Mortgage Debt, Investment Property, and other Bankruptcy News
By Zachariah Larson, Esq.

Bankruptcy law is fascinating in how it so often intersects with other areas of law. An automatic stay can stop litigating parties in their tracks in state court and drag them into federal court to preserve their claims. A million dollar judgment can be discharged in a bankruptcy proceeding when collection seems imminent, and a personal injury claim that is not yet finalized can be utilized for the benefits of creditors in a bankruptcy estate. Is that fair? According to Congress, the answer is “yes” and some debtors believe it is the American way.

Where previously all eyes were turned toward the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) and the subsequent rush of debtors to file before new laws went into effect in October of 2005, public attention is now focused on foreclosures, the credit crunch, the economic downturn, and the tax implications for those with properties that are upside down. As Southern Nevada is one of the poster children for the fallout of wild real estate speculation, it is important to look at the exact implications of a new Act signed by Congress. In addressing the subprime crises, and the real estate meltdown, Congress recently passed the Mortgage Forgiveness Debt Relief Act of 2007 (Act) providing in part for a modification of the Internal Revenue Code § 108 (covering whether discharged debt qualifies as income) to add a new subsection that provides for an exception to considering forgiven debt from foreclosures or short sales on primary residences as gross income for tax purposes. In short, if your primary residence is foreclosed on and you owe more on the mortgage than what the house is worth, you will not realize a gain for tax purposes pursuant to the Act.

THE TRAP: The Act only protects those who are losing their primary residence. The Act does not protect a taxable event triggering on investment property that is lost through either foreclosure, a short-sale, or given back via a deed in lieu. I repeat: the Act does not protect a taxable event triggering on investment property that is lost through either foreclosure, a short-sale, or given back via a deed in lieu! I emphasize this because almost every mortgage broker, real estate agent, accountant, and John Q. Public I have consulted with do not understand this possibly devastating consequence and believe the Act will protect them from dreaded ‘ghost income.’ Simply put, it does not.

The Act only protects those individuals who have acquisition debt on a primary residence up to two million dollars. The Act only applies to debt discharged in 2007, 2008, and 2009 (i.e., your foreclosure must happen during one of those fiscal years), and the Act does not apply to the debt incurred by those who “cashed out” or refinanced their primary residence. The Act also seems to apply only to a loss of a house because of the borrower’s financial condition or a decline in the home’s value. So, if you sign a deed in lieu, or do a short-sale, are you covered? Who knows, we are not there yet, but if I were a gambling man (ok, I am) I would not play chicken with the Internal Revenue Service.

In other words, if you are upside down in your house because you have cashed out your equity, and the cash out money was not used to remodel or add value to your primary residence, you are still going to be hit with ghost income for all the debt you incurred over and above the initial acquisition cost of your primary residence.

For a lot of people who utilized their home as an ATM in the days of boom, or whose total mortgage debt exceeds two million dollars, this spells big trouble. Why? Because when you lose a house in foreclosure, via a short sale, or by signing a deed in lieu, the lender will often times issue you a 1099-C for forgiveness of debt. Once this happens, your client is out of luck and is going to be on the hook for the taxes on ghost income not covered by the Act.

Bottom-line...if you have clients who are about to lose, or may lose multiple properties, please immediately tell them that it is time to immediately seek bankruptcy and/or tax advice. Additionally, while President George W. Bush signed the Mortgage Forgiveness Act into law, he has hinted that he may not sign another attempt by Congress to improve the fortunes of homeowners falling on hard times. The Foreclosure Prevention Act of 2008, as proposed, would in part allow for a broadening of circumstances in which a bankruptcy court could modify a mortgage for the debtor. Until such time any new laws are passed and set in stone, please understand the ramifications of giving up a primary residence or investment properties. Now that we have addressed the pesky real estate downturn and related tax issues, here are some other recent developments in bankruptcy law.

