Almost invariably, a consumer debtor will ask "what do I get to keep?" or "what do I lose?" Unlike dischargeability questions, which arise in relatively few consumer cases, the question of what property the debtor will retain arises in all cases. In perhaps a majority of consumer cases, the answer to the question is more likely than not that the debtor keeps everything—the classic "no-asset" case. One of the three most important functions that counsel for the individual debtor performs is the proper identification and selection of exemptions. (The other two, in my opinion, are selection of the appropriate chapter and completion of the schedules.) Debtor's counsel is responsible for advising the debtor in a manner that maximizes the property retained. On the other side of the coin, it is the obligation of trustees and trustees' counsel to ensure that the debtor does not retain property that the debtor is not entitled to retain.

Property, or perhaps more accurately, interests in property, may be either excluded from the estate under §541 of the Bankruptcy Code or be exempt under §522. In some instances, a particular asset may be both excluded from the estate and exempt under the exemption law applicable—e.g., qualified pension plans. There is, however, a fundamental difference: Property that is excluded from the estate never becomes property of the estate, whereas exempt property is part of the estate but is not subject to liquidation by the trustee for eventual use to satisfy the claims of creditors. In addition, property that is excluded from the estate is universal and beyond the reach of the trustee irrespective of whether or not it is exempt under the applicable exemption statutes. Finally, most exemption statutes have value limitations restricting the amount that may be claimed as exempt; property that is excluded is unlimited in amount. This can be a very important factor in non-opt-out states in choosing between federal and state exemptions.

Excluded Property

Section 541 specifically excludes certain property from the estate. From the consumer debtor's standpoint, the exemptions most likely to apply are those future earnings derived from personal services—i.e., future wages—under §541(a)(6) and the beneficial interest in spendthrift trusts under §541(c)(2). With respect to §541(a)(6), it is important to keep in mind that the earnings that are exempt are those resulting from services performed post-petition; earnings that have accrued (i.e., earned but unpaid) at the time the petition was filed are not excluded. Thus, if a debtor files at the midpoint of a pay period, half the earnings would be excluded but the other half would be included in the bankruptcy estate and subject to being turned over to the trustee unless otherwise exempt under the applicable exemption law.

The "spendthrift" trust exclusion of §541(c)(2) includes pension and profit-sharing plans containing anti-alienation provisions. These include ERISA-qualified plans (26 U.S.C. §401, et seq.); Civil Service Retirement (5 U.S.C. §8346(a)); Federal Employees Retirement System (FERS) (5 U.S.C. §8470(a)); Federal Thrift Plans (5 U.S.C. §8437(e)(2)); Military Survivor Annuities (10 U.S.C. §1450); and qualified pension plans of states or political subdivisions of the states (e.g., borough, municipality, county or city) (26 U.S.C. §457). Individual Retirement Accounts (IRAs) and Simplified Employee Plans (SEPs) established in accordance with 26 U.S.C. §408, and Roth IRAs established under 26 U.S.C. §408A, are not "spendthrift" trusts within the scope of §541(c)(2). However, some state and local retirement plans that do not fall within the scope of 26 U.S.C. §457 may be excluded depending on the provisions of the statutes establishing the plan and the plan instruments. In the absence of a controlling judicial decision, both the enabling statute and the plan documents should be reviewed to make this determination.

Although not too common, there are other provisions outside the Bankruptcy Code that create exclusions from the bankruptcy estate. For example, if the debtor is an Native American, he or she may have an interest in property that is specifically excluded from the bankruptcy estate. Examples of this include the exclusion of interests in Alaska Native Corporations [43 U.S.C. §§1606, 1607], restricted allotments under chapter 9, title 25, U.S. Code [25 U.S.C. §§334, et seq.], and money from the sale of land held in trust for an Native American [42 U.S.C. §410]. There are several other trust provisions contained in title 25, e.g., §543, and if the debtor is an Native American, the nature of the entitlement, in particular its status as part of a trust or under other restrictions, should be carefully examined and researched.

Although excluded from the estate, excluded property must nonetheless be included in the schedules of assets. There is no need for the debtor to claim an exemption for excluded property, but it is good practice to note the claim of exclusion as a note in the description of the property in Schedule A or B of Official Form 6.

