Carve-Out Agreement Creates Exemptible Equity

Posted by NCBRC - June 30, 2022

The debtor was entitled to obtain the benefit of her homestead exemption even though, at the time she filed her petition, she had no equity in the property, where “the secured creditor’s agreement to accept less money upon a sale creates equity in the home where none existed before.” Stark v. Pryor (In re Stark), No. 20-4766 (E.D.N.Y. June 28, 2022).

In 2004, the debtor and her husband took out a loan for $1,320,000 secured by a mortgage on their residence. They defaulted on the loan and, on in 2019, the mortgagee obtained a judgment of foreclosure. Five days before the scheduled foreclosure sale, the debtor filed for chapter 7 bankruptcy. At that time, the property was valued at $2,222,400 and was encumbered to the tune of $2,565,838.38. In her bankruptcy schedules she claimed a homestead exemption in the amount of $170,825. The trustee filed his report of no distribution and indicated that he had abandoned the property. Two weeks later, however, the trustee informed the court that the mortgagee had offered a “carve out” and he sought to rescind the notification of no distribution in order to sell the debtor’s residence.

The debtor opposed the motion and the sale of the property arguing that such carve-out agreements were prohibited by the Bankruptcy Code. She further argued that if the property were to be sold, she would be entitled to her exemption out of the proceeds.

The bankruptcy court found that carve-out agreements were not prohibited by the Code, and that because the debtor had no equity in the property at the time of her petition, she was not entitled to the exemption.

On the debtor’s appeal, the district court noted that ordinarily when property is subject to a mortgage greater than its value, the bankruptcy trustee will not be authorized to sell the property because the sale would not adhere to the benefit of unsecured creditors. An exception to this general rule is when the trustee and mortgagee reach an agreement under which the trustee agrees to sell the property and the mortgagee agrees to give up some of the recovery from the sale of the residence to benefit the bankruptcy estate. The court observed that under this “give-up” arrangement, unsecured creditors benefit from the distribution of the proceeds, the trustee benefits from the opportunity to gain a commission, and the mortgagee benefits from having the costs and trouble of the sale taken on by the trustee. The only person who does not benefit from the arrangement is the debtor. In fact, the debtor may be in worse shape since she may have to leave the property sooner than she would if the sale were done through regular foreclosure channels, and she loses the opportunity to negotiate any financial benefit from cooperation with the mortgagee.

With these practicalities in mind, the court went on to address the issues raised in this appeal. Although the debtor argued that the Code does not permit carve-out agreements in general or at least this agreement in particular, the court found it did not have to reach the question because the debtor did not object to the sale so long as she received the exemption amount.

The court went on, therefore, to address whether the debtor was entitled to take the exemption. To reach that question, the court had to determine the nature of the “value” created by the carve-out agreement. It found that “the value of the carve-out is ultimately derived from equity in the Property as defined by New York law.” New York provides for an exemption in a debtor’s residence over and above liens and encumbrances. While the debtor had no equity at the time she filed her bankruptcy petition, she argued that the carve-out deal, in order to benefit the estate, would necessarily create equity in the property. In other words, whatever reduction in debt the mortgagee agreed to, would become equity from which the debtor would be entitled to extract her homestead exemption. The court agreed.

In so holding, the court disagreed with the bankruptcy court’s finding that the “value” created by the trustee’s sale of the property under section 363, was in the mortgagee’s “monetizing the trustee’s power to sell” rather than in an increase in equity based on the agreed-to decrease in debt. It found that the carve-out agreement and trustee sale had all the earmarks of a typical property sale under which the property owner loses some or all of the “bundle of rights” associated with home ownership. Specifically, the court found “the Trustee is trading away, in exchange for the carve-out, Stark’s right to remain in the Property for an extended period without making mortgage payments; her right to exclude others during that period; and the like.” Thus, the “value” created by the carve-out agreement was associated with the homeowner’s property rights and were protected by the state homestead exemption.

The trustee next argued that the debtor was not entitled to the exemption because she had no equity in the property at the time she filed her petition.

The court found that the cases upon which the trustee relied were based on a misreading of Owen v. Owen, 500 U.S. 305 (1991). Owen held that a debtor’s legal interest in property passes to the estate upon the filing of the petition, and if the property is over-encumbered at that time, equity resides with the lienholder and the debtor cannot benefit from an exemption in the property. Under Owen, the debtor’s property interest is still exempt, but that exemption is subject to encumbrances. Because the debtor’s legal title passes to the estate, in the event the value of the property increases post-petition such that it exceeds the encumbrances, the debtor is entitled to take the exemption to the extent it is covered by new equity.

The court reversed and remanded.

Stark ED NY June 2022


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