Debtor May Avoid Tax Sale under 548 but Loses Equity

Posted by NCBRC - May 19, 2022

The debtor has standing to avoid a tax sale under section 548 but only to the extent of her exemption and allowed claims. She may not recover her equity in the property. Morawski v. Effect Lake, LLC., No. 20-1125 (Bankr. D.N.J. April 11, 2022).

On October 3, 2016, Effect Lake purchased a tax sale certificate encumbering the debtor’s home. In January, 2019, Effect Lake filed a tax sale foreclosure action in the state court and a lis pendens for the foreclosure action with the Essex County Register’s Office. The state court entered final judgment on September 30, 2019. The debtor filed her chapter 13 bankruptcy petition on February 7, 2020. Effect Lake filed a proof of claim for $141,947.88. At the time the debtor filed for bankruptcy, the redemption amount for the tax sale certificate was $90,323.88 and the property was valued at between $544,000 and $600,000.

The debtor filed an adversary proceeding seeking a finding that the tax sale was a fraudulent conveyance under section 548. The parties filed cross-motions for summary judgment. The bankruptcy court held a hearing and issued the following findings.

Section 548 permits a trustee to avoid a transfer of the debtor’s property if the transfer occurred within two years of the bankruptcy petition so long as the debtor received less than the fair market value for the property and the debtor was insolvent at the time of the transfer. In BFP v. Resolution Trust Corp., 511 U.S. 531 (1994), the Supreme Court found that mortgage foreclosure sales could not be avoided under section 548 so long as state requirements for the sale were met. Unlike mortgage foreclosures where the amount received for the property is presumed to represent its fair market value, however, a tax foreclosure sale in New Jersey lacks a competitive bidding process, therefore, the presumption of fair market value does not apply. The court therefore found that tax foreclosure sales could be avoided under section 548.

The court turned next to the issue of the debtor’s standing to obtain the relief sought. Section 522(h) gives a debtor standing to avoid a transfer so long as she could have claimed an exemption in the property under section 522(g)(1) had the trustee avoided the transfer, and so long as the transfer was involuntary and the debtor did not conceal the property. In this case, the debtor could claim her homestead exemption and therefore had standing.

Furthermore, the court found that, although section 548 refers to avoidance of the transfer by the trustee, the Third Circuit has held that debtors have derivative standing to launch an avoidance action under that section. But such action is for the benefit of the bankruptcy estate and, after the debtor takes her exemption, recovery is limited to the amount of creditor claims. The court found, therefore, that even if she prevailed on the avoidance action, the debtor would not be entitled to recover her equity in the property.

The court found that there were two factual issues requiring further evidence.

The first was the extent of allowed claims. Here, the undisputed allowed claims were Effect Lake’s claim and one other claim for $649.39. In the face of the debtor’s argument that there were additional allowed claims for administrative fees, the court found the record unclear and therefore unripe for summary judgment.

The next issue was whether the debtor was insolvent at the time of the transfer as required for section 548 relief. Under New Jersey law, the transfer date was the date of the lis pendens. Based on the debtor’s interrogatory answer that “Prior to the date of the foreclosure Judgment the debtor was not insolvent as the real property owned has considerable equity,” Effect Lake argued that she was not insolvent at the time of the lis pendens. The debtor explained, however, that her answer was based on her misunderstanding as to when the property transferred. In fact, she was insolvent at the relevant time.

The court rejected Effect Lake’s argument that the debtor’s later assertion of insolvency be disregarded under the “sham affidavit doctrine.” That doctrine allows a factfinder to reject a party’s sworn statement contradicting the party’s earlier sworn statement. The court found that New Jersey law is counterintuitive because the debtor continues to retain all the trappings of ownership at the time of the lis pendens. Therefore, the court declined to disregard the debtor’s assertion of mistake. The court also found that the transferred property itself could not be considered when calculating the debtor’s solvency.

Nonetheless, in the face of Effect Lake’s refusal to concede the debtor’s insolvency, the court declined to make a definitive finding on that issue and continued the hearing to allow the parties to present evidence. It therefore denied both motions for summary judgment on that issue.

In conclusion, the court granted both motions for summary judgment in part, and held for trial the issues of “(1) whether the Debtor was rendered insolvent by the transfer (to the extent this issue is not resolved in favor of the Debtor on summary judgment); and (2) the extent of allowed claims in this case.”

Morawski Bankr NJ Apr 2022


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