Who Benefits From Increased Home Value in a Chapter 13 – The Debtor or the Estate?

In a chapter 13 case, which typically lasts from 3 to 5 years while a debtor makes payments according to a plan, the value of the debtor’s property can fluctuate.   In a time like the present, when home prices are rising, sometimes dramatically, that could mean an increase in the value of a debtor’s home during the life of the chapter 13 which changes the financial dynamics in the case.  

The Bankruptcy Code provides that upon commencement of a bankruptcy case, an estate is created which is composed of all the debtor’s property (subject to certain exemptions and other considerations).  See 11 U.S.C. § 541.  In a Chapter 13 (which functions differently than a chapter 11), there is a process supervised by the Chapter 13 Trustee which involves the filing of a chapter 13 plan, usually early in the bankruptcy case.  The plan proposes the amount and timing of payments to creditors, and if confirmed, binds the debtor and all creditors to its terms.    In all cases, the plan must provide that all creditors be paid no less than if the debtor’s property were liquidated, with the proceeds used to pay creditors’ allowed claims.  Thus, part of the analysis of what must be paid under the plan involves a calculation of the equity in the debtor’s non-exempt assets.  Simply stated, the more non-exempt equity in the debtor’s assets, the more the debtor will likely have to pay in monthly plan payments to get a discharge.  If the plan is confirmed, the debtor will generally make monthly payments over a 3 to 5 year period.  

So, what happens to the chapter 13 plan when the value of the debtor’s home increases during the life of the case, and the debtor wants to sell the property and take advantage of the increase?  A New Jersey bankruptcy court recently looked at this issue, concluding that the debtor, not creditors, gets the benefit of the increase. 

Two seemingly inconsistent Code provisions govern this issue.  On one hand, Section 1306(a) provides that the estate includes all property “that the debtor acquires [and earns] after the commencement of the case but before the case is closed, dismissed or converted[.]”  On the other, Section 1327(b) (and many chapter 13 plans confirmed by bankruptcy courts) provides that property at confirmation is vested in the debtor.  And such vesting, under Section 1327(c), is “free and clear of any claim or interest of any creditor provided for by the plan.”

Courts adopting a so-called “estate preservation theory” focus on Section 1306(a) to the exclusion of Section 1327(b).  Under this theory, the estate continues post-confirmation, unchanged with the debtor merely obtaining a right to use the property.  Thus, any increase in value would inure to the benefit of the debtor’s creditors if the appreciated property were sold.

Other courts, focusing on Section 1327, use an “estate termination theory” which concludes that the bankruptcy estate ceases to exist altogether upon confirmation of the plan.  So any increase in value in property sold during the life of the plan would benefit only the debtor.

The New Jersey Bankruptcy Court in re Larzelere, 2021 Bankr. LEXIS 2318, 2021 WL 3745428 (Aug. 24, 2021) criticized both theories as rendering, as “superfluous,” one or the other provision of the Code.  Instead, the Larzelere court considered two other theories that tried to harmonize Sections 1306(a) and 1327(b).

The facts in Larzelere are simple.  On the bankruptcy petition date, an individual debtor valued his home at $219,000.  Under the plan, all property vested in the debtor upon confirmation.  Almost three years after confirmation, the debtor filed a motion in the bankruptcy court to sell the home for $348,000, and to use the excess proceeds to pay off his remaining plan payments early.  (The plan had provided for a payout of less than 100% to general unsecured creditors.) The Chapter 13 trustee objected to the sale, arguing that the estate was entitled to more so that creditors would now be paid in full.  Essentially, the trustee asked the court to find that the debtor’s estate (as opposed to the debtor individually) owned the property appreciation.

Larzelere addressed two “middle ground” approaches which some courts have used to reconcile Sections 1306(a) and 1327(b).  In the “estate transformation theory,” all property vests in the debtor at confirmation except for “property essential to the debtor’s performance of the plan[.]”  The Larzelere Court rejected this theory as impractical and difficult to implement. For one, it is sometimes hard to know whether property is essential to the debtor’s performance under a plan.  Second, even if that could be determined, the nature of property and a debtor’s needs are susceptible to change as the bankruptcy case progresses.  Property essential early on in a case may not be essential later.  This can leave creditors in the dark as to whether the automatic stay may be lifted under Section 362(d)(2), which allows the automatic stay to be lifted where property is no longer necessary for an effective reorganization.

Larzelere determined that, among the various competing theories, an “estate replenishment theory” was the most favorable.  Under this approach (the “majority view”), all property vests in the debtor upon confirmation.  The estate survives post-confirmation, with the estate being replenished with new property that the debtor acquires post-confirmation. 

Using this theory, the Larzelere court addressed whether the increase in value of the property constituted new property acquired by the debtor post-confirmation.  The court determined that the home which increased in value was not “new” property that replenished the estate, and rejected a view that would allow the home to be considered  a property interest separate from its value.  The Larzelere court thus sided with the debtor, holding that the appreciation accrued solely to the benefit of the debtor and not his estate. 

Given the high valuations in today’s real estate market, attorneys for individual New Jersey debtors with confirmed chapter 13 plans may want to notify their clients about this opinion to see if a sale of their home may make financial sense.