Bad faith bars conversion of Chapter 7 case to Chapter 13
BAPCPA came into effect and changed the circumstances under which a debtor could file for Chapter 13, as opposed to Chapter 7, relief. Normally, one can move to convert from one chapter to another if the need arises. In the recent U.S. Supreme Court Case of Marrama v. Citizens Bank of Mass., the court examined a situation where the debtor filed for Chapter 7, but misrepresented the value of a trust into which he had recently transferred a parcel of real property. 549 U.S. ____ (2007). When the Chapter 7 trustee questioned the debtor about the trust, the debtor moved to convert his case to a Chapter 13, wherein he would be permitted to retain more property but would be subject to a payment plan. The Supreme Court held that conversion to a Chapter 13 was properly denied based on the debtor’s bad faith but indicated that such a finding should be limited to continue to preserve the interests of the “honest but unfortunate” debtor.

Counterclaim to a preference action asserting claims against a debtor dismissed
A trustee, in seeking to recover in a preference action against a creditor, was met with a counter-claim from the creditor asserting claims against the debtor. Federal Rule of Civil Procedure (FRCP) 13 allows counterclaims against an opposing party but the claim of the creditor was not against the trustee either individually or as a representative. The counterclaim was held to have been therefore properly dismissed. Metcalf v. Golden, 488 F.3d 836 (9th Cir. 2007).

Creditor cannot offset their claim against a 11 USC § 303(i) award of fees
Subsequent to a dismissal of an involuntary bankruptcy petition (covered by 11 USC § 303, entitled “Involuntary Cases”), the bankruptcy court made a fee award against a creditor who then attempted to offset its prior claim against the amount of the fee award. The case had been dismissed because the creditor pulled the debtor into bankruptcy for an advantage in litigation. The Ninth Circuit discussed the policy implications of allowing a setoff in part by citing to In re Schiliro, 72 B.R. 147 (Bankr. E.D. Pa 1987) for the holding that “[i]f the petitioning creditor could suffer no other recourse except a reduction in his probably uncollectible judgment as a penalty for requiring a debtor to defend an unjustified case […] the disincentive built into the system to discourage such actions would evaporate.” The Ninth Circuit found denying the setoff to be consistent with prevention of “abusive filings of involuntary petitions.” Wechsler v. Macke Int’l Trade, Inc., 370 B.R. 236 (9th Cir. B.A.P. 2007).

Trustee’s “strong arm” powers under 11 USC § 544(a)(3) still strong
Taxel v. Chase Manhattan Bank is a Ninth Circuit opinion reaffirming the “strong arm” powers under 11 USC § 544(a)(3) wherein a trustee in bankruptcy has the power to regain title to real estate under restrictions similar to a bona fide purchaser. 361 B.R. 509 (2006). Though notice had arguably been given to a trustee of an unrecorded lien on real property of a debtor, the trustee’s bona fide purchaser status was preserved.

Chapter 11 plan confirmation still leaves breach of fiduciary duty claim unresolved
A bankruptcy court does not have the exclusive jurisdiction to resolve claims that relate to directors’ activities prior to bankruptcy. A confirmation of a Chapter 11 reorganization plan is unrelated to findings that would act under claim preclusion to bar litigation over questions of whether a breach of fiduciary duty occurred by director authorization of the filing of a bankruptcy petition. Davis v. Yageo Corp., 481 F.3d 661 (9th Cir. 2007).

Zachariah Larson is a partner at Larson & Stephens where he focuses his practice on bankruptcy from both the debtor and creditor sides. His practice also includes civil litigation, business start-ups, and guardianship. Mr. Larson is an executive board member of the Clark County Bar Association and serves on the State Bar of Nevada’s Professional Responsibility and Ethics Committee. He can be reached at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it or (702)382-1170.

Making a Federal Case Out of It: A Civil Defendant’s Guide to Removal
By J.D. Lowry

See that big futuristic-looking building on Las Vegas Boulevard, between André’s to the east and the Lewis Avenue Corridor park to the west? It’s the Lloyd D. George Federal Courthouse, home of the unofficial southern division of the U.S. District Court for the District of Nevada, and as civil defense counsel, you may have given short shrift to the idea that your client might do well litigating there.

