Making Sense of Bankruptcy: Using State Property Exemptions in Federal Bankruptcy

 Posted on August 12, 2015 in Bankruptcy

The U.S. Constitution makes bankruptcy a federal procedure. So why is the amount of assets you can protect different in each state?

The sentence we’re explaining today is:

The Constitution gives Congress power to make “uniform Laws” on bankruptcy, yet for much of our history it has had trouble doing so in part because of competition between states’ vs. federal powers, which eventually resulted in a compromise allowing each state to require debtors filing bankruptcy to use that state’s set of property exemptions instead of the federal one.

The Power to “Establish... Uniform Laws on the Subject of Bankruptcies”

From the beginning, and without change throughout our history, the U.S. Constitution has said that Congress has the power “to establish… uniform Laws on the subject of Bankruptcies throughout the United States.” Article 1, Section 8, Clause 4. The reason this was put into the Constitution was that the Framers wanted to economically unify the states, and for each state to have its own bankruptcy laws and procedures would instead cause conflicts among states and their residents.

This clause in the Constitution about “uniform laws on... Bankruptcies throughout the United States” makes it sound like filing a bankruptcy case should be the same in every state. But in fact two bankruptcy cases with the same facts could play out quite differently in different states. That’s because of two main reasons.

First, there are many areas of law that are reserved by the Constitution to the states ,and those state laws can greatly affect how the federal bankruptcy laws are applied. Some areas of state laws that affect bankruptcies include: personal property and real estate, marriage and divorce, state income and property taxes, insurance, personal injury, criminal, and debt collection. For example, federal bankruptcy law says that all of your assets at the time of filing are part of the “bankruptcy estate,” but it is state law that determines what belongs to you and what belongs to your spouse.

Second, the federal Bankruptcy Code explicitly allows certain aspects of bankruptcy law to be applied differently state by state. Perhaps the most important of these is that each state is allowed to decide whether people filing bankruptcy in that state must use that state’s list of property exemptions or can use the federal one contained in the Bankruptcy Code. Exemptions are a crucial part of bankruptcy law and procedure. They determine whether you can protect all of your assets when you file a Chapter 7 “straight bankruptcy” case, and they affect how much you have to pay to your creditors in a Chapter 13 “adjustment of debts” case. Differences in property exemptions from state to state, and between your state and the federal exemptions can have a big practical effect on your bankruptcy case.

For a rather extreme example involving two neighboring states’ homestead exemptions, you can exempt only $5,000 of value in your home if you live in Mobile, Alabama (Ala. Code Sect. 6-10-2), but if you live just 60 miles to the east in Pensacola, Florida, you can exempt an unlimited amount of value in your home (Art. X, Sect. 4, Fla. Const.).

How did it happen that the supposedly “uniform” bankruptcy laws ended up being applied so very differently in different states?

The Contentious History

Believe it or not this very issue has been fought over about throughout much of our country’s history. In fact it’s arguably part of why we didn’t have ANY bankruptcy law most of our first 110 years or so.

Through the late 1700s and much of the 1800s the economy went through a series of financial “panics.” During these farmers and merchants, particularly in the southern and western regions of the country, would lose their homes, farms and businesses, often to out-of-state creditors in the northeast. Because of this, laws exempting certain property from creditors were adopted and spread quickly through the South and the Midwest during the 1840s and 1850s.

Three different times during the 1800s Congress passed a set of bankruptcy laws, each time to address one of the reoccurring financial panics. But because of the disagreements among the states, and between the federal government and the state, none of these bankruptcy laws stayed in force for long, expiring or being repealed as soon as the economy improved. With no federal bankruptcy law in effect most of the time, various kinds of state laws tried to fill the gap in various ways, including through property exemptions.

The first “permanent” bankruptcy law was passed in 1898, but it could only muster enough votes in Congress by letting states continue to use their own system of exemptions for bankruptcies filed by their residents.

The Big Compromise

This brings us to the latest total overhaul of federal bankruptcy law in the late-1970s. At that point some in Congress wanted to continue using state exemptions as in the 1898 law, while others wanted a mandatory uniform federal system. A compromise was struck giving each state a choice: it could either require its residents to use the state’s own set of exemptions, or else let them use either a new set of federal exemptions or the state’s exemptions.

As a result in every state its residents filing bankruptcy can use their state’s exemptions, while 19 states (plus the District of Columbia) have chosen to also give their residents the option of using the federal exemptions. Those 19 states are Alaska, Arkansas, Connecticut, Hawaii, Kentucky, Massachusetts, Michigan, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Oregon, Pennsylvania, Rhode Island, Texas, Vermont, Washington, and Wisconsin.

So, that’s why bankruptcies, and particularly property exemptions, can look quite different from one state to another, in spite of the “uniform Laws” language of the Constitution.