In United States v. Warfield (In re Tillman), No. 21-16034 (9th Cir. 2022) the Ninth Circuit reversed the lower courts and determined that the chapter 7 trustee could not avoid the federal tax lien on the debtor’s homestead.
In Tillman, the debtor purchased a house in Prescott, Arizona. Prior to filing bankruptcy, IRS filed a notice of federal tax lien on the property stemming from a penalty she owed. Debtor claimed a $150,000 homestead exemption in the house under Arizona law. The trustee sued to avoid the tax lien on the exempt property for the benefit of the bankruptcy estate. At the time of the bankruptcy, she had paid off the underlying taxes set out in the lien notice but owed about $25,000 in penalties.
Bankruptcy Code section 522 permits debtors to claim certain property as exempt against unsecured creditors but not those who have security interest in the property claimed as exempt.
Bankruptcy Code section 522(c)(2)(B) provides that exempting property does not protect it from a tax lien properly filed before the bankruptcy case.
In this case, the Trustee sought to avoid the tax lien arguing that the underlying tax portion had been paid and that the remaining IRS claim was merely a claim for “penalty” under Bankruptcy Code section 726(a)(4) and that therefore, under Bankruptcy Code section 724 the tax lien could be avoided.
In the end, the 9th Circuit reasoned that Bankruptcy Code section 551 preserves property to be avoided UNLESS the property does not meet the definition of “property of the estate” under Bankruptcy Code section 541. That is, the avoidance provisions cannot transform property that would otherwise have remained outside the bankruptcy estate into property of the bankruptcy estate. Thus, the debtor’s valid exemption claim trumped the Trustee’s avoidance powers. When a debtor properly exempts a property interest under § 522, the exemption withdraws that property interest from the estate and, thus, from the reach of the trustee for distribution to creditors.
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