Postpetition Proceeds of Exempt Interests in Property: Who Owns the Appreciation?

• Author: Bartell, Laura B.

All types of property change in value over time. Sometimes that is a result of macroeconomic factors, such as inflation or deflation. Sometime that is a result of the owner's improvements or investments in the property. But when the individual owner of that property files for bankruptcy protection and claims the debtor's interest in the property as exempt under applicable law, who has the right to proceeds of that property to the extent that the value of the proceeds exceeds the exempt interest of the debtor originally claimed in the property?

It seems to be a tenet of faith for trustees that any appreciation in property of the estate belongs to the estate, and they have significant statutory support for that position. (1) But I suggest in this article that the characterization of the postpetition proceeds of exempt property as exclusively property of the estate is inherently flawed. Instead I maintain that when one looks at what is actually exempted under Section 522 of the Bankruptcy Code-the debtor's interest in property-one has to conclude that any proceeds obtained from property in which the debtor has successfully claimed an exemption belongs to the debtor to the extent of the debtor's proportionate share in the full interest in the property.

In Part I of this Article I will outline the issue, which is created when the debtor claims an interest in property as exempt, but the property is of a type as to which the applicable exemption statute imposes a limit on the value that can be exempted. The problem has been exacerbated by the amendments to Official Form 106C in the wake of the Supreme Court decision in Schwab v. Reilly, (2) which have made it almost impossible to claim an in-kind exemption for exempt property. Unless the property is abandoned by the trustee, title to the property itself is likely to remain as property of the estate, even if the exemption claim is no greater than the statutory limit on exempt property in that category. As a result, trustees invariably claim any proceeds representing subsequent appreciation as property of the estate. The problem is especially acute when the debtor has filed under chapter 13 and the exempt property is sold during the chapter 13 case or the case is subsequently converted to chapter 7. Because the sale in those situations is likely to occur long after the original filing, there is more likely to be significant appreciation claimed by the trustee.

In Part II I critique these cases, suggesting that the test of whether the trustee has an interest in postpetition proceeds should be a simple one-was the interest in property giving rise to the proceeds property of the estate at that time? If it was, the proceeds constitute property of the estate. If it was not, the proceeds belong to the debtor and are either exempt or not from the claims of postpetition creditors under applicable state law. In applying that principle it is important to recognize that what is exempted by the debtor is not the property itself but an interest in the property, the remaining interest in the property being retained by the estate. That can be conceptualized as an exempt percentage of the total value of all interests in the property as of the filing date. As a result, when the property is subsequently sold, the debtor should be entitled to the same percentage of the proceeds, because the entire property appreciated, not just the nonexempt portion.

Finally, I conclude with the policy reasons that support my interpretation, the basic principle that property rights include the right to realize any appreciation upon the disposition of that property. I suggest that the pervasive approach of awarding to the estate all appreciation in property in which the debtor has an exempt interest fails to give effect to the property interest represented by the debtor's exemption, is contrary to bankruptcy law and policy, and should be rejected.

1. PROCEEDS OF PROPERTY OF THE ESTATE AND PROCEEDS OF DEBTOR'S PROPERTY.

   Proceeds generated after the filing date fall into one of two categories. First, if the proceeds are generated after the filing date by the sale of property that was not exempt on the filing date, under Section 541(a)(6), "[p]roceeds, product, offspring, rents, or profits of or from property of the state" are included in property of the estate and will be administered like all other estate property. (3) Second, if the proceeds come from property that is abandoned by the trustee or is claimed by the debtor as exempt and is removed from the estate, the proceeds are not included in the estate under Section 541 because the proceeds come from property of the debtor and the trustee cannot claim them. (4)

