By Zachary Levy.
Bankruptcy serves to provide a “fresh start” to individuals facing financial hardship. However, for those facing claims by multiple creditors for excessive debts, this new beginning might also mean “ground zero.” To avoid this result and protect a debtor’s equity in certain types of assets from creditors, legislators established bankruptcy exemptions. One prominent exemption—the homestead exemption—protects a certain amount of equity in an eligible debtor’s home. Homestead exemptions vary widely from state to state, and effective December 31, 2021, new legislation in Arizona drastically changed the state’s exemption. Arizona House Bill 2617 (AZ HB 2617) makes multiple amendments to statutes regarding judgment liens and the homestead exemption. The question remains—what effects will this change really have on debtors and creditors?
History of Arizona’s Homestead Exemption
Prior to the enactment of AZ HB 2617, A.R.S. § 33-1101 provided that any person 18 years of age or older who resided in the state was eligible for a homestead exemption not exceeding $150,000 in value. The statute clearly expressed that $150,000 in homestead equity was exempt from attachment, execution, and forced sale. Correspondingly, A.R.S. § 33-964 provided that “a judgment shall become a lien . . . on all real property of the judgment debtor except real property exempt from execution, including homestead property.” (Emphasis added).
Read together, these laws generally prevented judgment liens from attaching to the debtor’s homestead property. An unsecured creditor could go to court, receive a favorable judgment, and under A.R.S § 12-1551, obtain a property interest in the debtor’s home—a lien. But the homestead property was exempt from attachment and execution. This meant the debtor owned their homestead property, up to $150,000, “free and clear of the judgment lien.”
Under these laws, a savvy Arizona homeowner could make things quite difficult for a judgment creditor seeking to collect. Refinancing was a common path. Through a cash-out refinance, a debtor would replace their old home mortgage with a higher-value mortgage and receive the difference in cash. This effectively took the debtor’s equity out of the home and left a judgment creditor with no right to the proceeds because the homestead property evaded judicial liens.
The Increased Exemption
AZ HB 2617 notably departs from the prior regime in multiple ways, the first of which is beneficial to debtors. The new law increased the amount of Arizona’s homestead exemption from $150,000 to $250,000. This jump affords homeowners greater protection when facing bankruptcy and seems particularly appropriate considering the recent spikes in Arizona home equity. While this number certainly doesn’t fare well against the unlimited homestead exemptions of Florida and Texas, it moves considerably further away from the $25,150 federal homestead exemption and gives Arizona homeowners a reason to rejoice.
The Tradeoff
The other ways in which AZ HB 2617 departs from Arizona’s previous homestead exemption regime are far from beneficial to debtors.
First, a civil judgment now automatically becomes a lien attached to all real property of the debtor, including homestead property, after the creditor records the lien in the county where the property is located. This new automatic lien provision applies to all existing judgments, “without regard to when the judgment was recorded,” including all past civil judgments. Unless a debtor previously filed for bankruptcy and avoided all existing liens, old judgment creditors can “claw back” and attach their liens to debtors’ homestead property. Before, the home was sacred. Now, the creditor has leverage. If a debtor wishes to voluntarily sell their home, the judgment creditor must be paid off first. The Arizona Legislature has made clear that the debtor’s homestead is far from free of encumbrances.
Second, and perhaps most importantly, a judgment creditor is now entitled to the debtor’s proceeds from a cash-out refinance. “If the judgment debtor receives cash proceeds from refinancing the homestead property that is subject to a judgment lien, the judgment creditor must be paid in full from those proceeds before the judgment debtor.” The homestead exemption does not apply to these proceeds. The old refinancing trick has had its day. Now, when a debtor refinances their mortgage with the hopes of turning equity into cash and escaping creditors, the judgment creditor takes the first bite of the pie.
The Effects
What the Arizona legislature giveth, the Arizona legislature taketh away. AZ HB 2617 provides debtors with an increased homestead exemption, but at the same time attaches all past and future judgment liens to the debtor’s real property and inhibits debtors’ ability to “cash-out” their equity in a home through refinancing. It is helpful to separate the “in-bankruptcy” and “out-of-bankruptcy” effects of these changes.
In bankruptcy, the debtor benefits. The debtor can now exempt an additional $100,000 of their homestead equity and, even though it is subject to attachment by a judicial lien, that homestead equity remains safe from execution or forced sale. In the case of a forced sale of valuable property, the judgment creditor gets paid last—after the debtor’s exemption and after other liens with priority, such as a mortgage, are paid out. As a further protection, a debtor can still avoid a lien if it would impair the debtor’s ability to claim the exemption.
Outside of bankruptcy, the creditor benefits. The creditor has a judgment lien attached to the debtor’s real property and if the debtor voluntarily sells their property or pursues a cash-out refinance, the judgment creditor has priority over the debtor to the resulting cash proceeds. The debtor’s ability to liquidate their equity is diminished, and the encumbrance may make it difficult for homeowners with judgments to secure financing from third parties.
Ultimately, AZ HB 2617 will likely lead to a stressed Arizona judicial system—more debtors filing for bankruptcy in order to capitalize on their exemption and work around the attached liens, old creditors rushing to record their liens in order to reclaim their piece of the pie, and inevitably a great amount of litigation regarding the possible exploitation of both parties’ rights.
