United States: Property Tax Interest Rate: Does "Nonbankruptcy Law" Include Law Specifically Limited To Bankruptcy?

Last Updated: August 23 2013
Article by Vicki R. Harding

In re Fowler , 493 B.R. 148 (Bankr. E.D. Cal. 2012) –

A chapter 13 debtor had two secured creditors:  a bank that held a deed of trust on the debtor's residence, and a county that had a lien on the residence for unpaid real property taxes.  The debtor's chapter 13 plan provided for payments to the two secured creditors, with nothing for the general unsecured creditors.  The plan called for payment of the real property taxes over time with 4% interest.  The plan was challenged on the basis that 18% per annum was the proper interest rate for the taxes based on a state statute setting a rate applicable specifically to tax claims in a bankruptcy.

Historically bankruptcy debtors argued that property tax claims should be treated the same as any other secured claim.  All that was required was to offer a payment stream that had a net present value equal to the value of the property – resulting in a standard evaluation of the appropriate interest rate for a secured claim.  (See, for example, Prime-Plus Cramdown Rate: You Can Forget Market Reality.)

However, the 2005 amendments to the Bankruptcy Code (BAPCPA) included several provisions designed to improve the status of property tax claims.  One of those changes was the addition of Section 511 of the Bankruptcy Code, which requires that payment of interest on a tax claim or payment of interest to enable receipt of the present value of a tax claim "shall be the rate determined under applicable nonbankruptcy law."  The expectation was that this would lead to significantly higher interest rates, since generally the interest rates in delinquent property tax statutes will be substantially in excess of market rates (barring a return to the astronomical interest rates of the 1970's).

In this case the applicable state statute generally established "redemption penalties" on unpaid tax obligations of 1-1/2% per month (i.e. 18% per annum), and then specifically stated that the amount calculated under the standard redemption provision "constitutes the assessment of interest" on tax claims in the context of a bankruptcy.

The debtor argued that this statute was unconstitutional and preempted because it was a "bankruptcy specific" statute that had a disparate impact on bankruptcy and nonbankruptcy debtors. (With respect to disparate impact, the debtor contended that a bankruptcy debtor would be able to claim a federal deduction for interest paid, while a non-bankruptcy debtor would not.)  According to the debtor, the reference to "applicable nonbankruptcy law" in Section 511 was not intended to include laws that are specifically limited to bankruptcy cases.

In fact, a prior bankruptcy court cited by the debtor and quoted by the Fowler court held in In re Collier, 416 B.R. 713 (Bankr. N.D. Cal. 2008) that the state statute was preempted because:

Congress' intent in enacting 11 U.S.C. §511(a) was clearly to prevent any distinction between bankruptcy and nonbankruptcy debtors with respect to the interest rate imposed on delinquent tax claims.  The thrust of [the state statute] is directly opposed to that intent:  i.e., it creates a distinction between the two types of taxpayers.

However, the Fowler court disagreed.  It did not find any basis for the Collier court's conclusion that the intent of Section 511 was to prevent any distinction between bankruptcy and nonbankruptcy debtors.

In addition, it did not buy the debtor's argument that there was non-uniform treatment of bankruptcy and nonbankruptcy debtors:  First, both groups paid 18% on delinquent taxes.

Second, the court noted that, contrary to the debtor's assertion that there were no cases, the U.S. Tax Court had concluded that, regardless of whether the state statute called the charge a penalty, the payments had the characteristics of interest and would be treated as such.

On this second point, the court also acknowledged a 9th Circuit opinion finding that "redemption penalties are just that, penalties, and not interest."  However, this case was decided in the context of a claim for a refund for an entity that was entitled to a refund of penalties that were not secured by a lien.  Subsequently, the statute was amended to provide that "every tax, penalty or interest, including redemption penalty or interest, on real estate is a lien against the property assessed."  The Fowler court felt that the reference to "redemption penalty or interest" was supportive of its position that there was no real distinction.

Third, the debtor also argued that this was an attempt to thwart the priority scheme of the Bankruptcy Code.  Specifically Section 726(a)(4) provides that to the extent that any "fine, penalty, forfeiture, or damages [is] not compensation for actual pecuniary loss" suffered by the holder of the claim, it is to be treated as an administrative expense, regardless of whether the related claim itself is secured or unsecured.

The Fowler court speculated that the debtor obtained this third argument from an unpublished decision of a bankruptcy court (available only through that court's website).  This decision held that the state statute's attempt to re-label a penalty as interest that could be included as part of an allowed secure claim was in direct conflict with Section 726.  However, this decision was before enactment of Section 511.  Without Section 511, interest had to be set at a "reasonable" rate in order to be allowed; whereas under Section 511, the rate for property taxes is whatever rate is set by nonbankruptcy law.  So, the Fowler court concluded that there was no longer a conflict.

The bottom line according to the Fowler court was that (1) "nonbankruptcy law" includes state statutes that are specific to bankruptcy, and (2) the state statute in this case was not preempted.

It took about a year to litigate this issue, ultimately resulting in this decision upholding the objection to the plan as proposed.  It is interesting that the debtor had the resources to pursue this matter to the end.  The unpaid real property taxes were ~$968.  The debtor proposed to pay the taxes at a rate of $18 per month with 4% interest.  While 18% is four and a half times as much as 4%, the actual dollar amounts involved were very small.  (Just for the record, shortly after the court issued its decision, the debtor filed a modified plan that was confirmed a couple of months later.)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Vicki R. Harding
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