Protecting Your Home Equity in a Chapter 7 Bankruptcy

For those who hire me as their Austin bankruptcy attorney, often the most pressing issue is what happens to the family home. If there are young children in the household who are comfortable with nearby friends and school districts, being forced to move adds immeasurably to the other stresses associated with a bankruptcy filing. And, there may be quite a bit of equity at stake.

If you have ever bought a home and occupied it as your primary residence, you have probably applied for a “Homestead Exemption” to get the benefit of reduced property taxes, which can be a significant amount in some tax jurisdictions. However, this exemption takes on a new role in the circumstances of a Chapter 7 bankruptcy. As a Texas resident, you are fortunate to live in a state where you may protect from creditors an unlimited amount of value in your homestead, subject, as with all rules, to some exceptions and limitations.

Your homestead may include all the improvements you’ve affixed to your primary residence, even swimming pools, outbuildings, and roads. However, if you are in a city setting, there is a limit of ten acres of property for an individual or 20 for joint filers. In a rural setting, that limit is 100 acres for a single person or 200 acres for a couple. The exemption also includes your burial plot, in case you were wondering.

If, however, you were to choose the Federal bankruptcy exemptions (and you can’t mix and match), the limit would be only $21,625 for an individual, or twice that for a family. Every state has different rules; if you were in Georgia, for example, the state exemption there is just about the same as the Federal exemption. But, even if you have, say, $2 million in equity in your principal residence, in Texas you may get to keep all of that under our generous state rules. In most other states you would fare much worse.

There is a length of residency requirement if the equity in your home exceeds $146,450. Your home, or it and its Texas predecessors whose proceeds you always reinvested within 6 months into your next home, must have been your primary residence for at least 40 consecutive months immediately prior to a bankruptcy filing. That provision is designed to prevent people on the eve of bankruptcy from shopping for states like ours with more favorable homestead exemptions. If you don’t meet the 40-month test, you are limited to $146,450 under a Federal regulation. Even if you rented your home to someone else for some portion of those 40 months, perhaps for a temporary military or job posting, and did not establish another homestead, you’re still covered.

Keep in mind that the homestead law protects only your equity net of certain other obligations, such as mortgages, tax liens, contractor liens, and court ordered payments stemming from a divorce. So, if your hypothetical $2M equity is in a $3M house which carries $1M in mortgages and other attached debts, those will not be erased by your Chapter 7 filing. If you decide to sell the house to satisfy those debts, you’ll get to keep all of what’s left. If you’re behind on payments, by the way, your first mortgage holder can ultimately foreclose on you and wipe out your entire $2M equity. When a bankruptcy case is filed, an automatic stay goes into effect for a limited time. It can protect you from such foreclosures and other collection efforts, but, if you’re in a situation where selling is advised, you do need to move along smartly toward an orderly sale of your home that maximizes your net proceeds. You may not have the luxury of holding out for the highest offer you think you can get. If because of that homestead exemption and a timely sale you end up with enough to write a check for your next home, you’ll take a lot of the sting out of moving.

And, one final point, your homestead exemption can be reduced if you have made what are considered fraudulent transfers of other assets into your home in the years prior to your filing. In that case a Federal limit of $146,450 may apply, or the US Trustee might even find a reason to lower that. What this says, for example, is that you can’t use a pile of cash to pay down your mortgage and boost your home equity as a way of protecting that cash from creditors under the homestead exemption. Your equity must have accumulated “organically” over time purely on the appreciation of your real estate.

As with all things related to a Chapter 7 filing, the details and timing matter. As your lawyer, I will ask you to rely on me to interpret the rules that apply to your specific situation and that help you preserve as much of your home equity as possible.