Even a Tax Authority May Sometimes Have to Pay

by Pepper Hamilton LLP
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This article was published in Law360 on August 27, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360. It is reprinted here with permission.

In Clinton County Treasurer v. Wolinsky, 511 B.R. 34 (N.D.N.Y. 2014), a Chapter 7 trustee sought to avoid a property tax foreclosure as a fraudulent transfer and then to recover damages from the foreclosing county. The bankruptcy court agreed that the transfer was a fraudulent conveyance, but awarded only about half of the damages requested by the trustee. Both the county treasurer and the trustee appealed.

Section 548 of the Bankruptcy Code allows a trustee to avoid both actual and constructive fraudulent transfers. In particular a transfer of property may be avoided if (1) the debtor has an interest in the property, (2) which is transferred within two years before the bankruptcy, (3) when the debtor was insolvent or became insolvent as a result of the transfer, and (4) the debtor received less than reasonably equivalent value for the transfer.

The county treasurer did not dispute the trustee on a factual basis but rather relied on an argument that a tax foreclosure sale results in reasonably equivalent value as a matter of law. The district court acknowledged that the U.S. Supreme Court concluded that regularly conducted mortgage foreclosure sales result in reasonably equivalent value as a matter of law and cannot be avoided (see BFP v. Resolution Trust Corp., 511 U.S. 531, 114 S. Ct. 1757, 128 L. Ed. 2d 556 (1994)). However, the Supreme Court specifically reserved its opinion on “other foreclosures and forced sales (to satisfy tax liens, for example).” Given the differences between mortgage and in rem tax foreclosures, the district court was not persuaded that the BFP analysis was applicable to a tax forfeiture.

The court also specifically rejected the county’s argument that avoidance “injures a municipality’s right to collect unpaid property taxes in foreclosure proceedings.” Instead, the court concluded that the “general policy favoring equal treatment of creditors” meant that the county should not be “enriched to the detriment of other creditors.”

Finally, the court noted that the question of fraudulent intent was not relevant. A constructive fraudulent conveyance can be avoided regardless of intent.

Turning to the trustee’s appeal, under Section 550 of the Bankruptcy Code, if a transfer is avoided the trustee can either recover the property or the “value” of the property. Generally courts use the market value of the property at the time of transfer less any consideration. The objective is to return the value lost as a result of the transfer.

In this case, the trustee sought to recover the assessed value of the property at the time of the transfer ($42,000) less the delinquent taxes, while the bankruptcy court allowed recovery of only the amount realized by the county at an auction sale held approximately two months after the transfer ($25,500 less taxes and expenses).

The district court believed that the $25,500 resulting from a public auction was more appropriate than the $42,000 assessed value. In addition, the court agreed that awarding damages in excess of what the county was able to collect would inequitably penalize the county.

Consequently, the court (1) agreed with the bankruptcy court that the trustee could avoid the tax foreclosure transfer and (2) concluded that the award of damages based on $25,500 as an estimate of market value was not clearly erroneous.

For jurisdictions where the tax authority first “forecloses” (or more accurately forfeits) property in satisfaction of outstanding property taxes, and then resells the property so that it obtains the benefit of any equity in the property (as opposed to the property owner), there is a clear risk that the tax authority could be forced to pay “market value” less the amount of the delinquent property taxes, particularly if the property owner subsequently files bankruptcy. Note that this exposure could extend for more than two years if the trustee asserts a fraudulent transfer claim under state law using its strong-arm powers under Section 544.

In one sense, this is only fair. In a tax foreclosure process that exposes the property to a public auction, where the taxing authority retains the amount of the delinquent taxes and the property owner (or other parties with an interest to the property) receive the benefit of any equity, this would not be an issue. In fact, an argument can be made that a tax authority’s appropriation of the property owner’s equity in a strict foreclosure process constitutes an unconstitutional taking.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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