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Ninth Circuit Reverses District Court; Trustee Can't Avoid Tax Lien on Homestead

(Parker Tax Publishing December 2022)

In a case of first impression, a panel of the Ninth Circuit reversed a district court and held that the trustee in a Chapter 7 bankruptcy may not use 11 U.S.C. Section 724(a) to avoid an IRS tax penalty lien and thereby preserve its value for the benefit of the bankruptcy estate. The panel held that Section 724(a) concerns a trustee's avoidance of qualifying liens attached to the property of the bankruptcy estate at the time of distribution, and when a debtor exempts a property interest under 11 U.S.C. Section 522, the exemption withdraws that property interest from the bankruptcy estate and hence from the reach of the trustee for distribution to creditors. In re Tillman, 2022 PTC 358 (9th Cir. 2022).


In 2015, Sandra Tillman purchased a residence in Prescott, Arizona (the Prescott Property) and granted a mortgage to Bank of America. The Prescott Property became Tillman's homestead under Section 33-1101 of the Arizona Revised Statutes (A.R.S.). Tillman owed federal income tax for 2015 but failed to timely file a return or pay her 2015 taxes. The IRS assessed Tillman's 2015 income tax liability and related penalties and interest. Tillman eventually fully paid the original tax liability but did not fully pay the penalties and interest, which initially totaled over $18,000. In 2018, the IRS recorded a notice of a federal tax lien securing the penalties against the Prescott Property.

In 2019, Tillman filed a Chapter 7 bankruptcy petition. The IRS filed a claim for Tillman's 2015 tax penalty liabilities and indicated its claim was secured by the lien it had filed. Tillman claimed a homestead exemption of up to $150,000 on the Prescott Property under A.R.S. Section 33-1101 as in effect before January 1, 2022), which the bankruptcy court permitted. At that time, Tillman's mortgage was for $364,381 and the IRS's secured tax lien was for $24,686.

The Chapter 7 trustee filed an adversary proceeding and sought a summary judgment order (1) avoiding the federal tax lien on the Prescott Property under 11 U.S.C. Section 724(a), and (2) preserving the value of the avoided federal tax lien on the Prescott Property for the benefit of the bankruptcy estate under 11 U.S.C. Section 551. In In re Tillman, 2020 PTC 213 (Bankr. Ariz. 2020), the bankruptcy court granted the trustee's summary judgment motion. The government appealed, and a district court affirmed the bankruptcy court's judgment in full. The government then appealed to the Ninth Circuit. During the pendency of the appeal, Tillman found a buyer for the Prescott Property and moved for approval to sell. The bankruptcy court permitted the sale of the property for $475,000, of which Tillman was ordered to pay $378,062 to Bank of America to cover the cost of the mortgage. The bankruptcy court ordered the trustee, after paying costs and the mortgage, to set aside a portion of the proceeds equal to the total value of the IRS's tax lien, $26,771, pending the outcome of this case. The remaining proceeds, approximately $30,000, were provided to Tillman as the value of her homestead exemption.

After a bankruptcy petition is filed, 11 U.S.C. Section 541(a) provides that a bankruptcy estate is formed consisting of specified property interest of the debtor. In some circumstances, the debtor may exempt property, thereby removing it from the bankruptcy estate. The exemptions available to a debtor are enumerated in 11 U.S.C. Section 522. However, 11 U.S.C. Section 522(b)(1) authorizes state legislatures to opt out of the Section 522 exemption scheme and provide their own exemptions. Arizona has opted out of the Section 522 exemptions and provides its own exemptions, one of which is the homestead exemption in A.R.S. Section 33-1101. The Arizona homestead exemption permits a resident to exempt her interest in real property in which she resides, up to $150,000 in value (as in effect before January 1, 2022). Consensual loans such as mortgages are not subject to the Arizona homestead exemption. Thus, depending on the value of the property, a mortgage can diminish the value of the homestead exemption available to the homeowners. The Arizona homestead exemption does not provide for any reduction in the exemption amount for tax liens.

Under 11 U.S.C. Section 522(c), a debtor remains liable for certain debts secured by liens, such as tax liens, even if the debtor has exempted property from the reach of unsecured creditors. However, 11 U.S.C. Section 724(a) authorizes a trustee to avoid a lien that secures a type of claim specified in 11 U.S.C. Section 726(a)(4) for the estate. Section 726 deals generally with the distribution of property of the estate, and Section 726(a)(4), as relevant here, addresses claims for non-compensatory penalties. If a trustee avoids a lien using Section 724(a), then under 11 U.S.C. Section 551, the trustee steps into the shoes of the lienholder and can recover that property interest for the estate, thereby increasing the property of the estate available to satisfy claims of unsecured creditors.

