What Does A Chapter 7 Debtor Own? At First, Virtually Nothing!

            One of the harder concepts to convey to Chapter 7 clients is that, as of the time the bankruptcy petition is filed and perhaps up until the case is closed, the Chapter 7 debtor owns virtually nothing.

            There is a good reason why many debtors fail to understand this. Most Chapter 7 individual debtors (this includes joint filings of married couples) do not lose anything in the process of filing bankruptcy except attorneys fees and filing fees, and a down-tic in their credit score, which then generally begins to rebound after they file Chapter 7.  Available exemptions usually cover everything they own so that their providing documents and information for the preparation of the bankruptcy schedules, signing of the documents, attendance at the creditors meeting, and mandatory credit counseling and debtor education are usually the extent of their participation in the process along with a few meetings with their attorney and the attorney’s staff. So it is reasonable for a person to think that if they do not lose anything once the bankruptcy has ended, then they never did.

            But, in Chapter 7, this is actually not the case. The moment a person files Chapter 7, they give up ownership of everything they own. Legally. Right down to their underwear and tooth brush. At the moment a petition is filed, a “bankruptcy estate” becomes the owner of all property previously owned by the debtor, and the Chapter 7 trustee administers the estate for the benefit of the creditors. 

            There are few exceptions to this, and even these exceptions must generally be noted somewhere on the debtor’s schedules and statements filed with the court as part of the debtor’s duty to disclose his or her complete financial situation. For instance, a valid 401-k plan is not technically property of the bankruptcy estate as a result of the Supreme Court ruling in Patterson v. Shumate decided way back in 1992. But it still has to be listed on Schedule B, the property list, so that the trustee has an opportunity to make a determination that it truly is a valid 401-k.

            But other than that, pretty much all property of the debtor is subject to this transfer of ownership. Now, to be sure, even though the trustee owns your stuff, he or she rarely takes any of it into actual possession. This is for the practical reason that debtors apply exemptions to their property which statutes give them, allowing them to keep certain property as part of their “fresh start” in bankruptcy. The debtor is allowed to exempt reasonable clothing, furniture, fixtures, automobiles, tools of the trade, and other things up to certain acceptable values. For most Chapter 7 debtors, the exemptions are enough to cover everything. 

            And sometimes not. Let’s say a debtor owns a Mickey Mantle rookie baseball card, which is worth quite a bit of money these days, and the debtor does not have an exemption to cover it or the money or desire to buy it back from the trustee (remember, the trustee owns it). In that situation, the trustee is free to take that baseball card to the highest bidder, sell it, and use it to pay administrative expenses and creditors to the extent it will do so.

            But even if all of the property of a debtor is exempt, the debtor still is not entitled to dispose of it in any way until the trustee no longer owns the property, and this is true even if the time has passed for the trustee to object to the claim of exemption the debtor has asserted for that property. The debtor may not sell, give away, or throw in the trash any property so long as the bankruptcy estate owns it.

            The trustee no longer owns the property, i.e. the property is no longer property of the estate under Section 541 of the Bankruptcy Code, in only one of two instances. 

            First, the trustee no longer owns the property of the estate if the trustee takes the affirmative step of abandoning the property under Section 554 of the Bankruptcy Code. This is actually a pretty simple process. Assuming that the trustee agrees as to the value of the property and the exemption is properly asserted by the debtor, the trustee need only file a one page notice with the court stating (for whatever reason; basically he or she does not care about it) his or her intention to abandon the property. The court gives notice of the intended abandonment to all creditors of the estate and other interested parties so that they can object if they have a basis to do so. If, after fourteen days from the court’s notice, no one objects, the property is abandoned, meaning it is no longer owned by the trustee and is now once again owned by the debtor to do with as the debtor wishes.

            The only other way that the debtor actually regains ownership of the property is for the bankruptcy case to close. Note that I emphasize close. I have seen debtors receive their discharge and think that does it, and that they are free at that point to do what they like. This is not an unreasonable conclusion, I suppose. Debtors are generally informed from the first consult (in my office, at least) that their “fresh start” in Chapter 7 begins, with limited exceptions, at the moment their bankruptcy petition is initially filed with the court.

            But, legally, the bankruptcy estate continues to own everything unless there has been an abandonment or the case closes. This is because the case closing constitutes a “deemed abandonment” of all property not administered by the trustee.

            Another caveat is that this only applies to property of which the trustee is aware, i.e. which is actually listed on the debtor’s schedules. This is critical to understand. If the debtor “forgets” to list the yacht sitting in the marina down at Cape Cod, that yacht becomes property of the bankruptcy estate nonetheless, and is never abandoned until the trustee is made aware of it, usually by amending the schedules and adding it. If the trustee finds out about it otherwise, he or she is free to re-open the case, take possession of the yacht, and use it to pay creditors. And it is probably too late for the debtor at that point to try to exempt it even if the debtor could have in the beginning.

            The failure to recognize the trustee’s ownership interests in the debtor’s property can lead to some frightful situations, some of which may not be recognized for years. I will offer an example to demonstrate such a possible outcome, and then let it go, this article already being longer than intended.

            I became aware recently of a debtor who filed Chapter 7, fully exempted the substantial equity in his home, entered into a Purchase and Sales Agreement for the home after the bankruptcy was filed, received his discharge in bankruptcy, and then closed on the home sale. A problem arose. The bankruptcy case had not yet closed and the trustee had not abandoned the real estate. It would have been a simple matter to get the trustee to abandon the property but the debtor mistakenly believed he did not need such authorization so he did not even bother to tell his attorney about the pending sale.

            In some manner, the closing agent found out about the seller’s bankruptcy. They conducted the closing but would not release the net proceeds from the sale to the debtor until they got “authorization” from someone, meaning the court or the trustee. So the debtor called his attorney, told him the problem, and the attorney basically told the debtor that he had no authorization to sell the home. The debtor was advised that he could do one of two things. He could go to the trustee and request some kind of abandonment, which he undoubtedly would have gotten, or he could wait until the case closed. Since it appeared that the case was going to close imminently, everything seemingly incident to that result having taken place, and it would take around three weeks for the abandonment to be final, he chose the latter approach. It actually took longer for the case to close and the title company, apparently exasperated with the delay, gave up and gave him the money anyway. The case closed about six days later.

            No harm, no foul. Right?

            Not necessarily. The deed and the mortgage were signed and recorded before the case was closed and since there was no abandonment, the debtor signed a deed for real estate he legally did not own. The new “owner” signed a mortgage conveying a property interest which he legally did not have. The closing agent turned over money to the debtor to which he was not entitled because the debtor had legally transferred nothing. Suggestions of liability abound all around. At a minimum, there should have been an execution of confirming documents for a date after the closing of the bankruptcy case. That would probably solve most if not all of the problems created by this situation.

            If that does not happen, it is hard to say if many or no problems result. This may be one of those title defects that no one ever picks up on and, in my experience, many title examiners miss this one. But to be thorough, and given that indicia of a bankruptcy rarely shows up in the registry of deeds, an examination of the records of the bankruptcy court as to the seller is a step that should always be taken.

            But the lesson to be learned and understood is this. If you are in any kind of bankruptcy, not just a Chapter 7, and want to sell or otherwise dispose of property, call your attorney first. You will undoubtedly save yourself a lot of headaches if you do.

 

©Leonard Deming, 2014