Why STATE Property Exemption Laws Can Be Used in FEDERAL Bankruptcies

The U.S. Constitution makes bankruptcy a federal procedure. So how come it’s different in every state because of the property you can protect?

The Constitution makes it sound like a bankruptcy case should be the same in every state. It says that Congress has the power “to establish… uniform Laws on the subject of Bankruptcies throughout the United States.” Article 1, Section 8, Clause 4.

But bankruptcies don’t sound like they are governed by “uniform Laws” if the residents of one state get to exempt (protect) way more of what they own than residents of another state. For example, 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 an hour’s drive to the east on I-10 in Pensacola, Florida, you can exempt an unlimited amount of value in your home (Art. X, Sect. 4, Fla. Const.).

How can the supposedly “uniform” bankruptcy laws be applied so differently in different states?

A Compromise

The reason is that the current law—created in the late 1970s—is a major political compromise involving the most basic tension in the Constitution– states’ rights versus federal power. (Remember, we fought the Civil War about this.)

The issue here is whether a federal set of property exemptions would be required for everyone throughout the country filing bankruptcy, or whether instead each state would be able to create its own separate exemptions to be applied to their residents filing bankruptcy. The compromise—quite firmly in favor of states’ rights—is that the Bankruptcy Code does contain a federal set of exemptions, but each state is allowed to “opt-out” of those federal exemptions and require its residents to use that state’s exemptions when filing bankruptcy.

So, if you live in one of 32 states, you cannot use the federal exemptions. Instead you must use your state’s separate set of exemptions. In the remaining 18 states and the District of Columbia, you can use either the federal or local exemptions.

A Long Time Coming

Before this was settled, it was probably the most contentious issue in bankruptcy law. In fact, it’s a big part of why we didn’t even HAVE a bankruptcy law during most of the 1800s.

Throughout that century, an ongoing political and economic fight raged between bankers mostly in the Northeast against farmers and small merchants mostly in the South and West. Because of regular cycles of financial “panics,” the farmers and merchants endured a pattern of losing their homes and farms to out-of-state creditors. Because of this, the first law exempting certain property from creditors was adopted in 1839 in Texas even before it became a state. From this exemption laws spread quickly through the South and the Midwest during the 1840s and 1850s.

Three different times during this same century, Congress passed a set of bankruptcy laws, each time to address the fallout from one of the reoccurring financial panics. But none of the 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.

So our latest late-1970s compromise was a long time coming. Some in Congress wanted to continue using state exemptions as in the 1898 law, while others wanted a mandatory uniform federal system. The compromise was that each state was given a choice: it could let its residents file bankruptcy using EITHER a new set of federal exemptions or the state’s exemptions, OR each state could require its residents to use the state’s exemptions.

The end result is that in every state’s residents are either allowed or required to use their state’s exemptions, while in 18 states residents also have the option to use the federal exemptions. Between states’ rights and federal power, it sure looks like this favors states’ right. The result is that bankruptcies can look quite different from one state to another, in spite of the “uniform Laws” requirement in the Constitution. That’s certainly true if you own a home with a sizeable amount of equity on one side of the Alabama-Florida border versus the other.

For those of you who live in California, it can get even more confusing. California opted out of the federal system but has two different sets of state exemptions that a debtor can use. Please note however, that the California debtor must pick one or the other exemption statutes; you can’t comingle. And the different exemption statutes can have a dramatic effect on the outcome of your case. Another reason why, if you are thinking about filing for bankruptcy in California, you need competent legal advice.