Selling Property Before Filing for Bankruptcy

You're allowed to protect (exempt) a certain amount of property when filing for bankruptcy using bankruptcy exemptions. Selling or transferring nonexempt property before bankruptcy can be a risky proposition. Although it's allowed in some cases, if done incorrectly—especially if you're trying to avoid paying creditors—you could face severe consequences.

What Is Exempt Property?

Exempt property cannot be taken by creditors to satisfy a judgment against you, and, when you file for bankruptcy, you're allowed to keep this property. Typical examples of exempt property include:

• some equity in your primary residence and a motor vehicle
• household goods and clothing, and
• Erisa-qualified retirement accounts.

State law determines which property you'll be able to protect. Every state has its own set of exemptions, but some states let you choose either the state exemptions or the federal exemption scheme. Nonexempt property is all of your property that you can't protect with an exemption.

Here's what happens to nonexempt property under the two primary bankruptcy chapters:

• In Chapter 7 bankruptcy, the bankruptcy trustee will sell nonexempt property and use the proceeds to pay your unsecured creditors (those creditors whose debts aren't secured by collateral).
• In Chapter 13 bankruptcy, you'll need to pay your unsecured creditors your disposable income or an amount equal to the value of your nonexempt property, whichever is greater.

You can find out more about your bankruptcy options by reading What Are the Differences Between Chapter 7 and Chapter 13 Bankruptcy?

When Can I Sell Nonexempt Property?

You own your property. You have the right to sell it before you file for bankruptcy. However, you must pay your creditors, too—and intentionally taking steps to deprive them of funds can rise to the level of fraud.

Although selling property when anticipating filing for bankruptcy can be tricky, it can be done. Here's the safe zone.

• It's okay to sell property when you need necessities. If you need money to make rent, buy food, buy you or your children clothing, or pay for medical costs, by all means, sell the boat or some other luxury item and use the proceeds to buy the things you need to live. Just sell it for what it's worth and keep good records (more below). The simple reality is that most people are cash poor before filing for bankruptcy, and you can sell property and use the money for necessities.
• Otherwise, get legal advice first. If, on the other hand, you'd like to sell property for any other reason, meet with a bankruptcy lawyer. The attorney will either be able to help you accomplish your goals the right way, or will explain why saving a little money isn't worth finding yourself in hot water with the bankruptcy court.

(Learn more about getting bankruptcy help by reading What Should I Expect From My Bankruptcy Lawyer?)

Problems Associated With Selling Nonexempt Property

Nonexempt property usually involves luxury items that aren't needed to maintain employment and a household, and are the first to go when money gets tight. Whether a pre-bankruptcy transfer or sale of property will land you in hot water will depend on the following factors:

• whether the property was exempt or nonexempt
• when you made the transfer
• whether you received fair market value for the property
• how you spent the proceeds, and
• why you made the transfer.

Here's how the court might look at each of these elements.

Did You Engage in Pre-Bankruptcy Planning?

Selling exempt property before you file for bankruptcy isn't a problem because the trustee couldn't have liquidated the property anyway. But there's little reason to sell exempt property that would be protected in bankruptcy.

On the other hand, it would be ideal if you could sell all of your nonexempt property and use the proceeds to buy more exempt property or pay down liens or mortgages on exempt property. This, however, is where it gets risky.

Selling nonexempt property to maximize or enhance your exemptions when you know or suspect that you will file for bankruptcy is generally referred to as "pre-bankruptcy planning." The bankruptcy laws discourage pre-bankruptcy planning, especially when done with the intent to hinder, delay or defraud creditors.

(Learn what happens when the bankruptcy trustee suspects fraud.)

How Long Ago Was the Transfer?

The court can look back in time and investigate a pre-bankruptcy transfer or sale of property. How far back the court will look varies depending on the type of property involved and the reason for the transfer. In most cases, the review period spans a year or two; however, with certain types of transfers, the court can look back as far as ten years.

You'll disclose prior transactions on official form Your Statement of Financial Affairs for Individuals Filing for Bankruptcy when you fill out your bankruptcy paperwork.

Did You Receive Fair Market Value for the Property?

Whether you received fair market value for the asset can play a role in determining whether the transfer was done to hinder, delay or defraud creditors. If you did not receive fair value for property transferred, the bankruptcy trustee might file a lawsuit (called an adversary proceeding) to recover the transferred property.

Once the trustee recovers the property, the person who received the transfer could make a bankruptcy claim to try to get the money back. If you could have claimed the property as exempt, you'd likely lose your exemption right.

(Find out more by reading What Is a Fraudulent Transfer in Bankruptcy?)

What Did You Buy With the Proceeds?

If you purchased new exempt property, increased the value of the existing exempt property, favored a particular creditor over others, or purchased luxury services, such as an expensive vacation, it's likely the transfer will come under scrutiny. Here's what could happen in your case:

If you prefer one creditor over others by paying down the debt owed to that one creditor with the proceeds or property, the trustee could file a lawsuit against the creditor to recover the payment or the property so that the proceeds can be used to pay all creditors equally. This applies to payments made to general creditors within 90 days before the bankruptcy filing and insider creditors, such as family, within a year before the bankruptcy filing.

If you purchased new exempt property or increased the value of your exemptions, the court could disallow the exemption, limit the amount of the exemption, or deny your discharge entirely, depending on what your intent was behind the transfer.

(For more information, see Pre-Bankruptcy Payments to Creditors: Can the Trustee Get the Money Back?)

What Was Your Intent When You Made the Transfer?

The court will attempt to infer your intent from the circumstances surrounding the transfer and will also consider your testimony. Every case is different, and you can't rely too heavily on what was allowed in the past to determine whether a particular transfer you make will be allowable.

Courts often look for "badges of fraud" to determine your intent, which may include a review of:

• whether you received fair value for the property
• whether you retained control over the property
• your financial condition at the time of or just after the transfer
• whether the transfer was to a family member or other person close to you
• whether the transfer was in response to someone's threat to sue you
• whether you concealed the transfer, and
• what you had left after the transfer.

Rules Preventing You From Sheltering Nonexempt Funds in Exempt Residential Property

If you sell nonexempt property within 1,215 days prior to your bankruptcy filing and use the proceeds to increase the value of your homestead residence (by paying down the mortgage, making improvements, or buying a more expensive house), the court can reduce your state homestead exemption by the amount of the enhancement to the extent that the value exceeds a set limit. (The cap amount changes periodically. See The Homestead Exemption in Bankruptcy for the current amount.) Under these circumstances, the court doesn't have to consider your intent behind the sale.

Simply repairing or maintaining your residence, or using sale proceeds to make your regular mortgage payment shouldn't trigger the reduction. This rule also doesn't apply to proceeds transferred from a prior residence into a new residence in the same state, or at all if you qualify as a family farmer.

To learn more about pre-bankruptcy planning, and actions to avoid before bankruptcy, see Bankruptcy Filing Considerations.