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.

Let’s take Joe the Plumber as our first example. Joe has a $2,500 monthly mortgage payment. Recently, however, Joe has been falling behind due to one of many reasons that have befallen us during this dire economy. Seemingly without warning, Joe misses his first payment.  He then misses another payment.  Judiciously, he seeks help and is able to work out a modification that will lower his monthly payment to $1,750 a month and wipe out his arrearages. You might think Joe is lucky. I would say Joe isn’t lucky, rather he is proactive. He understood his situation early, sought help and realized banks are more than willing to keep folks in their homes.

Now let’s take Jane the Occupational Therapist. Jane also has a $2,500 monthly mortgage payment. She too has fallen on hard times. Unfortunately, Jane is not as diligent as Joe and she waits 5 months before she seeks help, only after getting a notice of foreclosure from big bad bank’s attorneys. She too is able to work out a loan modification that will lower her payments to $1,750 and wipe arrearages. Wait! It seems waiting is the key. Not only did Jane save $7,500 more than Joe by not making three payments, she got to sit there and do nothing for 3 additional months?! Did I forget to mention that there was a foreclosure action on her? Did I also forget to mention that the banks were unwilling to speak to her because she was 5 months late and in foreclosure already? How much did she spend to not only get the modification but also fight the foreclosure action? Jane might not have been ahead of Joe after all!

Now let’s take Jack the Ripper. Like Joe and Jane, Jack also has a $2,500 monthly mortgage payment and has fallen on difficult times. Jack is so down on himself, he waits 9 months to seek help only after the bank’s attorneys send him a notice of sale. Jack is up in arms. He doesn’t want to lose his home, but he is 9 months behind, surely there is no remedy for Jack situation!? Luckily Jack calls his attorney, who tells him he has options up until the property is sold (and sometimes even immediately after). Bankruptcy! Bankruptcy? How is that going to help? Well, when you file a Chapter 13 the court issues an order (called the Order for Relief) that includes something not well-known – the “automatic stay.” The automatic stay directs your creditors to cease their collection activities immediately, no excuses. If your home is scheduled for a foreclosure sale, the sale will be legally postponed while the bankruptcy is pending–typically for three to four months. Oh and by the way, this will help protect against other creditors too. However, there are exceptions to this general rule that I will mention in a parenthetical but not get into now (lender can file a motion to lift the stay). Chapter 13 bankruptcy lets you pay off the “arrearage” over the length of a repayment plan you propose–five years in some cases. But you’ll need enough income to at least meet your current mortgage payment at the same time you’re paying off the arrearage. Assuming you make all the required payments up to the end of the repayment plan, you’ll avoid foreclosure and keep your home. But wait there’s more:  Chapter 13 may also help you eliminate the payments on your second or third mortgage too. If your first mortgage principal is greater than the value of your home, you may no longer have any equity with which to secure the later mortgages. That allows the Chapter 13 court to “strip off” the second and third mortgages and recategorize them as unsecured debt–which, under Chapter 13, takes last priority and assuming you stick to your repayment plan may not have to be paid back at all. Jack is sure one lucky guy! But did I mention that bankruptcies stay on your credit report for years! And did I mention all the fees fees Jack racked up filing for bankruptcy?

So what’s the moral of the story? First, don’t sit on your hands. Being proactive is essential to successfully dealing with bad situations. Call an attorney with experience in all facets of home retention. A good attorney will know what to do in every situation. Loan modification might be the best remedy, but not in all cases. Lowering principal balances on 2^nd and 3^rd mortgages might be the best remedy, but not in all cases. Ask questions, get answers and most importantly, be proactive.

On October 9, 2009, the federal bankruptcy court in the Southern District of New York wiped out a $461,263 mortgage on a debtor’s house after the bank could not prove that it had the right to collect the mortgage. The debtor refinanced a home loan with Mortgage World Banks, Inc. but fell behind. She filed Chapter 13 bankruptcy to restructure her debt. PHH Mortgage showed up at the bankruptcy proceedings as the servicer of the mortgage, which it claimed was held by US Bank. However, PHH could not show the paperwork demonstrating how US Bank ended up with a mortgage that was originally sold to Mortgage World Banks. Thus, the bankruptcy court threw the mortgage out.

However, the debtor still does not own clear title to the house, despite the bankruptcy ruling. There is a mortgage on her house, but it is uncertain who, if anyone, has the right to collect. Her attorney is considering a lawsuit to clear title. It may be the case that in the world of high finance, a house slipped between the cracks.

State courts have dismissed foreclosure cases where the purported creditor could not show it owned the mortgage. However, the recent ruling wiping out a mortgage is significant because the servicer lost the right to collect the debt due to the bankruptcy proceedings.