Preserving Your Homestead Exemption After Discharge

Updated August 25, 2023 Protecting Your Homestead Exemption After Discharge Arizona’s homestead exemption protects home equity value of $400,000 for...

Updated August 25, 2023

Protecting Your Homestead Exemption After Discharge

Arizona’s homestead exemption protects home equity value of $400,000 for a dwelling in which the person resides.  When an exemption is claimed on a debtor’s bankruptcy schedules, trustees, creditors or other parties in interest have thirty days following the meeting of creditors to object to the exemption.  If no objections are brought, the debtor is entitled to the exemption without further order of the bankruptcy court.  The debtor usually receives a discharge shortly thereafter.

Believing that the discharge resolves all issues, the homestead exemption can be a trap for the unwary if circumstances arise in the future.  Bankruptcy estates can remain open for years and this permits trustees to make claims against the property at a later date.  Debtors are often surprised to learn that their home is still property of the estate and they cannot sell it without taking further action.

Post-Petition Appreciation Goes to the Trustee

The first pitfall that can arise for unwary debtors is that post-petition appreciation of real property above the homestead amount will accrue to the benefit of the estate.  For example, if on the date of filing a property is valued at $750,000 and has a $400,000 mortgage, the debtor can reaffirm the mortgage and claim the $400,000 homestead exemption to protect their remaining equity in the dwelling.  Even though there is no equity for the trustee or estate, the dwelling still remains property of the estate until abandoned or the case is closed.  Because bankruptcy cases can stay open for several years, situations arise where property appreciation increases the equity beyond the $400,000 homestead amount.

Most people would assume that this post-petition appreciation will be for the benefit of the debtor who continued to live in the property, maintain the property, pay the mortgage, etc.  However, the Ninth Circuit has ruled in a case called Chappell that post-petition appreciation of real property accrues to the benefit of the estate.  This would mean that in the above scenario, if the dwelling appreciated to $1,000,000, the $200,000 in excess of the homestead exemption would have to be turned over to the estate.  The way to avoid this situation is to seek abandonment of the property from the estate at a time where there is no equity above the homestead allowance.

Debtors Cannot Sell Their Home Without Abandonment and Traceable Proceeds Must Be Segregated

Debtors often seek to sell their residence after discharge while the case remains open.  They then find out from their title agency that they cannot sell the dwelling with an open bankruptcy.  In order to sell the property and retain the homestead proceeds, debtors must file a motion to abandon the property from the estate.  Courts routinely grant this where there is no equity for the estate above the homestead allowance.  Once abandoned, it can be sold and the debtors retain the proceeds.  If, for some reason, title permits the transaction without abandonment, the homestead exemption attaches to the identifiable proceeds received for up to 18 months.  The debtors must reinvest those proceeds or the exemption is lost and the trustee can pursue the debtor for the full amount received.  Likewise, those funds must be segregated from other income and assets to that they can be traced.  If they are placed in a brokerage account and invested, courts have held that this voids the homestead proceeds exemption.

In order to avoid this, debtors should seek abandonment shortly after filing where they have sufficient equity in their house.  Debtors should not seek authority to sell the house but rather must motion the court to abandon the entire property.  In one case, the debtors sought authority to sell instead of abandoning the property from the estate.  The trustee objected to monitor that the identifiable proceeds exemption was sustained after 18 months.  When the debtors subsequently used some of those proceeds for living expenses and only re-invested a portion in a homestead exemption, the trustee sought a judgment against the debtors for the uninvested amount and prevailed.  All of this could have been avoided with a property timed abandonment.

Steps must be taken even after discharge to preserve one’s homestead rights.  Do not overlook the possibilities of the trustee bringing claims years after receiving a discharge.  Bankruptcy estates can remain open much longer than anticipated and it is an vicious trap for the unwary debtor who was not advised properly in advance.

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