Bankruptcy isn’t a one-size-fits-all financial solution. The federal Bankruptcy Code breaks down the process into several different types, or “chapters.” Some chapters are reserved for businesses. The two most common bankruptcy chapters for individuals are Chapter 7 and Chapter 13, and they’re vastly different.
Only Chapter 7, often referred to as the “liquidation” or “fresh start” bankruptcy, eliminates most debts—but this can come at a price.
It Might Not Eliminate All Your Debt
First, it’s important to understand not all debts are dischargeable or erasable in Chapter 7 bankruptcy. Federal law takes the position that eliminating certain debts would work against public policy. In other words, discharging them wouldn’t be in the best interests of the public as a whole. They include:
- Child support and other forms of family financial support
- Judgment debts resulting from “improper behavior,” such as driving under the influence
- Certain tax debts
- Fines or penalties imposed by a government entity
- Federal student loans
- Loans taken from tax-advantaged retirement plans
- Debts incurred through fraud
All these debts are non-dischargeable in Chapter 7 proceedings. Chapter 13 is more flexible.
Fraudulent debts aren’t automatically excluded, however. The creditor must establish that an individual misrepresented information when taking out the loan or committed some other type of fraud. This requires that the creditor file a motion called an “adversary proceeding” with the bankruptcy court. The debts can still be discharged if the judge doesn’t agree with the creditor.
What Is a Discharge?
Assuming your bankruptcy discharges a debt, you’re no longer legally responsible for paying it—ever.
The court will usually issue a discharge order within about four months from when you file your bankruptcy petition, assuming there are no complications like adversary proceedings. But you won’t have to wait that long for creditors to stop bugging you. An “automatic stay” goes into effect immediately, barring creditors from trying to collect from you while you’re in bankruptcy.
More than 99% of individual debtors who file for Chapter 7 receive a discharge, excluding dismissed or converted cases, according to the United States Courts website.
Filing for Chapter 7 Bankruptcy
The bankruptcy court clerk will send notice to all your creditors when you file for Chapter 7 protection, essentially warning them to cease and desist any collection efforts. The notice will include a deadline by which your creditors must file an adversary proceeding to object to your discharge, usually about two months after your “341 meetings.”
The 341 Meeting
This proceeding is named after Section 341 of the bankruptcy code. It’s often more casually referred to as the “meeting of creditors,” and it’s pretty much what it sounds like.
It usually takes place anytime from 20 to 30 days after you file your bankruptcy petition. Your creditors can attend, and you can be sure that your trustee (the person appointed to oversee your case) will be there. This meeting gives your creditors an opportunity to ask you questions about your debts and income. And yes, you must answer under oath and swear to tell the truth and nothing but the truth.
Filing for Chapter 7 bankruptcy can be a complicated process, and most consumers find they need the help of an attorney. You’re not just filing a petition asking for bankruptcy relief. You must also submit numerous other forms and schedules, detailing your earnings and monthly expenses, along with tax returns and other proof of income.
What Happens to Your Property?
Any property and assets you own become part of your “bankruptcy estate” when you file for Chapter 7 protection. Technically, you no longer own them—the court does. You can still live in your house and you can still drive your car, but you can’t sell or otherwise dispose of them.
Why? Because the bankruptcy trustee is authorized to sell or liquidate them to pay your creditors at least a portion of what you owe, thus the term “liquidation bankruptcy.” But remember, Chapter 7 is also referred to as a “fresh start bankruptcy.”
The law is set up so as to not to take everything you own. It wouldn’t be much of a fresh start if you were left sitting on a street corner with only the clothes on your back, so some of your property is exempt from liquidation—up to certain equity values in your house, automobile, and other property you’re entitled to keep. Exemption availability varies by state, so check with an attorney to see what you might qualify for.
For example, you might have a $100,000 homestead exemption. If your home is worth $100,100, it’s unlikely the trustee would sell it just to apportion $100 among all your creditors. But if your home is worth $200,000, the trustee would most likely liquidate it. You’d receive $100,000 from the sale—the amount of your exemption—and your creditors would receive the balance of the proceeds from the sale.
And if you still have a $50,000 mortgage against the property, you would receive $100,000, your mortgage lender would receive $50,000, and your creditors would get just $50,000, assuming the property sells for its full market value of $200,000.
You also have the right to “reaffirm” debts you don’t want to have discharged, such as your mortgage if you want to keep your home. This involves entering into a new agreement or contract with that creditor to pay off the loan regardless of your bankruptcy. The debt isn’t discharged; you’re still liable for paying it according to the new terms.
The bankruptcy court must approve all reaffirmation agreements you enter into if you’re not represented by an attorney. If you are, your attorney will have to attest to the court that they advised you as to all the pros and cons of this option.
The federal government publishes a list of exemptions, and most states have their own as well. You can’t mix and match. You must choose one set of exemptions or the other, whichever is most beneficial to you if your state allows you to do this. Not all do.
Qualifying for Chapter 7 Bankruptcy
Chapter 7 bankruptcy isn’t a "get out of debt-jail free" card for everyone. You must qualify.
You must show a genuine inability to pay off your debts to qualify for Chapter 7. This means you must earn less than the median income for a family of your size in your state, or pass a “means test” if you don’t. The test basically measures your projected average monthly income over the next five years against your reasonable living expenses and debts to secured creditors. If you have substantial excess income after paying your base expenses, the court takes the position that you should give that money to your creditors.
You must also complete a financial management course and file a certificate that you’ve done so before the court will approve your discharge. Certain exceptions to this rule exist, however. You might be excused if the trustee agrees there are no such courses available within a reasonable distance of your area, if you’re disabled, or if you’re a service member on active duty in a combat zone.
- You can’t have filed for Chapter 7 bankruptcy and received a discharge within eight years of submitting your current petition.
- You also can’t file for Chapter 7 within six years of entering into a Chapter 13 bankruptcy, unless all your unsecured debts were paid in the Chapter 13 proceeding or at least 70% of those debts were paid subject to certain “best-effort” conditions.
- You also can’t refile within 180 days of voluntarily dismissing a previous bankruptcy petition because a creditor lienholder sought relief from the bankruptcy court, or if the court dismissed your case because you violated one or more rules.
Even with the exemptions provided by the Bankruptcy Code, you could potentially lose at least some property if you file for Chapter 7, and it’s possible you might not qualify for Chapter 7. Not to worry—there’s still Chapter 13.
A Chapter 13 bankruptcy is one in which you enter into a court-approved payment plan to satisfy your debts over three to five years. The automatic stay applies to this chapter as well, meaning your creditors can’t harass you for more money during this time. They must accept the plan payments, which depend on your disposable income after expenses. Your property isn’t liquidated.
You must also continue to make current payments on secured loans, such as your mortgage. For example, if you’re behind with your mortgage payments, you can resume making regular monthly payments and roll the arrears into your Chapter 13 plan, paying them off over 36 to 60 months.
You must pay all “priority” claims in full through your plan. Priority claims are certain unsecured obligations, such as domestic support and administrative expenses, as specified in the bankruptcy code. You might only have to pay a portion of your non-priority unsecured debts, such as credit cards. The unpaid balances will be discharged.