   How do we determine whether the proceeds are proceeds of property of the estate or proceeds of property of the debtor? To begin with, property that is abandoned by the trustee is removed from the estate and becomes property of the debtor. (5) The trustee is permitted to abandon property under Section 554(a), (6) and does so by giving notice "to the United States trustee, all creditors, indenture trustees, and committees." (7) Objections may be filed and served within 14 days after the mailing of the notice, or within the time set by the court, and if a timely objection is filed, the court sets a hearing and resolves the issue. (8) If no objections are filed, the property is abandoned without action by the court. (9)

   The status of property in which the debtor claims an exempt interest is not so straight-forward. Once the debtor has established a right to an exemption (either by failure of a party in interest to raise a timely objection or by court order), what happens to the exempt property? Section 522(b)(1) states that the debtor is exempting the property "from property of the estate," which would seem to suggest that exempt property is removed from property of the estate and vests in the debtor. (10) Courts have uniformly so stated. (11)

   This principle certainly applies with respect to property for which there is no dollar limit for value of the property in that class that may be claimed as exempt by the debtor. If the debtor claims that the debtor's interest in the property is exempt, and there are no objections, the property itself will be entirely exempt and is removed from property of the estate and revests in the debtor. (12)

   However, the ability of a debtor to claim the full value of an asset as exempt and remove it from the estate if the applicable exemption law limits the exempt value of property of that type is unclear, especially in light of the Supreme Court's decision in Schwab v. Reilly. (13) The debtor, Reilly, who was a caterer, filed a chapter 7 bankruptcy case and listed certain cooking and other kitchen equipment on Schedule B (the former bankruptcy schedule on which debtors list their assets and the value of those assets) and stated that their value was $10,718. On Schedule C she claimed two exemptions, one for tools of the trade in the amount of $1,850 (which was then the applicable cap on the interest that could be claimed in that category under Section 522(d) (6)) and one for $8,868 for the remaining portion of the equipment in the "wildcard" exception of Section 522(d) (5) (which at the time allowed an exemption for the debtor's interest in any other property up to $10,225 in value). (14) Because the claimed exemptions did not exceed the amounts a debtor was permitted to exempt in the two categories, the trustee did not object to the debtor's claims, but when a subsequent appraisal disclosed that the true value of the equipment could be as much as $17,200, the trustee sought to auction the equipment and give Reilly the $10,718 in value that she had claimed as exempt. (15) Reilly argued that, by listing the full value of the equipment (as disclosed on Schedule B) as exempt on Schedule C, Reilly had intended to exempt the full value of the equipment even if it was more than the permitted value, and by not objecting the trustee had lost the ability to retain any of the equipment value for the estate.

   The Court concluded that the trustee has no obligation to object to exemptions if the amount specified in Schedule C falls within the statutory limit for the applicable category in order to retain the right to seek any amount by which the property actually exceeded those limits. Specifying a value for the exemption on Schedule C, even if that value equaled the estimated value of the property listed on Schedule B, did not put the trustee on notice that the debtor intended to claim the full value of the property, whatever that turned out to be. (16) Instead, the Court stated, that if the debtor wished to put the trustee on notice of a claim to the "full market value of the asset or the asset itself" (as opposed to a dollar-limited interest in the asset) :

   our decision will encourage the debtor to declare the value of her claimed exemption in a manner that makes the scope of the exemption clear, for example, by listing the exempt value as 'full fair market value (FMV) ' or '100% of FMV.' Such a declaration will encourage the trustee to object promptly to the exemption if he wishes to challenge it and preserve for the estate any value in the asset beyond relevant statutory limits. If the trustee fails to object, or if the trustee objects and the objection is overruled, the debtor will be entitled to exclude the full value of the asset. (17) Although the Court expressly stated that a 100% fair market value exemption claim would entitle the debtor to exclude "the full value of the asset," (18) the Court also cautioned in a footnote that "it is far from obvious that the Code would 'entitle' Reilly to clear title in the equipment even if she claimed as exempt a 'full' of '100%' interest in it" as opposed to "payment equal to the equipment's full value." (19) This casts some doubt on the idea that a debtor can exclude from the estate property that is subject to a limit on...