Using Chapter 13 to Undo a New York Tax Foreclosure

A federal court’s ruling on a pair of recent chapter 13 New York bankruptcy cases in western New York gives debtors outside of New York City, unfortunately, an unusual opportunity for keeping their homes after a county tax foreclosure. A debtor in this situation must file in chapter 13 and propose a repayment plan that includes paying off the arrearages of the tax debt in full. Then the debtor must initiate an adversary proceeding against the county to argue, somewhat peculiarly, that the tax foreclosure was a “constructive fraudulent conveyance” from the debtor to the county. Here’re what that term means and how the federal district court arrived at its decision.

A “fraudulent conveyance,” which differs from a preference, happens when a debtor sells property to another party for much less than its value, the goal being to cheat the debtor’s creditors in a bankruptcy of the benefit of liquidating the property. Often the buyer in a fraudulent conveyance is a trusted acquaintance of the debtor, e.g. selling a diamond ring to a family member. In the context of a tax-lien foreclosure, the fraudulent conveyance is “constructive” in the sense that while the parties did not intend to fraudulently convey property, the result of the conveyance for legal purposes is essentially identical: The bankruptcy estate is diminished to the detriment of the other creditors. Here, the debtor is using the doctrine to try to undo the tax foreclosure and keep the home. It’s unusual because usually it’s the creditors or the trustee who alleges that a transfer is a fraudulent conveyance, not the debtor.

So what happened in Gunsalus v. Ontario County, No. 17-6810 (W.D. N.Y. July 18, 2018)?

Two couples of married debtors (four people total) were in legally identical circumstances. Ontario County, N.Y., foreclosed on the Gunsalus and Hamptons for failing to pay around $20,000 in property taxes. Ontario County auctioned the properties for the amount of the tax debts, i.e. about $20,000 each, which is well below both their market values and even their values in a standard mortgage-foreclosure auction. Both couples, who had previously owned their homes free and clear of any mortgages, filed in chapter 13, claimed the federal exemptions (to trigger the fraudulent conveyance statute), included the tax debts in their repayment plans, and initiated adversary proceedings against the county alleging that the tax foreclosures were constructive fraudulent conveyances. After combining their cases to decide the issue, the bankruptcy court sided with the county, but a federal district court reversed the decision on appeal.

At issue was the fourth element of section 548(a) of the Bankruptcy Code’s elements for a fraudulent conveyance, which is the debtor receiving less than “reasonably equivalent value” for the transferred property. In normal fraudulent conveyances, the “reasonably equivalent value” is the fair market value of the property. However, in the context of a conventional, creditor-initiated real-estate foreclosure, the U.S. Supreme Court held in a 1994 case that the “reasonably equivalent value” was the actual sale value of the property, so long as the parties adhered to state foreclosure laws. The Court decided that mortgage foreclosures should not be treated as typical market exchanges, and that most states designed their foreclosure laws to avoid the draconian results of strict foreclosure actions in which the debtor would recover no surplus equity from the mortgage sale.

Ontario County and the Gunsalus and Hamptons disputed whether that 1994 case applied in the tax-lien context. Essentially, the county argued that it was entitled to a strict foreclosure situation in which it could keep the equity from the foreclosure auction and deny it to the debtors. For their part, the debtors argued that by keeping the equity, the tax foreclosure resulted in a fraudulent conveyance.

The district court determined that the facts in the tax foreclosures differed from those in the 1994 case the county was relying on because a tax foreclosure eliminates market forces entirely, and the sale values of the properties did not at all correspond to their values. The court then rejected the county’s policy arguments.

It’s possible that a higher federal court could overturn the district court’s ruling and restore the bankruptcy court’s original holding in the cases, but the district court’s reasoning appears persuasive.

The good news for debtors, then, is if they lose their properties to a New York tax foreclosure, then they can use chapter 13 to get them back, as the Gunsalus and Hamptons did. The snag, as discussed above, is that it’s limited to debtors outside of New York City’s five counties. This is because either the City takes title to the property, or it sells the lien to someone who must commence a regular foreclosure. Consequently, the situation won’t come up.

Regardless of your circumstances, if you are facing a tax-lien foreclosure, then it’s crucial to have an experienced New York bankruptcy lawyer handle your case.

For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy attorney Bruce Weiner for a free initial consultation.

Rosenberg, Musso & Weiner, L.L.P
26 Court St # 2211
Brooklyn, NY 11242, USA

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