Avoidance of Transfers of Entireties Property - No Harm No Foul
The doctrine of tenants by the entireties contemplates the ownership of property by the marital union itself ("one flesh") and not by the separate spouses as co-tenants. As a result, the Bankruptcy Code preserves the debtor's right, when only one spouse files a bankruptcy proceeding, to exempt the entireties interest to the extent allowed by state law.
(b) Notwithstanding §541 of this title, an individual debtor may exempt from property of the estate either—
(2)(B) any interest in property on which the debtor had, immediately before the commencement of the case, an interest as a tenant by the entirety or joint tenant to the extent that such interest as a tenant by the entirety or joint tenant is exempt from process under applicable nonbankruptcy law.
11 U.S.C. §522(b)(2)(B).
The attributes of a tenancy by the entireties include the following: (a) each spouse's present right to use and enjoy the property, which right is not generally transferable by one spouse nor is it attachable by creditors of one spouse and (b) an "expectancy interest," or right of survivorship upon one spouse's death, which right is generally transferable and attachable.1
Under the old Bankruptcy Act of 1898, property that was exempt under state law, such as entireties property, was not part of the assets of the bankruptcy estate.2 However, it is well-settled under the broader definition of "property of the estate" in §541 of the Code that property held as tenants by the entireties is part of the bankruptcy estate, subject to exemption under §522(b)(2)(B) to the extent allowed by state law.3
What happens when the debtor, prior to the bankruptcy proceeding and out of fear of losing the property, transfers his or her expectancy interest to the non-filing spouse or joins with the nonfiling spouse to transfer the property to a third party for little or no consideration? Can the trustee avoid the transfer and thereby become a co-owner of the property with the nonfiling spouse with the power to sell the property and divide the proceeds pursuant to §363(h)? Alternatively, does the ownership of the property revert to its tenancy-by-entireties status and hence becomes exempt, except to the extent of sale of the expectancy interest with limited value to the estate?4
Some courts have held that pre-petition transfers of otherwise exempt property, including the debtor's expectancy interest, are not subject to avoidance under either §547(b) or 548.5 These cases adopt the so-called "no harm, no foul" view, which reasons that since transfers of exempt property do not harm creditors, then such transfers are not subject to avoidance.6
The "no harm, no foul" viewpoint fails to consider the effect of §§550(a)(1), 551 and 522(g)(1) on the nature of the property recovered by the trustee. Under §550(a)(1), the property transferred is recovered "for the benefit of the estate" if the transfer is avoided under §§544, 547, 548 or 549.
Section 551 preserves "for the benefit of the estate" any avoided transfer. As a result, the property avoided becomes property of the estate, and the transfer itself is preserved as against any junior creditors.7
Once the voluntary transfer is avoided and the property becomes property of the estate pursuant to §§550(a)(1) and 551, the debtor is barred by the specific provisions of §522(g)(1)(A) from exempting the entireties property under §522(b)(2)(B):
Notwithstanding §§550 and 551 of this title, the debtor may exempt under subsection (b) of this section property that the trustee recovers under §510(c)(2), 542, 543, 550, 551 or 553 of this title to the extent that the debtor could have exempted such property under subsection (b) of this section if such property had not been transferred, if—
(1)(A) such transfer was not a voluntary transfer of such property by the debtor....
In In re Bryant, 221 B.R. 262, 264 (Bankr. D. Col. 1998), the debtor transferred his interest in the homestead to his wife and then filed for bankruptcy 60 days later. Equity in the property totalled approximately $30,000, which could have been claimed as exempt by the debtor under Colorado law. The court noted that "11 U.S.C. §548 makes no exception for the transfer of Ôexempt' property vs. nonexempt property." The court further rejected any exemption claim by the debtor if the transaction is unraveled because the transfer was voluntary and §522(g)(1)(A) prohibits such exemption.
In the case of In re Goldman, 111 B.R. 230 (Bankr. E.D. Mo. 1990), the debtor and his nonfiling spouse, earlier on the same day that he filed chapter 7, transferred to his son a piece of real property that he and his wife owned as tenants by the entireties. After the transfer was avoided under §548, the debtor attempted to claim the property as exempt under §522(b)(2)(B). The court ruled that the property would not revert back to its original tenants-by-the-entireties status. Further, the tenancy by the entireties ceased to exist when the debtor and his nonfiling spouse transferred the property. Therefore, there was no such ownership to which the court could return the property. After its recovery, the property was treated as though the husband and wife owned it as co-tenants such that the trustee could sell the property under §363(h) and retain one-half of the net proceeds.
In an interesting twist, the court in In re Altmeyer, 268 B.R. 349 (Bankr. W.D.N.Y. 1999), not only avoided the debtor's quitclaim deed to the nonfiling spouse, but also avoided the subsequent mortgage placed on the property by the nonfiling spouse, effectively charging the mortgage company with negligence for failing to ascertain the debtor's solvency before the transfer. The court ruled that the lien was taken with full knowledge of the deed's voidability due to the nominal consideration recited in the deed. The mortgage company could not avail itself of the safe-harbor provisions of §550(b)(1) due to its lack of good faith. The court authorized the trustee to sell the property and accorded one-half of the proceeds to the bankruptcy estate, unburdened by the lien. The nonfiling spouse was entitled to the remaining half of the sale proceeds subject to the entire mortgage.
