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Property Exemptions in Bankruptcy–A Grand Political Compromise

The amount of property you get to keep in a bankruptcy is the result of a 200-year-old Constitutional battle of states’ right versus federal power.  The Bankruptcy Code provides for a uniform federal set of property exemptions, but if you live in one of 35 states, including Colorado, you probably cannot use those exemptions. Instead you’re stuck with your state’s separate set of exemptions because your state has chosen to “opt-out” of the federal exemptions.

If bankruptcy law is federal law, how come states get to do that? Here’s the back story to this legal oddity.

You’ve heard that the idea of bankruptcy was important enough to our country’s founders that they made it part of the U.S. Constitution. It’s right near the top, in Article 1. The enumerated powers of Congress include “to establish… uniform Laws on the subject of Bankruptcies throughout the United States.”

But did you know that we didn’t have a federal bankruptcy law for amost a century after the signing of the Constitution? And the main reason we didn’t was based on the contentious issue of property exemptions?

How so? Throughout the 1800s—way before and long after the Civil War–the country waged a political and economic war between Northeastern bankers and Western and Southern farmers and small merchants. Because of reoccurring financial “panics” throughout the century, the farmers and merchants had good reason to worry about losing their homes and farms to out-of-state creditors. Largely in response to this, the first law exempting property from the collection of debt was adopted in 1839 in Texas, and spread quickly throughout the South and the Midwest during the 1840s and 1850s.

Also in reaction to the financial “panics,” three different federal bankruptcy laws were passed and signed into law during that century. But each resulted from a delicate compromise to deal with the immediate economic turmoil, and all were repealed as soon as the economy improved and the political winds shifted. When the first long-standing law finally passed in 1898, it could only get enough votes by allowing debtors filing bankruptcy to use their state law exemptions.

That 1898 bankruptcy law lasted 80 years. When it was repealed and replaced with the current Bankruptcy Code in the late 1970s, some in Congress wanted to continue using state exemptions, while others wanted to impose a mandatory uniform federal system.  The compromise: you can choose between a federal set of exemptions or the local state exemptions, UNLESS you are a resident of one of the 35 states which has “opted out” of the federal exemptions, requiring you to use that state’s exemptions.

Sounds like a big win for states’ rights. States get to decide whether their residents will have exemptions that are more generous or more narrow than the federal ones, and whether those residents have the choice between the two exemption systems or must use the state one. This system can help you or hurt you depending upon where you live and what you own. For better or worse,it’s a big exception to the Constitution’s pronouncement about “uniform laws on the subject of Bankruptcies.”

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