By Andrew J. Abrams
Boodell & Domanskis, LLC
Chicago, Illinois
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.
What Happened:
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.
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