A number of strategic considerations (aside from the largely irrelevant observation that generally the lines at the metal detectors are shorter, and the timely availability of elevators is greater than at the Regional Justice Center) may lead to a decision between you and your client to pursue removal of a state court action to federal court. However, those considerations are outside the scope of this article. This article provides a brief overview of issues the average private practitioner should keep in mind with respect to removal. As with any other issue involving the federal government, there are multiple exceptions and obscurities involved in federal removal jurisdiction that can represent pitfalls lying outside the well-trod paths of “typical” civil litigation. A review of 28 U.S.C. §1441 et seq., the statutes governing federal removal jurisdiction, is always a beneficial first step.

Is there a basis for federal jurisdiction?
Civil defendants (and criminal defendants too, although they also fall outside the scope of this article) have the ability, pursuant to 28 U.S.C. §1441 et seq., to remove to federal district court cases originally brought in state court over which federal jurisdiction nonetheless exists. Removing defendants have the burden of establishing federal jurisdiction, and the federal court is obliged to reject jurisdiction if any doubt exists as to its propriety. California ex rel. Lockyer v. Dynegy, Inc., 375 F.3d 831, 838 (9th Cir. 2004) (subsequent history omitted). Federal jurisdiction is strictly controlled, in part because courts generally favor allowing plaintiffs to pursue their claims in courts of their own choosing. Removal, like original federal jurisdiction, may be premised on two bases: the existence of a federal question, or the diversity of citizenship of the parties.

Federal question jurisdiction in the removal context may arise from the plaintiff’s pleading of one or more causes of action arising under federal law over which the federal district court would have had original jurisdiction. Federal agencies, federal officers, and members of the armed forces being sued as a result of acts taken under color of office have the right to remove their cases to federal court pursuant to 28 U.S.C. §1442 and 28 U.S.C. §1442a.

An important point for defense counsel to keep in mind is that the federal question giving rise to removal must arise from the plaintiff’s complaint. The defendant cannot create federal question jurisdiction through an affirmative defense, or through a counterclaim arising out of federal law. Also be aware that a handful of cases, including workers’ compensation cases and certain cases against carriers for damages related to shipments, are never removable or removable only under limited circumstances. 28 U.S.C. §1445.

The statute also allows removal on the basis of diversity of citizenship of the parties. 28 U.S.C. §1332(a). If no one on the plaintiffs’ side of the caption is a citizen of the same state as anyone on the defendants’ side of the caption, diversity of citizenship exists and, assuming that at least $75,000.00 is in controversy, the federal courts may assume jurisdiction. Removal is also available based on a hybrid of federal question jurisdiction and diversity jurisdiction arising under 28 U.S.C. §1369, for cases involving seventy-five or more deaths as the result of a single catastrophic accident. 28 U.S.C. §1441(e).

What if there would be complete diversity if not for the fact that the plaintiff sued your client, a Nevada resident, who has a good-faith basis to file a Federal Rule of Civil Procedure (FRCP) 12(b)(6) motion to dismiss? You may be representing a fraudulently joined sham defendant impled only to defeat diversity, and you can petition for removal to federal court and immediately thereafter move for dismissal. The defendant alleging that she has been fraudulently joined to defeat diversity bears a heavy burden, because the existence of any colorable claim by the plaintiff against that non-diverse defendant will suffice as proof that the joinder was not fraudulent.

Is it too late already?
Not if fewer than thirty days have elapsed since your client learned about the claim giving rise to federal jurisdiction. Receipt by the defendant, “through service or otherwise,” of the initial pleading setting forth the claim giving rise to federal jurisdiction triggers this thirty-day time limit, as does “service of summons upon the defendant if such pleading has then been filed in court and is not required to be served on the defendant”; if both of these events have taken place, the shorter time period applies. 28 U.S.C. §1446(b).

