Considering Converting from Chapter 13 to Chapter 7 with Appreciated Real Estate? Think VERY Carefully

This is an extremely timely and relevant issue here in the Bay Area/Northern District of California, where I practice.  If you filed a Chapter 13 bankruptcy case more than a year or two ago, and owned any real estate, the value of that real estate was probably very low at the time; the market hit bottom somewhere around early 2012.  But what a difference a couple of years makes! The last couple of years has seen an enormous explosion in the local residential real estate market.  So enormous in fact, that housing values are now at or above their pre-crash peak.  Your home is probably worth significantly more now than it was back then.

So let’s say you filed a Chapter 13 case back in 2013.  Your house was worth significantly less back then, and maybe you were “underwater.”  If that was so, had you filed a Chapter 7 case, a Chapter 7 trustee wouldn’t have been very interested in your house.  (Chapter 7 trustees make their money by liquidating valuable assets for the benefit of creditors.)  Let’s also say that now you want to get out of court Chapter 13 case, sell your house, and reap your profits.  Can you do that?  Can you convert to Chapter 7, get a discharge, and move on?  The answer to that question depends on the answer to another question:  If you convert, who gets that appreciated value, you or the Chapter 7 trustee?

Prior to the 2005 changes to the Bankruptcy Code, the answer to that question was very clear: On conversion, post-filing appreciation is yours.  And in the years since then, few had even bothered to ask the question of whether that rule was altered by the 2005 changes.  (In a down market, there was no point.)  But now, with a hot real estate market, Chapter 7 trustees are starting to look into it.

The theory being put forward in certain quarters revolves around the interpretation of § 348(f)(1) of the Bankruptcy Code.  § 348(f)(1)(A) says that “property of the estate in the converted case shall consist of property of the estate, as of the date of filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”  In other words, whatever interest the debtor had in the property on the date of filing, that’s what the Chapter 7 trustee gets on conversion.  That was the rule pre-2005, and it’s still the rule as most courts understand it.

However, proponents of this new theory argue that § 348(f)(1)(A) has to be read in conjunction with § 348(f)(1)(B), which was substantially altered by the 2005 changes.  It used to read: “valuations of property … in the Chapter  13 case shall apply in the converted case”.  However, post-2005, it now reads: “valuations of property … in the Chapter 13 case shall apply only in a case converted to [Chapter 11 or 12], but not a case under Chapter 7.”  The proponents argue that the Chapter 7 trustee doesn’t get whatever interest the debtor had at the time of filing; she gets the thing itself, and the value of her interest is that of the conversion date.  It basically turns the existing rule on its head.

This is by no means an accepted position; as of the date of writing (June 30, 2015), I know of no caselaw clearly and cleanly adopting this position. (Indeed, one court, the Bankruptcy Court for the Eastern District of Tennessee, in In re Hodges, 518 B.R. 445, declined to directly accept this theory.)  A Chapter 7 trustee may well face an uphill battle convincing a court to reverse current interpretations of law.  But this is not a frivolous argument, and at least one of the Oakland Chapter 7 trustees has stated that she intends to use this theory to pursue the asset if a case with this situation is assigned to her. If one of the trustees is looking into it, you can bet the others are, too.

Where does that leave you if you’re in such a situation?  Simply put, don’t convert.  Not now anyway.  You don’t want to be a test case.  Yes, the trustee may have an uphill battle in making this argument, but if she wins, your house will be liquidated and your appreciated value will be taken too.  The risk is just too great.

If you are a homeowner in a Chapter 13 case and are considering converting to Chapter 7, be very careful, and be sure to ask your attorney if he or she is familiar with this issue.

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