The basics of bankruptcy
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,
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
"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 &
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 of Resolving
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,"
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
"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
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
"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
Dana Dratch is a freelance
writer based in Atlanta.