I recently received an email that posed an interesting scenario in Chapter 7 bankruptcy liquidation.  Although I have written on the subject of Chapter 7 liquidation I haven’t addressed the specific fact pattern in detail.  This post fills that lacuna.

The question posed was a bit long, so I will summarize it.  The questioner asked whether a sufficiently large tax lien on a debtor’s principal residence would dissuade a Chapter 7 Trustee from seizing and liquidating the house.  My answer not only deals with the question posed, it also includes a discussion of the exemption implications as well.

The analysis depends primarily on 724(a), 726(a)(4), and 11 U.S.C. §§ 551.  Based on these Code sections, the tax lien has two potentially negative implications to the case.


I.  The Trustee Can Avoid The Tax Lien To Create Equity For The Estate


A.  The Taxing Authority Will Release The Lien


If there appears to be no realizable equity solely because of a tax lien, the Trustee is free to ask the taxing authority ― whether the IRS, or the FTB, or both ― to release the lien to create realizable equity for the bankruptcy estate.  A taxing authority is willing to release a lien in this context because upon liquidation of the asset, its priority tax claim will be paid ahead of the general unsecured debt ― meaning that the taxing authority will get money right away rather than having to wait for the debtor to sell or refinance the property.  In addition, after the Court grants the debtor a discharge, the taxing authority will still have a claim against the debtor for the unpaid, nondischargeable portion of the tax debt.  Thus, from the taxing authority’s perspective, there is no down side to releasing the lien.


B.  Illustration


Suppose, for example, the debtor’s house was worth $500,000, and the debtor had encumbrances of $150,000 (first mortgage), $100,000 (second mortgage), and $100,000 (tax lien).  Then the encumbrances total $350,000 (= $150,000 + $100,000 + $100,000), leaving equity of $150,000 (= $500,000 – $350,000).  Therefore, if the debtor is eligible for an exemption of up to $175,000, he might believe that the house is safe from the depredations of the Chapter 7 Trustee.  However, if the Trustee convinces the taxing authority to release the lien, then the total encumbrance is now only $250,000 (= $150,000 + $100,000), meaning that there is now equity of $250,000 (= $500,000 – $250,000).  With these numbers the Trustee will seize and sell the house.


C.  Statutory Reasoning


With the taxing authority’s cooperation, the Trustee can avoid the tax lien using 11 U.S.C. § 724(a) (“The trustee may avoid a lien that secures a claim of a kind specified in section 726 (a)(4) of this title.”) coupled with 11 U.S.C. § 726(a)(4) (which applies to “any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim.”), to create equity for the estate.  In sum, the presence of tax liens is not an impediment to the Trustee seizing and selling the home.


II.  Tax Liens Take Priority Over The Debtor’s Exemption


A.  The Avoided Tax Lien Belongs To The Bankruptcy Estate


11 U.S.C. § 551 provides (with emphasis added):  “Any transfer avoided under section . . . 724 (a) of this title . . . is preserved for the benefit of the estate . . .” Therefore, to the extent that equity is created by the tax lien avoidance, that equity is not exemptible.  In other words, if the equity prior to the avoidance of the tax lien is less than the exemption amount, the exemptible equity will not be increased to its maximum level by the tax lien avoidance.


B.  Illustration


Let us return to the example that we used to illustrate the concept of creating realizable equity by tax lien avoidance.

In that example, we supposed that the debtor’s house was worth $500,000, and that the debtor had encumbrances of $150,000 (first mortgage), $100,000 (second mortgage), and $100,000 (tax lien).  Therefore, the encumbrances totaled $350,000 (= $150,000 + $100,000 + $100,000), leaving equity of $150,000 (= $500,000 – $350,000) prior to any tax lien avoidance.

Because of § 551, if the Trustee increases the equity to $250,000 through tax lien avoidance, the additional $100,000 in equity belongs to the bankruptcy estate, to be used to pay creditors.  It does not belong to the debtor.  Therefore, even though there is now $250,000 in equity after the tax lien avoidance, the debtor can only exempt $150,000.  Thus, after the liquidation the debtor would receive a check for $150,000 rather than $175,000.

If you’re a debtor and need bankruptcy protection, contact an extremely knowledgeable and highly skilled bankruptcy attorney to guide you through the process.


Image courtesy of Flickr (Licensed) by David Goehring