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Bankruptcy Basics

Chapter 7 - Liquidation

  • Liquidation means that some of your property may be sold to help pay down your debts.
  • Most, if not all, of your unsecured debts will be erased. Unsecured means that the property is not backed by collateral; the lender cannot repossess it.
  • If you owe on a secured debt, property that is backed by collateral (such as a car loan, mortgage, etc.) you can either allow the creditor to repossess the property, continue to pay the loan under contract, or pay the creditor a lump sum equal to the current replacement value of the property (if the creditor agrees).
  • You get to keep any property classified as "exempt" under state/federal law (clothes, car, household furnishings, etc.)
  • Chapter 7 can be used by individuals and businesses
  • Chapter 7 can eliminate many kinds of debts, such as credit card debt, medical bills, and unsecured loans, however; there are many types of debts, including child support and spousal support obligations and most tax debts, that cannot be wiped out in bankruptcy.

Chapter 13 - Reorganization (Individual)

  • Unlike Chapter 7 that absolves debt, Chapter 13 reorganizes debt. Filers propose a repayment plan that details how they will pay back their debts over the next three to five years.
  • The minimum repayment amount is based on income, how much you owe, and how much your unsecured creditors would have received if you'd filed for Chapter 7.
  • With secured debts, Chapter 13 gives the option to make up missed payments to avoid repossession or foreclosure.
  • Chapter 13 bankruptcy is also known as "wage earner" bankruptcy because, in order to file for Chapter 13, you must have a reliable source of income that you can use to repay some portion of your debt.
  • To qualify for Chapter 13, your secured debts must be less than $1,149,525 and your unsecured debts less than $383,175. These amounts are periodically adjusted for inflation. The next adjustment will be April 1, 2016. Chapter 11 - Reorganization (Business)
  • Used by financially struggling businesses to reorganize affairs.
  • Typically used when business debts have exceeded the Chapter 13 limitations or if substantial nonexempt assets are owned (such as several pieces of real estate).
  • Can be used by individuals but it is very expensive and time-consuming. Chapter 13 is the better choice for individuals.

Chapter 12 - Reorganization (Farmers)

  • Chapter 12 is almost identical to Chapter 13.
  • To be eligible, at least 80% of your debt must arise from the operation of family farm.
  • Chapter 12 has a higher debt ceiling to accommodate the large debts associated with operating a farm. It also offers the debtor more power to eliminate certain types of liens.
  • Only a few hundred people file for Chapter 12 each year, while hundreds of thousands file for Chapter 13.

The New Bankruptcy Law

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was passed in April 2005. By October 2005, most of its tenets came into effect. The purpose of the new law was to end the practice of people abusing the system; hence the name.

Here are some of the most important changes:

Credit Counseling

  • All filers must complete credit counseling, whether the repayment plan is feasible or not.
  • Counseling agencies must be approved by the US Trustee's Office and a certificate of completion must be presented before you can file.
  • If your claim is granted, subsequent counseling is required to learn personal financial management. You must complete the counseling before any debts will be discharged.
  • All counseling services are to be paid by the consumer who is filing for bankruptcy.

Restricted Eligibility for Chapter 7

  • Under the old rules, most filers could choose the type of bankruptcy that seemed best for them -- and most chose Chapter 7 over Chapter 13. The new law will prohibit some filers with higher incomes from using Chapter 7.

Current Monthly Income

  • You must measure your current monthly income against the median income in your state for a family of your size.
  • Your "current monthly income" is not your income at the time of filing, but the average income over the last 6 months.
  • If your income is less than or equal to the median, you can file for Chapter 7. If it is more than the median, however, you must pass "the means test" - another requirement of the new law -- in order to file for Chapter 7.

