Bankruptcy Exemptions Examined after Schwab v. Reilly

Bankruptcy Exemptions in the Wake of the Schwab Decision

A recent decision of the United States Court of Appeals for the Third Circuit addressed the issue of whether a debtor who claimed a homestead exemption could benefit from a mortgage avoided by a chapter 7 trustee.

In In re: Messina, 2012 U.S. App LEXIS 16289, *3 (3d Cir., Aug. 6, 2012), the debtors claimed the maximum allowable bankruptcy exemption in their residence despite that they had two mortgages, the combined amount of which exceeded the fair market value of the property. However, because the debtors’ first mortgage was not executed before a notary, the debtors listed it as an unsecured obligation. Id. The trustee did not timely object to the debtors’ claimed exemption. Id. at *4. The trustee avoided the defective first mortgage under section 544(a) of the Bankruptcy Code and relevant state law. Id. at *5. The trustee then sold the property pursuant section 363(f) of the Bankruptcy Code and moved to value the debtors’ exemption at $0, reasoning that the first mortgage remained enforceable upon the debtors on the petition date. Id. at *7. The debtors cross-moved for an order requiring the trustee to pay them the value of their claimed exemption from the proceeds of sale. Id.

On March 6, 2006, the United States Bankruptcy Court for the District of New Jersey entered an Order valuing the Messina debtors’ exemption at $0 and denying the debtors’ cross-motion. On appeal, the District Court reversed the Bankruptcy Court and found the trustee’s objection to the debtors’ exemption to be time barred. Messina v. Neuner (In re Messina), 2007 U.S. Dist. LEXIS 92609, *29-30 (D.N.J. Dec. 17, 2007) citing Taylor v. Freeland & Kronz, 503 U.S. 638 (1992). The United States Court of Appeals for the Third Circuit remanded the case to the District Court to consider the impact of the, then recent, decision of the United States Supreme Court in Schwab v. Reilly, ___ U.S. ___, 130 S. Ct. 2652 (2010) upon its ruling. On remand, the District Court determined that, under Schwab, Bankruptcy Rule 4003(b) did not preclude the trustee from objecting to the debtors’ exemption since an asset recovered as a result of an avoidance claim (i.e., the sale proceeds) is distinct from the property claimed as exempt (i.e., the debtors’ equity interest in their home). Messina v. Neuner (In re Messina), 2011 U.S. Dist. LEXIS 9637, *21-22 (D.N.J. Jan. 31, 2011). The Court of Appeals affirmed that decision. In re: Messina, 2012 U.S. App LEXIS 16289, *23 (3d Cir., Aug. 6, 2012) (“…avoidance of the [ ] mortgage was a separate asset… [the debtors] claimed an exemption in the residence, not in the proceeds from the sale of the residence.”).

The Messina case interprets the decision of the United States Supreme Court in Schwab to extend beyond limiting debtors to the actual dollar value of their claimed exemption. At least in the Third Circuit, debtors must distinguish between an exemption in an asset and an exemption in the proceeds from the sale of that asset in the event that a trustee avoids a lien on that property.

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