by Where tax liens are specifically excepted from the debts to which a debtor’s exempt property cannot be liable, the debtors here could not exercise the trustee’s avoidance powers under section 522(h) to avoid their tax debt, nor could they benefit from the trustee’s successful avoidance action. Hutchinson v. IRS, No. 19-60065, amended opinion (9th Cir. Dec. 23, 2021).
When the debtors filed for chapter 7 bankruptcy, they owed taxes to the IRS. Of that debt, $162,000 represented penalties and was secured by a lien on the debtors’ home. The debtors filed a two-count adversary complaint. In the first count they alleged that because the IRS claim was tax penalty under section 726(a)(4), the lien securing it was avoidable by the trustee under section 724(a). They alleged that because the trustee had not avoided the lien, they could do so themselves under section 522(h), to the extent the lien encumbered their homestead. In the second count they sought to have the avoided lien preserved for their benefit rather than for the benefit of the estate. The trustee responded asserting his right to avoid the lien for the benefit of the estate. The IRS separately moved to dismiss the debtors’ complaint. The bankruptcy court granted the IRS motion to dismiss. Later, the court entered an order avoiding the lien upon motion by the trustee pursuant to section 724(a). The debtors appealed dismissal of their complaint, and the Bankruptcy Appellate Panel for the Ninth Circuit affirmed.
On appeal to the Ninth Circuit, that court found that the debtors could not avoid the IRS’s lien under section 522(h). That section permits a debtor to avoid a transfer when three conditions are met: 1) the transfer must be avoidable by the trustee under section 724(a), 2) the trustee must not attempt to avoid the transfer, and 3) the debtor could have exempted the property under section 522(g)(1) if the trustee had avoided the transfer. A further component of the third requirement is that the debtor could have exempted the property under section 522(b) “if such property had not been transferred.”
The debtors argued that because California law allows them to exempt homestead property up to $100,000, they could have exempted the property under section 522(b). The court disagreed. In section 522(c)(2)(B), Congress created an exception under which exempt property remains liable for tax liens. For that reason, in DeMarah v. United States (In re DeMarah), 62 F.3d 1248 (9th Cir. 1995), the Ninth Circuit held that a debtor may not avoid a tax lien under section 522(h) even though the trustee could have avoided the lien under section 724(a).
The court went on to say that even if it had the power and were inclined to reconsider the holding in DeMarah, the debtors appeal failed on the independent ground that the trustee, in fact, did avoid the tax lien. Therefore, the debtors did not meet the second requirement of section 522(h).
The court turned to whether the bankruptcy court properly preserved the avoided lien for the benefit of the estate rather than the debtors. Section 551 provides that a “transfer avoided under section . . . 724(a) . . . is preserved for the benefit of the estate but only with respect to property of the estate.”
The debtors argued that section 522(i)(2), which provides that a transfer avoided under section 724(a) may be preserved for the benefit of the debtor to the extent of a homestead exemption, overrides section 551. The court disagreed. It found that section 522(i)(2) itself was overridden by the bright-line rule in section 522(c)(2)(B) that debtors “lack the right to remove tax liens from their otherwise exempt property” without regard to whether the tax lien is avoided by the trustee. The court emphasized that section 522(h) cannot be used to “make an end run” around section 522(c)(2)(B). Because debtors cannot use their exemption rights to avoid a tax lien under section 522(c)(2)(B), the court found it would be incongruous to allow them to reap the benefit of the avoided lien under section 522(i)(2).
The court affirmed.