Note that the thirty-day time limit for removal does not begin until the plaintiff has plainly asserted a claim giving rise to federal jurisdiction. In other words, if the plaintiff’s original complaint provides no basis for federal jurisdiction, but the plaintiff subsequently amends his complaint in a manner that creates a basis for federal jurisdiction, the thirty-day removal period commences upon the date of service of the amended complaint. Similarly, if the complaint does not plainly set forth a basis for federal jurisdiction, but a subsequent “amended pleading, motion, order, or other paper” does set forth such a basis, the defendant has thirty days from service of that subsequent document to request removal. Lovern v. General Motors Corp., 121 F.3d 160, 162 (9th Cir. 1997). Keep in mind that the “other paper” may be discovery responses or deposition testimony, and the “order” may be the state court’s order dismissing a non-diverse co-defendant who has reached a settlement with the plaintiff.

The defendant has no duty to investigate facts underlying an equivocal complaint to determine whether or not a basis for federal jurisdiction exists. Harris v. Bankers Life and Casualty Co., 425 F.3d 689, 694 n.4 (9th Cir. 2005). However, if the basis for removal is diversity jurisdiction, there is a one-year deadline from the date of commencement of the action during which removal based on newly discovered grounds may take place. 28 U.S.C. §1446(b). Thus, if you suspect that discovery will demonstrate that purportedly non-diverse parties are actually diverse, it behooves you to conduct that discovery within the first year following commencement of the lawsuit if you plan to use such diversity as a basis for removal to federal court. Also be aware of the one-year deadline if it is possible that all non-diverse defendants will settle out of the case within the first year.

Have I already waived federal jurisdiction?
Probably not. A defendant only waives federal jurisdiction if, after removability has become apparent, the defendant “takes actions in state court that manifest his or her intent to have the matter adjudicated there, and to abandon his or her right to a federal forum.” Resolution Trust Co. v. Bayside Developers, 43 F.3d 1230, 1240 (9th Cir. 1994). Anything short of proceeding to adjudication on the merits will likely not suffice as a waiver by a defendant of federal jurisdiction. Id.

What do I file, and where?
File a Petition of Removal, signed under FRCP 11, in the federal court. The Petition of Removal must contain, according to 28 U.S.C. §1446(a), a “short and plain statement of the grounds for removal,” and must be accompanied by “a copy of all process, pleadings, and orders served” upon the removing defendant(s). “Promptly” thereafter, per 28 U.S.C. §1446(d), the defendant must provide written notice of the filing of the Petition of Removal to all other parties, and file a copy of the Petition of Removal with the state court. The state court will then “effect the removal” and “proceed no further unless and until the case is remanded.”

The Petition of Removal must be filed through the CM/ECF e-filing system. The required $350 fee is payable by credit card through CM/ECF. If you are not already registered for electronic filing with the District of Nevada, you may do so by calling (888) 674-2323 and/or following the directions on the District of Nevada’s website, www.nvd.uscourts.gov. This assumes, of course, that you have been admitted to practice before the District of Nevada; if you have not, the relatively quick and painless application process is detailed in Local Rule IA 10-1 (which is also available on the District of Nevada’s website).

Will I get sent back to state court?
Maybe. The federal court is obligated to remand to state court any removed case over which the federal court loses jurisdiction. Federal jurisdiction can be lost if, e.g., the federal court dismisses the federal cause of action on which you based your petition for removal, or if discovery demonstrates that the amount in controversy in a diversity case will not exceed the jurisdictional threshold of $75,000.00.

Further, if your Petition of Removal is procedurally defective, the plaintiff may move to remand the case to state court within thirty days. 28 U.S.C. §1447(c). The plaintiff also may move for remand based on a lack of federal subject-matter jurisdiction at any time prior to final judgment. Fees and costs are available, in the federal court’s discretion, to a plaintiff who is successful in obtaining remand. Remand orders are not appealable except in civil rights cases initially removed under 28 U.S.C. §1443.

In conclusion, don’t be afraid to take the case against your client to federal court. Just don’t forget your photo I.D.!

J.D. Lowry is an associate in the intellectual property and technology group of Lewis Brisbois Bisgaard & Smith LLP. She is an alumna of Hollins University and the Washington and Lee University School of Law, and has practiced law in Nevada since 2001.