By Andrew J. Abrams
Boodell & Domanskis, LLC
In Smith v. SIPI, LLC (In re Smith), 811 F.3d 228 (7th Cir. 2016), the United States Court of Appeals for the Seventh Circuit found that a lawfully conducted sale of real estate under Illinois’ tax sale procedures can be avoided if the sale was not for “reasonably equivalent value” for purposes of Section 548(a)(1)(B) of the Bankruptcy Code. This decision is significant – particularly for attorneys in Illinois and other states that employ a similar “interest rate method” for collecting delinquent real estate taxes – in holding that, unlike with mortgage foreclosure sales, compliance with the Illinois tax sale procedures does not insulate a property’s tax sale to satisfy delinquent real estate taxes from avoidance actions.
Debtors Keith and Dawn Smith lived in a Joliet, Illinois property at the time of their 2007 bankruptcy filing. Real estate taxes went unpaid and, in 2001, the county auctioned the tax lien on the residence (but not the residence itself). Appellee SIPI, LLC purchased the tax lien by paying roughly $5,000 (the $4,046.26 in delinquent taxes and some miscellaneous costs). Debtors failed to redeem the property by paying SIPI the delinquent taxes (and applicable interest) and, therefore, SIPI applied for, obtained, and recorded its tax deed with the county on April 15, 2005. Then, only four months later, SIPI sold the property to Midwest Capital Investments, LLC for $50,000, making Midwest the title holder to the property.
Following their 2007 bankruptcy filing, Debtors filed an adversary complaint against SIPI and Midwest seeking to avoid the tax sale as a fraudulent transfer. The Bankruptcy Court conducted a trial and ultimately concluded that Debtors had proven a fraudulent transfer because the property was not transferred for reasonably equivalent value, limited the Debtors’ recovery from SIPI to $15,000 (the amount of Illinois’ homestead exemption), and found that Midwest had an absolute defense to liability as a subsequent transferee in good faith.
In particular, the Bankruptcy Court determined that the Supreme Court decision of BFP v. Resolution Trust Corp., 511 U.S. 531 (1994), did not apply to Illinois tax sales. The Supreme Court in BFP held that a mortgage foreclosure sale that complies with state law is necessarily for “reasonably equivalent value” as a matter of law, even where the forced sale process generates a sale prices well below the fair market value.
On appeal, the District Court reversed, finding that BFP did apply and, therefore, the tax sale could not be set aside as a fraudulent transfer because SIPI complied with applicable state law requirements. The Debtors appealed to the Seventh Circuit.
The Seventh Circuit Ruling:
The Seventh Circuit agreed with the Bankruptcy Court, finding that BFP did not apply to Illinois tax sales and affirmed the Bankruptcy Court’s holding that the transfer of the Debtors’ residence for roughly $5,000 was not for reasonably equivalent value based on the factors usually applied in Section 548 avoidance actions.
The Seventh Circuit reached this outcome after first highlighting how the Supreme Court in BFP noted that its decision “covers only mortgage foreclosures of real estate. The considerations bearing upon other foreclosures and forced sales (to satisfy fax liens, for example) may be different.” It then, following this direction, turned to the Illinois tax sales procedures and how they different from a judicial foreclosure.
Illinois uses what is referred to as the “interest rate method” for collecting delinquent real estate taxes. At a county tax auction, parties bid on the tax lien (not the property itself) by bidding not on the total price of the property but, instead, as decreasing interest percentages. The bidders, therefore, are bidding down, with the winning bidder being the one that demands the lowest penalty interest rate from the delinquent taxpayer to redeem the property. The Seventh Circuit cited how, in the vast majority of tax sales, the penalty percentage paid by the winning bidder is zero percent, meaning the ultimate purchase price of the property (although there is a risk the owner would redeem) is the amount of outstanding taxes. Many other states use the “overbid method,” where the bidding starts at the total amount of taxes and interest due, and bidders then bid the potential amount they would be willing to pay in return for title to the underlying property.
Unlike the overbid method, Illinois’ interest rate method means that “[t]here is no bidding on what the bidder would be willing to pay for the property itself, as with the overbid method” and “thus differs dramatically from the competitive bidding in BFP, which focused on ‘the context of [a] … sale of real estate.’” Bidders are bidding on who would accept the least amount in penalty interest (a floor) rather than who would pay the most for title to the property (with the fair market value being the ceiling). Given these “critical differences,” the Seventh Circuit agreed with the Bankruptcy Court and declined to extend BFP to Illinois tax sales. The Seventh Circuit distinguished decisions by the Fifth and Tenth Circuits applying BFP to tax sales because, in those cases, the states followed the “overbid” system (which is similar to the competitive bidding at the foreclosure sale in BFP).
The Seventh Circuit also agreed with the Bankruptcy Court’s award of $15,000 to Debtors – the amount of one Illinois homestead exemption as debtor Dawn Smith alone held title. The Seventh Circuit dismissed the Debtors’ claim to the entire property value because Debtors were both debtors and debtors in possession and argued that they were entitled to full trustee powers. The Seventh Circuit, instead, noted that Debtors had power to avoid the transfer pursuant to Section 522(h) (as reflecting property that could have been exempted if not for the prepetition transfer) and no authority existed allowing Debtors themselves to recover beyond the exempted value. Rather, any additional recovery would have been for the benefit of Debtors’ estate (and creditors).
Finally, the Seventh Circuit reasoned that SIPI was the initial transferee under Section 550 of the Bankruptcy Code and, liable to Debtors, while Midwest (which bought the property from SIPI) was the immediate subsequent transferee under Section 550(a)(2) of the Code. Midwest, therefore, could present a defense under Section 550(b)(a) of the Code that it took the property for value, in good faith, and without knowledge of the voidability of the transfer. The Seventh Circuit found that the Bankruptcy Court did not commit a “clear error” in determining after trial that Midwest proved these elements. The fact that Midwest knew there was a tax deed in the chain of title was not enough, according to the Seventh Circuit, to defat a finding of good faith where there was no evidence that Midwest knew the Debtors were insolvent or that the transfer to SIPI was for less than reasonably equivalent value.
What You Need to Know:
Seventh Circuit practitioners – and those in other states that employ the interest rate method for tax sales – can rely on this decision to undo tax sales of a debtor’s property where the amount paid was for less than reasonably equivalent value. This could create a meaningful recovery for trustees and creditors seeking to bring assets into a debtor’s estate, as well as debtors themselves where, like the Debtors here, they otherwise could raise a homest For those attorneys that advise buyers at tax sales, they should advise their clients that in the event of the owner’s subsequent bankruptcy, the sale could potentially be avoided.ead exemption.