Trustee Can Avoid Tax Penalty Lien for Benefit of Estate

Posted by NCBRC - June 19, 2021

Under sections 724(a) and 551, the chapter 7 trustee could avoid the penalty portion of a federal tax lien on the debtor’s homestead property and preserve the value of the avoided lien for the benefit of the bankruptcy estate. United States of America v. Warfield, 2021 WL 1530094 (D. Ariz. April 19, 2021) (case no. 3:20-cv-8204).

At the time she filed for chapter 7 bankruptcy, the debtor owned a house worth $475,000 for which she claimed a $150,000 state homestead exemption. The home secured a mortgage and a federal tax lien. The bankruptcy trustee filed an adversary proceeding to avoid the penalty portion of the tax lien for the benefit of the estate. Both the debtor and government opposed the motion. The bankruptcy court granted summary judgment in favor of the trustee and the government appealed.

Section 724(a) permits a trustee to avoid a lien for a pre-petition tax penalty and, under section 551, any transfer avoided under section 724(a) “is preserved for the benefit of the estate but only with respect to property of the estate.”

On appeal, the court began with the government’s argument that the bankruptcy court erred in allowing the trustee to avoid the lien. The government argued that “property of the estate” within the meaning of section 551 means property that is part of the estate at the time of the avoidance proceeding. Because the debtor’s homestead exemption had been allowed at the time of the trustee’s motion, the government argued it was not property of the estate. The court disagreed. It found that Congress did not specify a temporal component of section 551 and, therefore, it was proper to interpret the phrase as it is defined in section 541. That section specifies that “property of the estate” is determined as of the petition date. Here, the homestead property was subject to exemption only if it was part of the estate at the petition date, therefore, the property fell under the definition set forth in section 541.

The government next argued that the language of section 522(c) “connotes that exempt property maintains its exempt status from the outset of the case, rather than after the deadline to object passes.” The court found that the homestead exemption did not have the effect of removing from the bankruptcy estate that portion of the debtor’s homestead that was encumbered by the tax lien. “Here, the Tax Lien attached to Debtor’s equity interest in the Property, which meant that, upon bankruptcy, the homestead exemption that otherwise could have served to remove Debtor’s interest in the Property from the property of the estate was ineffective to allow Debtor to reclaim that portion of the interest encumbered by the Tax Lien. Thus, even assuming without deciding that the government’s interpretation of § 522(c) is correct, Debtor could not claim an exemption for the value of the Property encumbered by the Tax Lien.”

The court also disagreed with the government’s contention that, under section 522(c)(2)(B), the debtor’s exemption existed alongside the tax lien rather than third in line behind the tax lien as held by the bankruptcy court. The government argued that “the statute’s use of the words ‘property exempted’ means that ‘property can be exempted and remain liable for a debt secured by a tax lien at the same time’ and that, if ‘exemptions apply only after tax liens are accounted for, § 522(c)(2)(B) would have little meaning.’” The court disagreed with the government’s interpretation of the scope of the section, finding that it merely means that a debtor’s exempt property remains subject to a tax lien after the close of the bankruptcy case.

Having found that the trustee could avoid the tax lien, the court turned next to whether the automatic lien preservation provision of section 551 applied or whether the debtor should have been permitted to recover the value of the lien under section 522(g). That section provides that notwithstanding section 551, a debtor may recover the value of a lien avoided by the trustee if the debtor could have avoided the lien under section 522. The government argued that the test for whether the debtor could have avoided the lien was whether she could have exempted the property to which the lien attached. The court relied on In re DeMarah, 62 F.3d 1248 (9th Cir. 1995), which held that, while section 522(h) would normally allow a debtor to avoid a lien for a non-compensatory penalty, section 522(c) limits a debtor’s right to avoid a tax lien. The court explained that, in DeMarah, “the Ninth Circuit necessarily ruled that the debtor would have been unable to exempt the property from the estate under § 522(g). Accordingly, DeMarah compels the conclusion that Debtor may not exempt the Property under § 522(g).” Because the debtor would not have been able to avoid the tax lien, she could not benefit from section 522(g).

The court affirmed.

Warfield D Ariz Apr 2021





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