Bankruptcy carries with it a stigma of financial irresponsibility and mismanagement. However, that stigma is undeserved. The majority of bankruptcies are caused by unforeseen expenses such as medical bills or unpredictable events such as the breadwinner getting laid off. The truth is that bankruptcy is a very powerful tool that, when used correctly and strategically, can grant a financial fresh start to deal with these unfortunate events. This article will provide a basic overview of consumer bankruptcy.
Let’s start with the basics. There are two major types of bankruptcies utilized by individuals and small business owners—Chapter 7 and Chapter 13. Chapter 7 bankruptcy is sometimes called “straight” or “liquidation” bankruptcy. Such a filing cancels your debts, but a court-assigned bankruptcy Trustee will have the power to sell (or “liquidate”) your property and use the proceeds to pay off your creditors. Shortly after filing, the debtor must attend a creditor’s (or “Section 341”) meeting before the Trustee to answer basic questions about his financial situation under oath. If everything goes right, your debts are discharged six months after you file.
Certain assets are considered exempt and cannot be liquidated by the Trustee. If you don’t have any non-exempt assets, then nothing gets liquidated and your creditors get nothing. State law determines which assets are exempt. In New York, up to $50,000 of the equity in a home is exempt, or $100,000 for a married couple filing jointly. Retirement accounts such as 401(k)s are exempt. Up to $2,400 of a car’s equity is exempt. There are other exempt assets in New York, but these are the most common. It is important to know exactly what is exempt to prevent unnecessarily losing assets during a bankruptcy.
Chapter 13 bankruptcy, sometimes called reorganization bankruptcy, is quite different from Chapter 7. In a Chapter 13 bankruptcy, you don’t have to hand over any property, but you must use your future income to pay some or all of what you owe to your creditor over a three- or five-year plan, depending on the size of your debts and income. Creditors will typically take a discount on the debts that they are owed; the baseline is that each creditor has to be paid as much as they would have received under a Chapter 7 bankruptcy.
To a certain extent, the choice whether to file a Chapter 7 or Chapter 13 is out of your hands. The Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”) of 2005 limits the ability of a debtor to file a Chapter 7 bankruptcy. There is a means test that prevents a Chapter 7 filing if the debtor makes too much more than he spends on basic living expenses. The theory is that the surplus can be used to pay off the creditors in Chapter 13. It will not be a surprise to most that credit card companies spent over $100 million lobbying for BAPCPA.
Certain kinds of debt are very difficult to discharge in bankruptcy. Student loans, tax liens, and child support arrears are the three most common types of these so-called “non-dischargeable” debt. It is technically possible to get student loan debts discharged by showing “undue hardship,” but successful showings are few and far between.
A bankruptcy court may refuse to grant a discharge if it believes that there is bad faith in the bankruptcy filing. A person who files repeatedly may have his later bankruptcies rejected. Sometimes, debtors try to transfer assets to their friends and relatives relatives in an attempt to keep it out of their creditors’ hands, which is frowned upon and may cause problems. Likewise, debtors who rack up a huge credit card bill for luxury goods right before filing for bankruptcy may find themselves stuck with the tab.
As you can see, bankruptcy may be a very useful tool. Most people don’t say “Hey, I have no debt now, but why not build up tons of debt and then just go bankrupt?” Filing for bankruptcy is usually done begrudgingly. Someone who lost their job and had to rack up credit card debt to pay the bills for a while may find themselves struggling to make the minimum payments given the bank’s insanely high interest rates, fees, and penalties. A bout of illness may cost tens of thousands of dollars of unforeseen debt. Credit card companies are aware of the bankruptcy laws—as we have seen, they lobbied Congress to change the laws in their favor. They factor in the risk of bankruptcy when making loans as a cost of doing business.
The moral of the story is don’t be embarrassed or afraid of the unknown, bankruptcy is there to help you. Let us figure out together the proper path for you to go down. You’d be surprised to hear that you may be able to avoid bankruptcy completely. But if bankruptcy is right for you, we can help you figure out how to maximize the exempt assets you have, and help you avoid problems with the Trustee. Come in for a free consultation.