Two tests for bankruptcy

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Dear Bankruptcy Adviser,
I have filed for Chapter 7 after failing the income test but passing the means test. I was unemployed for four months and have $85,000 in unsecured debt that I have been barely paying off, and $500,000 on a secured debt associated with a house in foreclosure.

The problem is that for the last two months I have had a high-paying job. What are the chances that I will be moved from Chapter 7 to Chapter 13?
— Nelson

Dear Nelson,
This is an excellent question, but one that is difficult to answer because I do not have all the facts in your case. However, you may be faced with the decision to either convert from Chapter 7 to Chapter 13 or have the Chapter 7 dismissed.

I need to explain your question for those who do not know the two bankruptcy tests.

When you file a consumer bankruptcy, there are two tests you must “pass” in order to qualify for Chapter 7, aka “fresh start” bankruptcy. If you fail either of these tests, you may be required to enter Chapter 13 — a reorganization plan — for the next three years to five years, or have your Chapter 7 case dismissed.

The first is the old test, under the old law, which looks at your income versus your ordinary and necessary monthly expenses. This is the test that many highly-paid professionals passed under the old law. Some people were paying twice the average for rent in their area or paying $500 a month for their child’s school tuition. And, in general, the creditors got fed up and said a person’s excessive spending habits should be closely scrutinized before allowing that person to qualify for Chapter 7 bankruptcy.

The result of creditor challenges was the new law, or “means test.” This test looks at the average income in the state in which you live and compares everyone equally.

Your income over the past six months will be compared to the average person in your state. Based on that average, a presumption arises as to whether you may or may not qualify for Chapter 7 bankruptcy. Failing the means test means that a presumption arises that you can pay back some of your creditors. And you, the debtor, must overcome that presumption. Quite often, debtors can still qualify for bankruptcy even though they make more than the average income in their state.

In very general terms, the means test is made up of two prongs: First, are you below median income? If so, you are not subject to the means test, only the income vs. expenses test. Second, do you have potential disposable income when your expenses are compared to average expenses in your area, as compiled by the IRS?

Failing one test and passing the other simply means that you will need to prove that you still qualify for Chapter 7 bankruptcy protection. If you have made good money for two months, but not over the past six months, then it is possible for you to fail the income vs. expenses test and pass the means test. Please note that having higher-than-average income does not mean you definitely will fail the income vs. expenses test.

You stated that your income has been high for the past two months. If this income is going to continue into the foreseeable future, you might be able to pay back your creditors some of the money you borrowed. However, if the last two months was just a short-term project that ended right after you filed your case, then likely you can still qualify for Chapter 7.

You need to explain the circumstances surrounding your current employment and why it will not continue into the future. You may benefit greatly by consulting with a bankruptcy attorney, since you are not familiar with acceptable versus unacceptable expenses.

At the same time, you need to be realistic and understand that if you are now earning a good living and there is some money left over after necessary and ordinary expenses, you may have to pay your creditors some or all of the money you borrowed. Creditors deserve to be repaid some of the money borrowed when your income permits it.