When that difficult time comes and you must discuss with your failed real estate investor client what would happen in bankruptcy, there's often a lot of interest in the application of the homestead exemption. Usually, of course, you'll be turning this file over to specialists, but here's some general information worth noting.

Thanks to Jonathan Rivin, San Francisco, for contributing these items.

BANKRUPTCY; HOMESTEAD: Fair market value, rather than forced sale value, of a bankruptcy debtor's residence should be used in determining the amount of a secured claim in a Chapter 11 case when the debtor keeps possession of the residence; hypothetical costs of sale are not to be subtracted from the valuation of the residence when determining the amount of the secured claim. In re Taffi,68 F.2d 306 (9th Cir. 1995).

The case involves a junior IRS lien far in excess of the available equity in the property.

Under 11 U.S.C. § 506(a), an allowed claim of a creditor secured by a lien on property in which the estate has an interest is secured to the extent of the value of the "creditor's interest" in the estate's interest in the property, and such value is to be determined "in light of the purpose of the valuation" and the "proposed disposition or use of the property."

Where the debtor retains possession of the residence, there is no reason to reduce the amount of an already undersecured claim to forced sale value when no forced sale is contemplated. Doing so decreases the already devalued interest in the property. Further, hypothetical costs of sale should not be deducted because when a creditor forecloses on a residence, it receives all the proceeds of the sale. There is no basis for assuming that the costs of sale are being paid with the first dollar of sale proceeds rather than being added to the debtor's deficiency. Comment: This is not the first Chapter 11 case to reach this conclusion. Some bankruptcy mavens have speculated that we might see different results when the issue arises in a Chapter 13 proceeding.

BANKRUPTCY; HOMESTEAD: A bankruptcy debtor is entitled to California homestead exemption from the proceeds of the sale of a residence, but not the value of post-bankruptcy petition appreciation in the residence's value. In re Alsberg, 95 C.D.O.S. 7988 (9th Cir. BAP, 1995).

At the time the bankruptcy debtor in the instant case filed for Chapter 11 bankruptcy, he owned a residence worth $259,000, which was encumbered by a promissory note secured by a deed of trust for $225,125. Several months later the residence was sold for $380,000. The proceeds of the sale amounted to approximately $115,000 after payment of the mortgage, applicable costs of sale and capital gains tax. Subsequently, the debtor claimed a homestead exemption of $45,000, and moved to compel the trustee to abandon the proceeds of the sale, arguing that because the amount owed on the mortgage, plus the homestead exemption exceeded the value of the residence at the time of filing, the residence was effectively removed from the bankruptcy estate at the time of filing.

The court noted that the homestead statute gives the debtor a $45,000 exemption as of the time of sale, not a $45,000 equity in the property. At the time the bankruptcy petition was filed, the debtor's interest in the residence passed to the bankruptcy estate. Therefore, the estate is entitled to all post-bankruptcy petition appreciation in the property, and the debtor is entitled only to the $45,000 of the sale proceeds as his homestead exemption.

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