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When someone files bankruptcy, an estate is created. The property in the estate is defined in the Code, and it is the property in the estate that is used to pay creditors. But how do you value property of the estate if the nature of the interest held in the real estate changes after the petition date? On Friday, the 7th Circuit Court of Appeals answered that question.

In January 2004, the debtors filed for chapter 13 relief and sought to avoid a judgment lien (valued at about $8,200) on their residence. The lien arose from a deficiency judgment following an automobile repossession. Debtor’s estimated their interest in the residence to be valued at $65,000, subject to a mortgage of about $58,000. Their interest in the residence reflected an encumbrance of a life estate interest held by a relative. Under Indiana law, the homestead exemption at the time was $15,000 ($7,500 per debtor).

Two years later, after the plan was confirmed, the debtor’s filed a motion seeking to avoid the lien on the property. A month prior to the filing of the motion, the mother released her life estate interest by a quit claim deed, thus conveying the property to the debtors a fee simple interest. The value of that interest was determined to be $95,000. However, when the debtors sought to avoid the lien on the property, they used the prior valuation of $65,000.

The creditor argued that the valuation that should be used is the new one of $95,000. After an unsuccessful appeal to the District Court, the Court of Appeals was called upon to answer one question: for the purposes of avoiding a lien under Section 522, when should the debtors’ interest in the real estate be determined?

The Court looked to Section 1306 and what constitutes property of the estate:

Property of the estate includes, in addition to the property specified in section 541…. all property…that the debtor acquires after the commencement of the case but before the case is closed.

Section 541(a)(1) identifies property in the estate as including “all legal or equitable interests of the debtor in property at the commencement of the case.” And Section 541(a)(7) lists property of the estate as including “[a]ny interest in property that the estate acquires after the commencement of the case.” Based on that, the Court held that the value of the real estate should be determined at the fair market value at the time it was recorded in December 2005. The lien could not be avoided.

To get access to the opinion, and to hear the oral arguments of the case, Click Here.

A recent Massachusetts Bankruptcy Court decision set forth the standard that the majority of Federal Circuits have adopted: a bankruptcy debtor may avoid a wholly unsecured lien on the home.

The case involved a debtor who claimed their home was worth $370,000. The balance of the first mortgage was approximately $ 376,000, and a second mortgage, held by American Home, had a balance of approximately $95,000. In the Chapter 13 plan, the debtor proposed to pay American Home as an unsecured creditor as a “result of ‘cram down of unsecured claim on second mortgagee on Debtor’s principal residence.” The debtor also field a Motion to Determine Secured Status under Section 506(a). (Despite adequate and proper notice, American Home did not challenge the debtor’s expressed intentions.)

Even though the Bankruptcy Code expressly prohibits modification of mortgages on a debtor’s primary residence under Section 1322(b)(2), the Court found that Chapter 13 plans may avoid liens on a debtor’s residence that are wholly unsecured. As this view appears to have been adopted in other districts, the Bankruptcy Court ruled in favor of the debtor, and allowed the debtor’s motion seeking a determination that American Home’s mortgage was unsecured.

For Massachusetts homeowners contemplating bankruptcy and looking at declining property values, this decision is welcome news.

In re Pelosi, Chapter 13 case no. 07-16820 (February 21, 2008).