Homesteads and the Law on Remainders

A recent decision by the US Bankruptcy Court has invalidated certain so-called “Homestead” protections in real estate that will likely affect many Massachusetts residents. First, a little background:

Massachusetts, like many other states, has a Homestead Act that is designed to protect a significant part of Massachusetts residents’ equity in their primary residences. There are many technical details, but the basic idea is that the homeowner’s equity is automatically protected from creditors for up to $125,000, and that protection can be increased to $500,000 simply by recording the proper form with the Registry of Deeds. The protection provided by the Homestead Act also protects the homeowner’s equity if the homeowner files for bankruptcy. Here is a simple example: John and Mary properly record a homestead declaration on their primary residence (“Whiteacre”). Times get rough, and John and Mary file for bankruptcy protection. Whiteacre is worth $650,000, and the bank has a first mortgage on Whiteacre for $250,000. The bank has first priority ($250,000); John and Mary have the second priority because of their recorded homestead declaration ($500,000). Because these two priority rights add up to $750,000, which is more than the value Whiteacre, John and Mary get to keep Whiteacre (but they have to pay the bank). Other creditors, including the bankruptcy trustee, get nothing from Whiteacre.

Here is what can happen, though, if you do some estate planning, as was the case for Nicole Gordon. Nicole’s ownership in Whiteacre was a “remainder”. Nicole’s remainder arose because Nicole’s mother had a “life estate” in Whiteacre (which means that Nicole’s mother owned Whiteacre for her own lifetime), but upon her death, mom’s interest would automatically terminate, and Nicole’s remainder interest would automatically become full and complete ownership. Nicole had duly recorded the proper homestead declaration on her ownership of the remainder interest in Whiteacre. This is a common and quite appropriate device often used for estate planning and Medicare planning.

Then some bad things happened, and Nicole filed for Bankruptcy. In her filing, Nicole claimed her homestead exemption in the remainder interest that she owned in Whiteacre. The judge, however, disagreed. On March 13, 2013, a US Bankruptcy Appellate Panel of the First Circuit ruled that even though Nicole’s remainder was a recognized ownership interest in real estate, the Homestead Act failed to include a remainderman (such as Nicole) in its definitions of an “owner” for the purposes of homestead protection. As a result, Nicole lost her remainder interest, so when her mother dies, the Bankruptcy Trustee will automatically own the interest that Nicole had expected to have. Consequently, Nicole lost the house.

But take hope. There is a technical corrections act pending before the Massachusetts Legislature. It is by no means a sure thing, but if passed, the bill will correct this seemingly illogical result and will expressly include the owner of a remainder interest in a primary residence as an “owner” entitled to the protection of the Homestead Act. In the meantime, however, there are a lot of remaindermen out there whose careful estate planning has inadvertently wiped out their statutory homestead protection.