Whether you’re up to your neck in loans, out of work or stretching one small paycheck to meet ever-growing obligations, nearly everyone occasionally flirts with the idea of ditching their debt.
But the reality of bankruptcy is that it’s a complicated legal procedure that will trash your credit rating.
Many states have their own bankruptcy regulations, which can make a big difference in what property you’re allowed to keep. Since bankruptcy is a court-monitored activity, the bankruptcy trustee, your creditors and a judge also will be involved.
Most individuals filing for bankruptcy opt for either Chapter 7 or Chapter 13. While rules vary widely from state to state, here’s a general rundown on each:
Commonly known as liquidation, this form of bankruptcy basically allows filers to give up assets in exchange for discharge of their debts. This is frequently the option for people who have few or no assets, often little or no income, and a lot of debt.
“You would use a Chapter 7 if you don’t have assets of value that the trustee would try to sell,” says David Greer, chairman of the consumer bankruptcy committee of the business law section of the American Bar Association and principal with Norfolk, Va.-based Hofheimer Nusbaum, P.C.
Bankruptcy stops most garnishments, although it depends on why you’re being garnished. What you will be allowed to keep will depend largely on your state laws. Some states allow you to keep all of the equity in your home, while others exempt a certain amount. In some places, individuals may keep their household goods. Some states, like Virginia, allow filers to keep wedding and engagement rings.
“Well over 90 percent are considered no-asset cases,” says Henry J. Sommer, editor-in-chief of Collier on Bankruptcy and counsel with Philadelphia-based Miller, Frank & Miller.
Chapter 7 usually takes three to five months from the date of filing to the final discharge. You can file only once in six years.
Depending on the state you live in, you may or may not be able to keep your home, car or a portion of your savings. If you manage to hang onto a home or car after a Chapter 7, you must keep up payments if you want to keep the property.
Since Chapter 7 is obviously an option of last resort, check carefully to see what assets you can keep and what you stand to lose before you even consider filing.
At filing, the individual provides a list of all assets and obligations. A bankruptcy trustee goes over the list and decides whether to sell any unprotected assets to pay outstanding debts. Creditors can object on several grounds, including sudden disappearance of assets and lies in the bankruptcy filing.
But Chapter 7 won’t make all debts go away. Those likely to stick with you include:
- Most student loans
- Child support
- Debts incurred through fraud
- Liabilities resulting from drunk driving
- Criminal fees, penalties and restitution
Chapter 7 could also eliminate some tax debt, says Mark S. Wallace, attorney with Los Angeles-based Stutman, Treister & Glatt, PC. But it will not help if the tax debt is secured or “relatively fresh,” says Ken Weil, author ofResolving Your Clients’ Tax Liabilities.
This option will also be more damaging to your credit rating than a Chapter 13 filing, according to John Ulzheimer, a solutions delivery consultant with Fair, Isaac & Co., the company that pioneered credit scoring and created the model for the FICO score.
The impact will vary depending on how recently the bankruptcy occurred and how many debts were discharged.
“The more accounts, the more impact,” says Ulzheimer. As the bankruptcy gets older, even though it remains on the report, the “impact will diminish,” says Ulzheimer.
Also known as debt adjustment, Chapter 13 allows individuals to temporarily halt foreclosures and collection actions while they draft and execute a plan to repay some or all of the debts over a three- to five-year period.
“In many cases, if you are behind on your mortgage or your car loan, and you don’t think you can catch up quickly, you file a Chapter 13,” says Sommer, author of Consumer Bankruptcy: The Complete Guide to Chapter 7 and Chapter 13 Personal Bankruptcy. “That’s probably the No. 1 reason people file Chapter 13.”
This type of bankruptcy “allows you to restructure your debts and change the interest rates on some of your loans,” says Greer.
To retain a home, filers have to keep making their monthly payments. But the amount that was past due at filing can be included in the bankruptcy debts, and paid over the life of the bankruptcy plan.
“Other secured debts, such as a car loan, can be restructured,” says Greer.
Chapter 13 differentiates between three types of debt:
- Priority debts, which often include some taxes and child support, have to be paid in full. In addition, individuals may be liable for interest that accrues on priority debts after the bankruptcy is filed, Weil says.
- Secured debts, which are debts secured with some form of collateral, must be paid up to the full value with interest over the life of the plan.
- Unsecured debts, like credit cards, typically receive just a percentage of the total due. The amount will vary depending on the individual’s disposable income, amount of the original debt and how many creditors are waiting in line.
Chapter 13 also allows filers to eliminate some tax liabilities, including those that result from late filing, not filing and fraud, says Weil, a Seattle-based attorney who specializes in bankruptcy and taxes. But if the tax debt is relatively recent, the debt has to be paid in full.
The repayment plan must be approved by the bankruptcy court and the trustee and creditors are allowed to object. Sometimes individuals file for Chapter 13 only to find out they must convert it to a Chapter 7. Also, there are monetary limits to the amount of debt you can have in a Chapter 13.
If the plan passes muster with the court, then all disposable income is given to the trustee, who keeps a percentage as a fee and parcels out the rest to the creditors in accordance with the plan. There is no time limit for filing a second Chapter 13, but a creditor could ask to have serial attempts dismissed as “bad-faith filings,” says Greer.
Even though it lingers longer, Chapter 13 is kinder on the credit score than a total liquidation, says Ulzheimer.
“Both are considered bad,” he said. “However, in reality, what you see in Chapter 13 is a little different.”
The credit report should reflect that loan balances are decreasing and the creditor is making an effort, Ulzheimer says. “It’s definitely the lesser of two evils.”
One final note: At the end of any bankruptcy, you might receive a 1099 form from creditors listing your discharged debt as unreported income, says Weil. But debts discharged in bankruptcy do not count as income, he said. If the IRS asks, supply the documentation that shows the 1099 form resulted from a bankruptcy.
There is no Chapter 20 in the bankruptcy code. Instead the term refers to filing a Chapter 7 followed by a Chapter 13 (the sum of which is 20), says James R. Beaman, a Tucson-based attorney and co-author of The Complete Idiot’s Guide to Surviving Bankruptcy. The purpose of the second filing: to get rid of debts that are not dischargeable under Chapter 7.
This type of action is “pretty rare,” says Sommer. More common is that individuals get into debt again within six years of a Chapter 7 and end up filing a Chapter 13.
Be warned: some judges and creditors see the move as a scam. Creditors have the right to object and the judge can toss the action, says Greer. Some judges will allow the second filing, provided there is a legitimate reason.
Get a good attorney
If you are considering bankruptcy, this is no time to go it alone. You need an experienced lawyer who specializes in bankruptcy to navigate the federal laws, state laws and tax consequences. Your future lifestyle hinges on getting the best advice and making the smart choices.
“Seek the advice of a good bankruptcy attorney about what your options are,” says Sommer.
If you decide to file, you definitely need an experienced bankruptcy attorney. Steer clear of petition preparers, typing services or paralegals, says Sommer. And if you are even considering filing on your own, remember the old adage that a man who acts as his own attorney has a fool for both an attorney and a client.
“It’s a very bad idea,” says Sommer. “Chances are mistakes would be made that would cost you more than paying an attorney.”