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Tax Sales, Exemptions, and Fraudulent Transfers

Q: If a debtor files Bankruptcy after taxes are sold, the redemption period has expired, and the property is sold to a disinterested third party, can Bankruptcy still help them recover that property?

A: Kind of. The debtor is out of luck unless the redemption period expired within the 2 years prior to the filing. Then things get a lot more interesting. And that is exactly what happened in the Chapter 13 case of In re Smith.

Inheriting Property, Losing it to a Tax Sale

The Smiths inherited property in 2004 as to which 2001 real estate taxes had already been sold. Although they had until April 2005 to redeem the sold taxes by paying the tax amount plus statutory interest, they failed to do so. As a result the tax buyer was able to obtain a tax deed on April 15, 2005.

Filing Chapter 13 and an Adversary Complaint

Nearly 2 years later, on April 13, 2007, the Smiths filed a Chapter 13 case and Adversary Complaint to avoid the sale of their property pursuant to 11 USC 548. Their Adversary case was appealed all the way to the 7th Circuit.

When Was the Property Transferred?

The initial issue before the 7th Circuit was when the tax sale legally took place – that is, when it was “perfected.” Was it once the redemption period expired? Once the tax deed was issued? The Court determined the sale was perfected when the tax deed was issued.

With the date of perfection fixed, the next question was whether the issuance of a tax deed constituted the kind of transfer that can be undone via Bankruptcy – a Fraudulent or Preferential transfer. Certainly 11 U.S. 548(a)(1)(B) permits the Bankruptcy Trustee to avoid the transfer of an interest of the debtor in property of the Estate made within 2 years before the filing of the petition; but only if the debtor received less than reasonably equivalent value in exchange and was either insolvent when the transfer was made or became insolvent as a result.

Was Reasonably Equivalent Value Given?

The Court quickly determined that the Smiths were insolvent when the property was taken by the tax buyer. But had they received “reasonably equivalent value”? The winning bid at a Sheriff’s Sale is presumed to be a “fair and proper price” or “reasonably equivalent value,” so was this situation (a tax sale) like that one (a foreclosure?). The Court said “No.” So when the tax buyers attempted to rely on BFP v. Resolution Trust Corp., 511 U.S. 531, 114 S. Ct. 1757, 128 L. Ed. 2d 556 (1994) and claimed that the Smiths received “reasonably equivalent value,” the 7th Circuit distinguished that case. After all, it pertained to foreclosure sales and had already been distinguished in the context of tax sales. (See Williams v. City of Milwaukee (In re Williams), 473 B.R. 307, 320 (Bankr. E.D. Wis. 2012), aff’d in part, City of Milwaukee v. Gillespie, 487 B.R. 916 (E.D. Wis. 2013)).

Instead, the Court noted that the Illinois tax sale process does not provide for competitive bidding – unlike a Sheriff’s Sale. The only purpose for a tax sale is to deliver funds to the taxing body. There is essentially no relationship between the sale price and property value. State law allows for the tax buyer to potentially receive a windfall: but Bankruptcy law does not.

Using that standard, tax sales (virtually) always fail to satisfy 11 U.S.C. 548 and, as a result, will always constitute fraudulent transfers. Here, based on testimony, the Smiths’ property had an appraised value of nearly 20x the amount paid at the tax sale. Even the 3rd-party purchaser to whom the tax buyer sold the property only paid about half the appraised value. Regardless of the amount paid for the property, however, the key was that its value was greater than the Debtors’ homestead exemption ($15,000).

If The Transfer Was Invalid, Now What?

So if the issuance of a tax deed in this context constituted a “fraudulent transfer” that was invalid under Sec. 548 of the Bankruptcy Code, what was the proper remedy? Sec. 550(a)(1) of the Code allows for recovery from the initial transferee (the tax buyer), but what about the 3rd party purchaser? After all Sec. 550(b)(1) protects bona fide purchasers (“BFPs”) if they give value, in good faith, without any knowledge concerning the voidability of the transaction.

In this case the 7th Circuit found that merely because the 3rd party purchased a tax deed, and merely because the resulting tax deed arose from taxes bought at a sale, the buyer did not lose his BFP status altogether. Instead, his purchase is free and clear up to the value of relevant State-law exemptions ($15,000 per person) in the value of the property.

All’s Well That Ends…?

In this case the Debtors were able to retain up to $15,000 per person (their Illinois Homestead Exemption) in the value of the underlying property. Additionally, the debtors were awarded costs under Bankruptcy Rule 7054. Was it a “win” for the Debtors? It certainly wasn’t the total loss that it could have – and some would say should have – been.

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