Exemptions

Debtors face two potential situations. If domiciled in an "opt-out" state, there is no choice; the debtor must use state exemptions. In other states, the debtor has a choice between two exemption laws, the federal exemptions under §522(d) or the law of the domiciliary state. In those states, it is generally necessary to examine the debtor's assets and compare the outcome using both the federal and applicable state exemptions. The debtor may use the exemption laws that are the most beneficial to the debtor. One must note, however, that in the case of a husband and wife whose estates are jointly administered they may not "split" the exemptions: both must claim either state or federal exemptions. However, if federal exemptions are available and elected, the exemption amounts apply to each debtor so that a husband and wife have the advantage of two exemption amounts. Most states also permit each debtor to utilize a full exemption with some exceptions applicable to particular exemptions. In opt-out states (there being no choice), the process, while easier, may not result in a better outcome for the debtor.

There are certain basic principles governing the application of exemptions in bankruptcy that must be kept in mind:

• Exemptions can only be applied to the equity in the exempt property. They do not protect against liens—i.e., only where the property has equity (value in excess of encumbrances) is an exemption of any benefit in bankruptcy.
• Exemptions may be applied only to the interest of the debtor in the property. If property is jointly owned with a non-spouse or a non-filing spouse, only that interest that the debtor has is exempt. The interest of the non-spouse or non-filing spouse is not part of the debtor's estate.
• Eligibility to claim and the amount of an exemption is determined as of the date the bankruptcy petition is filed. For example, a person may not claim a federal homestead exemption in a dwelling unless the debtor resided in that dwelling on the date the petition was filed.
• Most exemptions have value limitations, and only the value of the property to the extent it does not exceed the value limitation is exempt. Consequently, the trustee may sell "exempt property" and retain the proceeds in excess of the exempt amount for the benefit of the estate.
• Under §522(k), if the property subject to the exemption is sold by the trustee, the debtor's exempt interest is not liable for the payment of administrative expenses except for the expenses incurred in avoiding transfers of the property or interests in the property, e.g., avoidance on nonconsensual preferential transfer that the debtor claims as exempt under §522(g).

Another point to remember is that although property may be exempt, that does not mean that the property is protected from all creditors. One major exception applicable to consumer cases involves spousal or child support obligations. Section 522(c) excludes support obligations from the prohibition against satisfaction of pre-petition obligations from property claimed as exempt under §522. In addition, several exemption statutes also exclude family support obligations from their operation.

Space limitations preclude a discussion of the process in those states that have not opted out. For a complete discussion of state and federal exemption laws, one should refer to Thomson West's Bankruptcy Exemption Manual, which is updated annually. Instead, this column focuses on the §522(b)(2)(A) provision: "any property that is exempt under federal law, other than subsection (d) of this section." That provision is important to practitioners in both states that have elected to opt out and those states that have not. In the opt-out states, it provides exemptions in addition to those allowed under state law. In other states, recognition of the availability of those exemptions under state law may be important in assessing which exemption law, state or federal, is the most advantageous for the debtor. Only too frequently, practitioners overlook the additional exemptions that may be available under non-bankruptcy federal law when state exemptions are elected or mandated.

The legislative history of the 1978 Bankruptcy Code lists some of the federal exemptions, other than those contained in §522, that are available. In addition, changes to federal law since 1978 have added exemptions not included in the listing contained in the legislative history. The following list includes some of the items exempt under non-bankruptcy federal law in addition to those permitted under state law. Some of these are also exempt under §522(d) and choosing federal exemptions will not result in their loss. This should be kept in mind when determining which exemption law, state or federal, is the most advantageous to the debtor.

• Foreign Service Retirement and Disability payments (22 U.S.C. §4060).
• Social Security benefits (42 U.S.C. §407).
• Compensation paid for war injuries (42 U.S.C. §1717).
• Wages of fishermen, seamen and apprentices (46 U.S.C. §601) (unlike the future wages excluded by §341(a)(6), this exemption may be applied to accrued but unpaid wages).
• Civil service retirement benefits (5 U.S.C. §8346) (in a district that does treat these as excluded, they may be claimed as exempt).
• Longshoreman's and Harbor Worker's Compensation Act death and disability payments (33 U.S.C. §916).
• Railroad Retirement Act annuities and benefits (45 U.S.C. §228(L)).
• Medal of Honor pensions (38 U.S.C. §1562(c)).
• Federal homestead lands on debts contracted before issuance of the patent (43 U.S.C. §175).
• Disability and death benefits paid to federal employees (5 U.S.C. §8130).
• Veterans' benefits (38 U.S.C. §5301(a)).
• Servicemen's and veterans' life insurance benefits (38 U.S.C. §1970(g)).
• Benefits paid surviving spouses of lighthouse service personnel (33 U.S.C. §775).
• Military retirement pay (10 U.S.C. §1440).
• Judicial survivor's annuity (28 U.S.C. §376(n)).
• Service members' deposits in savings institutions while serving outside the United States (10 U.S.C. §1035(d)).