The "no harm, no foul" rule, which insulates transfers from avoidance under §548 or acts as a bar under §727(a)(2) to denial of discharge, is a judge-made rule that has been soundly criticized.8 The avoidance of a transfer of a debtor's entireties interest does not result in the property reverting to being held in its original tenancy by the entireties. Rather, the property is then held jointly by the trustee and the nonfiling spouse, and §522(g)(1) prohibits the debtor from claiming as exempt an avoided voluntary transfer of entireties property.9 Instead, recovered assets should be treated as a co-tenancy and liquidated, with half the value going to the bankruptcy estate and the other half going to the nondebtor spouse.
While the "no harm, no foul" rule, which prohibits avoidance of transfers of exempt property, is tempting, such exception to avoidance is not contained in §548 as noted above and has been extremely criticized. Property held as tenants by the entireties with a nonfiling spouse that was fraudulently transferred, whether to the nonfiling spouse or in conjunction with the nonfiling spouse to a third party, is barred by §522(g)(1) from exemption once the transfer is avoided. The trustee is entitled to sell recovered property pursuant to §363(h) and divide the net proceeds with the nonfiling spouse.
1 United States v. Craft, 535 US 274, 122 S.Ct. 1414, 152 L.Ed.2d 437 (2002); In re Arango, 992 F.2d 611, 613-14 (6th Cir. 1993); In re Bunker, 312 F.3d 145, 151 (4th Cir. 2002).
2 Lockwood v. Exchange Bank, 190 U.S. 294, 298-99, 23 S.Ct. 751, 47 L.Ed. 1061 (1903).
3 Chippenham Hospital v. Bondurant, 716 F.2d 1057 (4th Cir. 1983); Napotnik v. Equibank and Parkvale Savings Assn., 679 F. 2d 316 (3rd Cir. 1982); In re Grosslight, 757 F.2d 773 (6th Cir 1985).
4 The sale of the expectancy or survivorship interest by the trustee is in question. Compare In re Papelow, 972 F.2d 730 (7th Cir. 1992); In re Arango, 992 F.2d 611 (6th Cir. 1993); In re Ryan, 282 B.R. 242 (D. R.I. 2002); In re Dawson, 14 B.R. 822 (E.D. Tenn. 1981); In re Musolino, 391 F.3d 1295 (4th Cir. 2004); and In re Thomas, 14 B.R. 423 (Bankr. N.D. Ohio 1981);
5 See In re Treiber, 92 BR 930 (Bankr. N.D. Okla. 1988) (rejecting the trustee's action to avoid a preferential transfer to the nonfiling spouse of entireties property in satisfaction of a debt owed), and In re Turner, 45 B.R. 649 (Bankr. S.D. Ohio 1985) ("it serves no purpose for the trustee to seek the avoidance of a transfer which removed no nonexempt property from the estate").
6 This reasoning has also been applied in overruling objections to discharge under §727(a)(2) for pre-petition transfers of the entirety interest to the nonfiling spouse. See In re Jones, 97 BR 36 (Bankr. D. Mont. 1989); In re Peeples, 105 B.R. 90 (Bankr. M.D. Fla. 1989); In re MacDonald, 50 B.R. 255 (Bankr. D. Mass. 1985); In the Matter of Agnew, 818 F.2d 1284 (7th Cir. 1987) ("a transfer may be found to be a fraudulent conveyance only if it reduces the assets that are actually available to a creditor"), and In re Fornabaio, 187 BR 780 (Bankr. S.D. Fla. 1995) ("the transfers of exempt property cannot adversely affect any creditor").
7 United States v. Whiting Pools, 462 U.S. 198, 103 S.Ct. 2309, 76 L.Ed.2d 515 (1983), and In re Van de Kamp's Dutch Bakeries, 908 F.2d 517 (9th Cir. 1990).
8 In re Bernard, 96 F.3d 1279, 1282 (9th Cir. 1996) ("depletion of assets is not a prerequisite to denial of discharge" and the "definition of Ôtransfer' is extremely broad"); In re Wickerstrom, 113 B.R. 339, 349 (Bankr. W.D. Mich. 1990) (the policy of pro rata distribution "would become seriously deficient" if transfers of entireties property were shielded from recovery); In re Barbera, 1996 Bank. LEXIS 965 at 24 (Bankr. E.D. Mich. 1996) ("the 'no harm, no foul' defense does, in fact, appear to conflict with §522(g)"), aff'd., 1998 U.S. App. LEXIS 13171 at 5 (6th Cir. 1998) ("because the debtor secretly transferred ordinarily exempt tenancy-by-entirety property, its exempt status was destroyed"); In re Smoot, 265 B.R. 128, 136 (Bankr. E.D. Va. 1999) ("the 'no harm, no foul' approach seemed more appropriate under the older Bankruptcy Act, in which exempt property was not part of the bankruptcy estate"); In re Sanders, 213 B.R. 324, 332 (Bankr. M.D. Tenn. 1997) (citing Wickerstrom, which held that "despite the wife's interest in the funds before they were transferred...the funds transferred were 'of an interest of the debtor in property'"), and In re Sandoval, 1998 U.S. App. LEXIS 18559 (4th Cir. 1998) ("the clear weight of authority in the circuits provides that lack of value is not a valid defense").
9 In re Yasipour, 238 B.R. 289, 292 (Bankr. M.D. Pa. 1999); In re Hope, 231 B.R. 403, 412-13 (Bankr. D.C. 1999); In re Carpenter, 56 B.R. 704, 706 (Bankr. D. R.I. 1986); In re Duncan, 329 F.3d 1195 (10th Cir. 2003) (denying claim of exemptions where debtor transferred to the debtor and his wife property held solely by himself); In the Matter of Rotunda, 55 B.R. 386 (W.D. Pa. 1985); and In re Snyder, 66 B.R. 886 (Bankr. D. Mass. 1986).