Homestead Exemption vs. Avoided & Preserved Mortgage (In re Travers; In re Cancel & Gonzalez)

By: Donald L Swanson

A bankruptcy trustee cannot transform an exempt homestead into property of the bankruptcy estate by avoiding and preserving a mortgage lien against it. 

That’s a fundamental rule of law established by two opinions from the First Circuit Court of Appeals: one in 2014 and one on August 6, 2021.

Background

Here’s what happens:

• Homeowner mortgages his/her home to secure payment of a promissory note;
• Later, Homeowner files bankruptcy, claiming a homestead exemption and staying current on the promissory note; and
• The bankruptcy trustee finds a defect in and avoids the mortgage lien (under § 544), which is preserved for the bankruptcy estate (by § 551). 

Q & A

So, the question is: What does the bankruptcy trustee do now?

The answer is: It can get complicated.

In re Traverse

That question presented itself in the case of Degiacomo v. Travers (In re Traverse), 753 F.3d 19 (1st Cir. 2014).

–Facts

Virginia Traverse owns and has lived in her home since 1999.  In 2005, she gets a $200,000 loan and mortgages her home to secure it—but the lender fails to record the mortgage.   

In 2007, Traverse grants a second home mortgage to another lender to secure a $31,000 loan—this mortgage is properly recorded. At all times, Traverse stays current on payments to both lenders.

On August 14, 2011, Traverse files Chapter 7 bankruptcy:

• valuing her home at $223,500;
• scheduling amounts of the two mortgage liens at $185,777.30 and $29,431.04, respectively; and
• claiming a homestead exemption under her state’s $500,000 homestead exemption—no one objects to this exemption claim.

–Lawsuit & Appeals

Her Chapter 7 trustee sues to, (i) avoid the 2005 mortgage, and (ii) preserve it for the benefit of the bankruptcy estate.  She counterclaims for a declaration that the Trustee can sell only the mortgage itself and not her home, unless she defaults on payments and triggers the right of foreclosure.

The Bankruptcy Court rules in Trustee’s favor on all issues, and the Bankruptcy Appellate Panel affirms, declaring that the trustee is entitled to sell the home to liquidate the preserved mortgage interest.

Traverse appeals, and the First Circuit reverses.

–First Circuit’s Analysis

A bankruptcy trustee has the right, under § 363(b), to sell “property of the estate” for the benefit of a debtor’s creditors.  However, since a debtor’s exempt property is removed from the estate, § 363 does not empower the trustee to sell exempt interests. Nor does a bankruptcy trustee ordinarily sell property solely for the benefit of secured creditors.

So, a trustee will sell a debtor’s home only when equity exists over the mortgage liens and the homestead exemption—thereby, obtaining equity for the benefit of the bankruptcy estate and its unsecured creditors.  When, however, a home’s value will yield no equity, after payment of liens and the homestead exemption, a trustee should abandon the property.  

Traverse’s $500,000 homestead exemption leaves no equity for her bankruptcy estate, and she is current on mortgage payments, which prevents a foreclosure.

–First Circuit’s Conclusion

“We affirm today the principle that the preservation of a lien entitles a bankruptcy estate to the full value of the preserved lien—no more and no less.”  In other words, the trustee cannot sell the homestead.

In this circumstance (an avoided and preserved lien on a homestead, with current payments), the trustee may take one of the following actions:

• sell the mortgage;
• claim the first proceeds from a voluntary sale of the home; or
• wait to exercise the rights of a mortgagee in the event of a default;

[Note: the First Circuit’s opinion does not discuss whether the Trustee or the holder of the promissory note is entitled to Traverse’s post-petition mortgage payments (see footnote 9).]

In re Cancel & Gonzalez

The same question is presented in this opinion: Segarra Miranda v. Banco Popular de Puerto Rico (In re Cancel & Gonzalez), Case No. 20-9006 in U.S. First Circuit Court of Appeals (issued 08/06/2021). 

But the question is not reached because a mortgage lien interest was never created—so, there is nothing to avoid or preserve.  I’ll try to explain.

–Facts

In 1981, Jose Cancel and Carmen González purchase their home in San Juan, Puerto Rico.  In 2003 they borrow $163,400.00 and grant a home mortgage as security—but the lender fails to record the mortgage.

On September 17, 2015, Cancel and González file Chapter 7 bankruptcy, scheduling the value of their home at $150,000, subject to a $127,990 lien. Puerto Rico law exempts the entire value of a homestead, and they claim this exemption — no one objects to the exemption claim.

The mortgage holder files a proof of secured claim for $127,921.08.  Debtors object to the claim, because the mortgage is not recorded.  The bankruptcy court, (i) sustains their objection to the secured nature of the claim, but (ii) allows it as a “general unsecured” claim that is discharged.

–Adversary Proceeding & Appeals

Then, the bankruptcy Trustee sues to avoid the mortgage lien and preserve it for the bankruptcy estate.  Debtors move for a summary judgment dismissing the Trustee’s suit—which the Bankruptcy Court grants. 

On appeals by the Trustee, this ruling is affirmed by both the Bankruptcy Appellate Panel and the First Circuit Court of Appeals.

–First Circuit’s Analysis

The trustee argues that, under Puerto Rican law, an unrecorded mortgage is a transfer of property of the debtor that would be voidable under § 544—that Puerto Rico’s mortgage rules are “nearly identical” to the state laws at issue in Traverse.

The First Circuit disagrees. Here’s why.

Puerto Rican law on an unrecorded mortgage is different ftom the state law at issue in the Traverse opinion.   In Traverse, the state law applies a “title theory” of mortgages, under which:

• a mortgage transfers legal title to the mortgage holder;
• recording gives notice to third parties; and
• Under an unrecorded mortgage, the mortgagee retains, (i) superior title over the mortgagor and third parties with actual knowledge of the mortgage, but (ii) inferior title to third parties without actual knowledge of the mortgage.

Puerto Rico has a fundamentally different scheme of mortgage rights—using a Property Registry system:

• a deed is not “recorded” until the Property Registry determines that it is valid;
• recording is part of the process of creating a valid property instrument;
• a mortgage must be recorded for it to confer any interest in the underlying real property; and  
• the Supreme Court of Puerto Rico confirms that a mortgage-holder does not acquire property rights until the mortgage-holder begins the registration process.

–First Circuit’s Conclusion

An unrecorded mortgage in Puerto Rico does not trigger the trustee’s avoidance powers under 11 U.S.C. §§ 544. That’s because the holder of the unrecorded mortgage owns nothing.  Accordingly, the unrecorded 2003 mortgage is not a “transfer of property of the debtor” that would allow the Trustee to invoke 11 U.S.C. § 544.

The result is that (i) Debtors keep their home, without any further obligation, and (ii) costs of the appeal “are awarded against appellant Trustee.”

Conclusion

Avoidance, preservation and liquidation of a mortgage lien on a debtor’s homestead exemption property can be tricky.

But in the First Circuit, we can be certain that a debtor’s homestead exemption rights will be protected.

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