This month’s edition of  Dirt Tales looks at an issue that commonly arises when a party has filed bankruptcy.  The facts in the cases presented in each series are true occurrences, except for the names of the parties involved.  

Attorney Able is hired by a client who is purchasing Blackacre.   Able conducts his title examination and discovers there are three judgments against the seller (“Seller”) of Blackacre.   Able advises Seller’s attorney of the judgments and requests they be paid from the proceeds of the sale.  Seller’s attorney produces an order from a bankruptcy court listing all three judgments and contends that the judgments were wiped out by his client’s bankruptcy in Chapter 7.  Because the judgments were listed on the bankruptcy order Able closes without them being paid off.  Some months later Able’s client is served with an order of execution from one of the judgment creditors and he is advised by Able to file a claim on his title policy, which insured the purchase free and clear of the judgments. The question becomes whether the judgment creditor execute on real property whose judgments were discharged in bankruptcy?  The answer to the question will depend upon the Chapter of bankruptcy that relief was sought, but for purposes of this article we will look only at Chapter 7 since that was the Chapter under which the seller filed.

A careful reading of the bankruptcy order held the answer to the question posed above.  The order stated “the personal obligations of the debtor are hereby discharged”.  What this means is that although the Seller’s personal obligation or responsibility for the debt had been discharged in bankruptcy the judgments attaching to the land had not been discharged.  The next question is whether or not it would have been possible to have had these judgments discharged also against the land.

Let’s look at the relevant portion of the Bankruptcy Code.  11 U.S.C. §522(f)(3) states a “debtor may avoid the fixing of a lien on an interest of the debtor in property to the extent that such lien impairs an exemption to which the debtor would have been entitled.”  In October 2005 the Bankruptcy Code was amended with changes being made to what kind of liens could be avoided.  Section 522(f) now prevents the avoidance of a judicial lien for domestic support obligations.  The debtor must now also indicate whether exemptions are being claimed under §522(b)(2) or §522(b)(3) and whether the debtor claims a homestead exemption that exceeds $125,000.00.

In order for a Chapter 7 bankruptcy order to avoid (defeat) a lender’s security interest(s) three requirements must be met:

            First, the security interest must be 1) non-possessory, and 2) non-purchase-money.  A possessory security interest is one in which the creditor is in possession of the collateral.  A purchase-money security interest is one that secures repayment of the very money used to purchase the collateral.

            Second, the collateral must fall within the specific list of property in §522(f)(1)(B).  The list includes personal, family, and household items (i.e., generally non-commercial items) as well as homestead rights. 

            Third, the collateral must be on the list of property exempt under state law, and the security interest must “impair” the debtor’s exemption; i.e., the security interest must prevent the debtor from enjoying the full benefits of the exemption statute, such as their homestead exemption in the property.  To determine the extent to which the security interest “impairs” the debtor’s exemption, §522(f)(2) says to add the amount of the secured loan to the amount of the debtor’s exemption and subtract from that total the value of the collateral.  Any positive number is an impairment of collateral and the amount which may be avoided.  

In the present case the Seller either did not qualify for an avoidance or he overlooked this provision in his filing.  Regardless, the judgments against him remained attached to the property and needed to be dealt with at the sale of the property.  Whenever you come across judgments or other liens that you are told have been discharged in a Chapter 7 bankruptcy always obtain a copy of the Order of Discharge and read it carefully.  Look at the language closely that deals with the lien or judgment to determine whether the Order grants a personal discharge or whether it removes the lien against the real property.