The Exemption Process

Section 522(l) requires the debtor to file a list of the property that is claimed as exempt. This is accomplished by completing Schedule C of Official Form 6. The trustee and creditors have 30 days after the meeting of creditors is concluded within which to object to the exemptions claimed, unless the court for cause extends the time upon motion made before the 30-day period expires (F.R.Bank.P. 4003(b)). If no objection to the claimed exemptions is filed within the 30-day period, exemptions are allowed as claimed. One exception to the 30-day rule that has been recognized is that an objection to the value of the property claimed as exempt may be filed at any time. Another recognized exception is that a creditor in defending against a lien avoidance action (discussed further below) may raise the validity of the claimed exemption.

It should also be noted that in most districts, even property that is claimed as exempt remains property of the estate until such time as it is abandoned by the trustee. Also, most circuit courts that have ruled on the issue have ruled that appreciation in the value of property claimed as exempt inures to the benefit of the estate to the extent that the increase in value exceeds the exemption amount. This has even been held to apply when the increase is an increase in the equity as a result of payments made on the underlying indebtedness secured by the property or improvements to the property paid for by the debtor. Debtors too frequently believe that because they have claimed the property as exempt they may utilize it or dispose of it as they see fit. Unpleasant consequences can result if the debtor disposes of the property before the case is closed and the property abandoned under §554(c). Counsel for debtors should make debtors aware of the status of exempt property and the limitations on its use or disposition.

Although there is authority that abandonment of property, simply because it is exempt, is impermissible under §554(b), in those cases where the case is expected to remain open for an appreciable period of time, it may be in the best interests of the debtor to move for an order compelling the trustee to abandon exempt property. This is particularly true where the homestead exemption is involved. Frequently, debtors are forced to alter lifestyles and reduce expenses post-petition—i.e., the debtor simply cannot afford to continue to make the house payments. In those cases, the debtor will want to sell. As long as the property remains property of the estate, only the trustee is empowered to sell it after notice and a hearing. If there is no excess equity that will enure to the benefit of the estate, the trustee, quite understandably, will not be particularly interested in getting involved in the sale. On the other hand, in those cases where the equity is borderline between being totally exempt and excess equity, the trustee and the courts should be wary of abandonment. In those cases, it may be beneficial for the trustee and the debtor to agree that the debtor proceed with the sale with a specific provision in the abandonment order that the trustee be provided a copy of the seller's closing statement and all net proceeds in excess of the exemption amount be paid to the trustee. One should also bear in mind that frequently sale of a residence requires some measure of repair or restoration, either functional or cosmetic. These should be taken into consideration so that those costs are treated as costs of sale and not charged against the exemption.

"Creating" Equity

Although, as noted above, only the equity in property may be exempted, it is possible to "create" equity by avoidance of certain liens against the property. Section 522(f) permits debtors to avoid judicial liens (other than a lien for spousal or child support) and nonpossessory, nonpurchase-money security interests in specified personal property to the extent such liens impair an exemption. This right extends to household furnishings and goods, wearing apparel, appliances, books, animals, crops, musical instruments, jewelry, implements, professional books—or tools—of trade, and professionally prescribed health aids. Under this provision, a lien is considered to impair an exemption when the sum of the liens on the property plus the amount that would otherwise be exempt exceeds the value of the debtor's interest in the property. However, a lien that has been avoided is not considered in this determination. In opt-out states or states that permit a debtor to waive exemptions under §522(d), the lien in implements, professional books, or tools of trade or farm animals and crops may not be avoided to the extent the value exceeds $5,000.

When the debtor avoids a lien under §522(f), the debtor's exemption replaces the position of the holder of the avoided lien. Thus, the holder of an unavoided or unavoidable lien junior to that of the avoided lien does not move up in priority: The debtor's exemption trumps the interest of that lienholder to the extent of the avoided lien or the exemption amount, whichever is less.

Footnotes

¹ Board Certified in Consumer Bankruptcy Law and Business Bankruptcy Law by the American Board of Certification. Return to article