Persons who file for personal bankruptcy according to Chapter 7 of the US bankruptcy code can generally retain some assets. Specifically, at the state level there tend to be exemptions for certain asset classes up to certain thresholds. The main exemption is the homestead exemption, which enables the filer to retain home equity in his primary residence up to the exemption amount. The homestead exemption ranges from $ 0 in Maryland to an unlimited amount in 8 US states, including Florida and Texas, in 2006. Personal bankruptcy is quite common in the US, with about one million Chapter 7 filings in 2009, and homestead exemptions therefore frequently apply. With a home ownership rate of about 67 percent in the US in 2009, the homestead exemption significantly affects the financial position of households that emerge from personal bankruptcy, especially in high exemption states.
The homestead exemption potentially affects household portfolio choice, as a household needs to have home equity to benefit from the wealth protection offered by the homestead bankruptcy exemption. This paper provides an empirical and a theoretical investigation of the impact of the homestead exemption on household portfolio allocation, and in particular on the share of home equity in net worth and on home ownership.
The estimation uses household level data from the Survey of Income and Program Participation (SIPP) of the US Census Bureau. This data source provides information on wealth allocation and a host of personal and household characteristics for approximately 30,000 households. The homestead exemption is found to have an economically significant effect on a household’s home equity share in net worth. A one standard deviation increase in the homestead exemption level of $ 354,303 starting from a level of zero is estimated to increase the share of home equity in total wealth by 22 percent, which is about half its standard deviation.
The positive relationship between the home equity share and the exemption level is estimated to be stronger for households with low net worth, as these households may face a higher bankruptcy risk. The home equity share is also relatively sensitive to the homestead exemption for households that report poor health, as this could trigger bankruptcy through income loss or major medical expenses.
Furthermore, households with mortgage finance, shorter house tenure, and a younger household head tend to have home equity shares that are more strongly affected by the homestead exemption level. This could reflect that these households also have relatively uncertain financial prospects.
Download
Who invests in home equity to exempt wealth from bankruptcy?