The government argued that the bankruptcy court erred in holding that the trustee could avoid a tax lien for penalties on Tillman's exempt homestead property under 11 U.S.C. Section 724(a) and then use 11 U.S.C. Section 551 to take the value of the lien from Tillman's exemption and preserve it for the benefit of the bankruptcy estate. In the government's view, the bankruptcy court erred because Tillman's homestead exemption withdrew her exempt property from the property of the estate. Therefore, the government contended, the trustee could not use Sections 734(a) and 551 to avoid and preserve a lien on exempted property, because such property is not property of the estate.


A panel of the Ninth Circuit agreed with the government's position and reversed the district court. The panel noted that the issue of whether Sections 724 and 551 permit a trustee to avoid a lien secured by a debtor's exempt property was one of first impression before the Ninth Circuit.

The court reasoned that property interests held by a bankruptcy estate evolve over the course of the bankruptcy proceedings. The term "estate," in the court's view, refers to the property at a particular point in time - such as at the beginning of the case - rather than the estate in perpetuity. The court noted that under 11 U.S.C. Section 541, the property of the estate can be increased if the trustee can recover non-debtor interests in property through the various transfer and lien avoidance provisions of the Bankruptcy Code. Conversely, the court observed that the property interests of the estate may be reduced during the course of the bankruptcy by various means, including by a judicially authorized exemption. The general rule, according to the court, is that exempt property is withdrawn from the estate and immediately revests in the debtor.

The court noted that 11 U.S.C. Section 724(a) allows a trustee to avoid a lien that secures a claim of a kind specified in Section 726(a)(4). Section 726(a)(4), in turn, states that "property of the estate shall be distributed" in payment of any allowed claim for a fine arising before the earlier of the order for relief or the appointment of a trustee. Thus, the court determined that Section 724(a) applies to property that is part of the estate at the time of distribution based on its express reference to Section 726(a)(4). According to the court, when a debtor properly exempts a property interest under 11 U.S.C. Section 522, the exemption withdraws that property from the estate and, thus, from the reach of the trustee for distribution to creditors. Such an exempted property interest, the court said, revests with the debtor and no longer belongs to the estate. Accordingly, the court concluded that a trustee may not avoid a lien under Section 724(a) (that secures the kind of claim specified in Section 726(a)(4)) that is attached to exempt property which is no longer part of the estate.

The court therefore determined that Tillman was entitled to exempt up to the full $150,000 value of the homestead exemption interest permitted under the applicable version of Arizona's exemption law. The value of Tillman's homestead exemption, the court found, was not subject to a deduction of the IRS tax penalty lien. However, the court further found that Tillman took her exempt interest in the Prescott Property subject to the IRS penalty lien. In the court's view, the bankruptcy court's holding - that the trustee could avoid the IRS's tax lien on the exempt property and apply the value of the lien for the benefit of the bankruptcy estate, while Tillman's exempt homestead remained encumbered by the tax lien - created a troubling result of penalizing Tillman twice for the same debt. This outcome, the court observed, made Tillman worse off, which violated of the Bankruptcy Code's policy of giving debtors a fresh start. The court noted that under its holding, Tillman would be subject to the tax lien only once, as a surviving lien on her homestead exemption.

Observation: The panel concluded that its holding was consistent with the holding of In re Hutchinson, 2021 PTC 341 (9th Cir. 2021), in which the Ninth Circuit rejected the debtors' argument that IRS tax penalty liens which had been avoided by the trustee could be preserved for the benefit of the debtors to the extent of their homestead exemption. The panel observed that unlike in this case, in Hutchinson the court was not called on to resolve any dispute as to the applicability of Section 724(a) to the property at issue.

In a dissenting opinion, one judge reasoned that the panel should have affirmed the trustee's avoidance of the IRS's lien because the Bankruptcy Code creates no exception to the trustee's avoidance power for liens on exempt property. According to the dissenting judge, the plain text of Sections 724(a) and 726(a)(4) give a trustee the authority to avoid a federal tax penalty lien, and estate property does not evolve over the course of a bankruptcy proceeding. Rather, the judge opined that exempt property is protected from prepetition debts, but is not wholly removed from the bankruptcy estate.

For a discussion of relief provided to individuals in a chapter 7 bankruptcy, see Parker Tax ¶16,130. For a discussion of the discharge of taxes in bankruptcy, see Parker Tax ¶16,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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