Thursday, June 12, 2014

Does the homestead exemption protect prepaid rent?

From a debtor's perspective, Illinois' $4,000 wildcard exemption can seem woefully inadequate. Imagine receiving a $8,000 tax refund, but owing much more than that to several different creditors, all of whom have filed suit to collect their money. Those creditors may be able to take half of the tax refund. But the debtor can use other exemptions besides the wildcard to protect the excess cash from those lawsuits. Also, if the debtor is forced into bankruptcy, he can use his other exemptions to shield that excess money from the bankruptcy trustee.

There are actually several ways to exempt excess cash. The debtor can invest in a qualified retirement plan up to the applicable yearly limits proscribed by the IRS. The debtor can pay down a car loan so that he has up to $2,400 in equity in the car. The debtor can purchase a whole life insurance policy naming his spouse or children as beneficiary. The debtor can also prepay a mortgage and exempt up to $15,000 in equity in his homestead. 

But what if the debtor cannot afford to invest in a retirement account, or may have already invested the maximum? Assume that he does not own real estate. Can he send his landlord all of his excess cash and then use the homestead exemption to protect that equity? I think so. Here is the Illinois Homestead Exemption statute:
Every individual is entitled to an estate of homestead to the extent in value of $15,000 of his or her interest in a farm or lot of land and buildings thereon, a condominium, or personal property, owned or rightly possessed by lease or otherwise and occupied by him or her as a residence, or in a cooperative that owns property that the individual uses as a residence. That homestead and all right in and title to that homestead is exempt from attachment, judgment, levy, or judgment sale for the payment of his or her debts or other purposes and from the laws of conveyance, descent, and legacy, except as provided in this Code or in Section 20-6 of the Probate Act of 1975 [755 ILCS 5/20-6]. This Section is not applicable between joint tenants or tenants in common but it is applicable as to any creditors of those persons. If 2 or more individuals own property that is exempt as a homestead, the value of the exemption of each individual may not exceed his or her proportionate share of $ 30,000 based upon percentage of ownership. 735 ILCS 5/12-901.
I always thought you had to own real estate to claim a homestead exemption, but after actually reading the statute (novel concept huh?) it appears that a debtor can exempt up to the $15,000 of his interest in a lot of land and buildings thereon "rightly possessed by lease or otherwise" and occupied by him or her as a residence. The annotations do not provide any support for this concept, but it appears that the language of the statute is clear.

Of course, savvy creditors' counsel will claim that any attempt to prepay rent to avoid an obligation to a creditor is a fraudulent transfer. But there is plenty of federal case law that supports "exemption planning" on the eve of a bankruptcy filing. Those cases are easily analogized for purposes of state court litigation. 

For instance, the Seventh Circuit has held that conversions of assets from non-exempt to exempt forms within the year preceding a bankruptcy filing are not necessarily fraudulent to creditors. In re Smiley, 864 F.2d 562, 566 (7th Cir. 1989). Also, the U.S. Bankruptcy Court for the Western District of Wisconsin, in a very thorough opinion dealing with exemption planning, looked specifically at the amount of money at stake, among other things, to determine whether claimed exemptions should be upheld. See In re Bronk, 444 B.R. 902 (Bankr. W.D. Wisc. 2011). That court noted that when deciding on whether to uphold claimed exemptions, the temptation is to place considerable weight on the amount of money a debtor hopes to shield from creditors. This sentiment, the court noted, manifests itself in a variety of characterizations, such as a "smell test" or the age-old adage that "pigs get fat and hogs get slaughtered." The court went on to reject any notion that the size of the claimed exemption was itself indicative of fraud. The court very clearly held that a debtor should not be prohibited from the full use of his exemptions. The court even quoted Judge Learned Hand from a different context when that judge noted that "There is nothing sinister in arranging one's affairs so as to keep taxes as low as possible." 

So, to make a long story short, there is support in the law for last-minute exemption planning on the eve of bankruptcy or trial, even when that exemption planning involves creative applications of existing law, including the prepayment of rent to a landlord. 


Anonymous said...

Citation should read "In re Bronk,444 B.R. 902 (Bankr. W.D. Wisc. 2011) (you omitted a digit and placed the case in the district court, not the bankruptcy court)

Michael W. Huseman said...

Thanks!! I made the correction.

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