation would be called to the attention of the client well before the filing of the petition. For example, if a vehicle had $10,000 of value and there was a $2,000 lien against the vehicle, and the client asserted a $3,450. federal exemption on the vehicle (and assuming no wild card was available because he needed the full homestead exemption) then in that case an offer to purchase the Trustee’s interest in the vehicle of about $4,550. (or less to account for a cost of sale factor that the Trustee would incur in an actual sale setting) would be made to the Trustee with the proposed monthly repayment lasting about one year or less.
In the event the amount of non-exempt equity is much higher than the client can afford to pay in about the one year that a Trustee might typically give, then the client has a choice to either allow the Trustee to sell the property or convert the case to Chapter 13. In the event of such a sale, the client would receive the exempt amount upon the sale of the property with the remainder going to the Trustee, which the Trustee will then use to pay his own fee as Trustee and the auctioneer’s fee with the balance of the funds going to the general unsecured creditors.
An alternative option would be to avoid any sale whatsoever and convert the case to Chapter 13 and repay the required non-exempt amount of this asset over a period of 3-5 years to general unsecured creditors. In the context of a Chapter 13 case, the non-exempt equity is also looked at. However the Chapter 13 Trustee is not looking to sell the property, but rather is looking to simply account for the property that you do have that is non-exempt. In the event the client’s non-exempt amount is $15,000 then he’ll want to see at least $15,000 going to general unsecured creditors and priority creditors, such as credit cards or some IRS taxes. Of course one problem with the conversion to Chapter 7 is that there will be other rules in Chapter 13 that need to be met, such as the disposable income test (which is closely reviewed in Chapter 13 cases) and also Form 22. Also, the value used by the Chapter 13 Trustee may be the higher market price, rather than the lower private party price which is often used to value vehicles in the context of a Chapter 7 case. For all these reasons, the amount of funds spent in a Chapter 13 may be significantly higher than those spent by working out the matter in a Chapter 7 case. Advice from experienced bankruptcy counsel is needed here.