The Means Test

  • The purpose of the means test is to figure out whether you have enough disposable income, after subtracting certain allowed expenses and required debt payments, to make payments on a Chapter 13 plan.
  • To find out whether you pass the means test, you start with your "current monthly income," calculated as described above. From that amount, you subtract both of the following:
  • Certain allowed expenses, in amounts set by the IRS. Generally, you cannot subtract what you actually spend for things like transportation, food, clothing, and so on; instead, you have to use the limits the IRS imposes, which may be lower than the cost of living in your area.
  • Monthly payments you will have to make on secured and priority debts. Secured debts are those for which the creditor is entitled to seize property if you don't pay (such as a mortgage or car loan); priority debts are obligations that the law deems to be so important that they are entitled to jump to the head of the repayment line. Typical priority debts include child support, alimony, tax debts, and wages owed to employees.
  • If your total monthly disposable income after subtracting these amounts is less than $100, you pass the means test, and will be allowed to file for Chapter 7. If your total remaining monthly disposable income is more than $166.66, you have flunked the means test, and will be prohibited from using Chapter 7.
  • So what about those in the middle? They have to do some more math. If your remaining monthly disposable income is between $100 and $166.66, you must figure out whether what you have left over is enough to pay more than 25% of your unsecured, non-priority debts (such as credit card bills, student loans, medical bills, and so on) over a five-year period. If so, you flunk the means test, and Chapter 7 won't be available to you. If not, you pass the means test, and Chapter 7 remains an option. Once you've calculated your income, compare it to the median income for your state. (You can find median income tables, by state and family size, at the website of the United States Trustee, www.usdoj.gov/ust; click "Means Testing Information.")

Homestead Exemption

  • Homestead exemptions are restricted to $125,000.
  • A 40 month residency must be established
  • Example 1: In Arizona, the homestead exemption is $100K. No matter when you have acquired your home, the amount of equity you are allowed to keep in your home is $100K. If you have more equity than this, you will probably be forced to sell.
  • Example 2: Kansas, Texas, Florida, Iowa, and South Dakota have unlimited homestead exemptions. So if you have $1 million in equity in your $2 million dollar Texas mansion, and you've owned it more than 3.3 years before filing a bankruptcy, the equity is completely exempt. If you bought it within the last 3.3 years, you are only allowed to have $125K in equity.

Child Support

  • Child support will move from #7 to #1 on the list of payment priorities.

Accommodations for the Military

  • Special accommodations for active-duty service members, low-income veterans, and those with serious medical conditions in the new income test for bankruptcy applicants.

Victims of Natural Disasters

  • Credit counseling will not be required
  • Debtors who cannot provide required documents due to a natural disaster will not face enforcement actions.
  • Trustees are to consider the income loss, increased expenses, and other effects of a natural disaster as "special circumstances" that may allow a debtor who doesn't otherwise pass the means test to qualify for Chapter 7.
  • Trustees will provide alternate means for debtors to attend creditors' meetings, if necessary.
  • For more on these rules, go to the website of the United States Trustee, www.usdoj.gov/ust, and click "Enforcement Guidelines for Debtors Affected by Natural Disasters."

Lawyers May Be Harder to Find - and More Expensive

  • New and complicated requirements will demand more time.
  • Lawyers must personally vouch for the accuracy of all information their client provides.
  • The added time and risk = increased attorney fees.

Property Must Be Valued at Replacement Cost

  • Old law - property was valued at what it could be sold for in a "fire sale" or auction.
  • New law - property is valued at what it would cost to replace it. This is sure to jack up the value of property, which means it is more likely to be sold by the trustee to pay off debts.

State Exemptions Aren't Available to Recent State Residents

  • To qualify for state exemptions, residency was established at 3 months under the old law. The new law established residency at 2 years.
  • New exemption laws could make a big difference in the amount of property you get to hold on to.
  • Because exemption amounts vary widely from state to state, these new residency requirements could make a big difference in the amount of property you get to hold on to. For example, if you recently moved from California to Nevada and you have a fairly valuable car, you might want to wait to file for Chapter 7: Once you've been in Nevada for two years, you can claim its $15,000 exemption for motor vehicles. If you have to use California's exemptions, you can keep only $2,300 worth of equity.

Although state exemption laws differ, they typically allow you to keep these types of property:

  • Equity in your home
  • Insurance
  • Retirement plans
  • Personal property
  • Public benefits
  • Tools used on your job
  • Wages