THE BASICS OF CHAPTER 7 AND CHAPTER 13 BANKRUPTCY
AND HOW TO SELECT THE RIGHT CHAPTER
What is Bankruptcy?
As provided for by Article 1, Section 8 of the United States Constitution and codified in Title 11 of the United States Code (the "Bankruptcy Code"), Bankruptcy is the right we all have to be freed of excess debt by having some or all of our debts extinguished while at the same time protecting our assets so we can get a “fresh start” and go on to lead newly productive lives. This is accomplished through a “discharge” and the way it is obtained depends on whether it is a Chapter 7 or Chapter 13 bankruptcy that is filed.
Chapter 7 In a Chapter 7 bankruptcy, covered in Chapter 7 of Bankruptcy Code, all dischargable debts are discharged usually in a period of 3 to 4 months.
Chapter 13 In a Chapter 13 bankruptcy, covered in Chapter 13 of the Bankruptcy Code, a percentage of the debt is repaid through a 3 to 5 year plan depending on the Debtor's income and expenses. After the plan is completed, the remaining dischargable debt is discharged and any non-dischargable debt remains.
There are limits to what kinds of property can be protected in bankruptcy and there are limits to what kinds of debts can be discharged. If the Debtor files a Chapter 7 bankruptcy and has equity in property exceeding in value the amount of the allowed exemptions, the property will be sold to pay their creditors. They can instead file a Chapter 13 and so long as the Debtor's creditors will receive the dollar equivalent of what they would have received in a Chapter 7 case (had the property been liquidated) through the Chapter 13 plan, the property will be protected, but the Debtor has to pay some of the debt back in order for that to be accomplished.
What Property Can Be Protected?
Property is protected in bankruptcy using exemptions. Many states have their own exemption systems, but there is also a federal exemption system that is used in situation where the Debtor's state allows for them to be used instead. Some states allow you to use either the federal system or that state's own exemption system. Other states, like California, have “opted out” of the federal exemption system, but here we have two sets of state exemptions to choose from, found in sections 703 and 704 of the California Code of Civil Procedure. You can only use one or the other, and the set of exemptions you use depends on the type of property the Debtor needs to protect. The 703 series has a generous wildcard exemption currently worth $30,825.00 (including the maximum allowed unused portion of the homestead exemption) that can be used to protect any kind of property. The 704 series, however, has generous homestead exemptions, but has no wildcard exemption. The Debtor will choose the set that will provide the greatest amount of protection for their assets. If a Debtor is married but is filing bankruptcy without their spouse, they can not use the 703 series of exemptions without the non-filing spouse signing a “Spousal Waiver” which basically waives their right to use the same exemptions during the time the bankruptcy is pending.
A Debtor must have lived in the state where they are filing bankruptcy for the two years before filing in order to be able to use that state's exemption system. If the Debtor has not lived there for two years, then they must use the exemption system provided for by the state where they lived for the majority of the 6 month period directly proceeding the beginning of the two year period.
Some states have residency requirements to use their exemption scheme, so in that case the Debtor would simply use the federal exemptions.
What Debts Are Dischargable?
Generally, dischargable debts include but are not limited to:
Credit card debt
Unpaid balances after foreclosure or surrender of secured property like a home or car
A list of which debts are NOT dischargable in bankruptcy is found in Section 523 of Title 11 of the U.S. Code - Exceptions To Discharge”. They include:
Domestic Support Obligations
Debts incurred while driving under the influence
Debts ordered to be repaid by the court because they were incurred by fraud or deceit
Criminal fines and penalties
The effect of a discharge is covered in Section 524; the primary effect is for the Debtor to no longer be liable for the debts which are covered by the discharge.
What Changes Happened Because of the Bankruptcy Law Change in 2005?
In 2005, in response to the demands of credit card companies who thought the bankruptcy rules at that time were too lenient on consumer debtors, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act. The result of the act is a law that makes the bankruptcy process more cumbersome and expensive than the prior law. The previous major overhaul happened in 1978 and it took approximately 10 years of litigation for all the wrinkles in the law to be smoothed out. BAPCPA has similarly prompted a lot of litigation and it will probably also take about ten years to smooth the wrinkles out.
The Main Effects of BAPCPA
- More debts are now non-dischargable (taxes, student loans, credit card fraud in Chapter 13
- Imposes a longer period of time to repay debts for those earning above the state median who must file a Chapter 13
- Filing fees for both Chapter 7 and Chapter 13 have increased
- Imposition of two credit counseling sessions for which there are fees;
- There are new requirements for attorneys that take more time to comply with and thus attorney fees have gone up
- More people are pushed into a Chapter 13 bankruptcy with the imposition of a “means test”.
- In Chapter 13, there are new limitations on the ability to reduce payments to secured creditors to the actual value of the collateral; for cars: you must have owned and financed the car for 910 days; for other personal property: you must have owned and financed the property for 1 year.
How Does Bankruptcy Work?
Bankruptcy is a good option when a person is at the point where they are significantly in debt and are using their credit cards to pay for basic living necessities, like food and rent. A bankruptcy, like a tax return, is made up of many different documents which include the Petition, Schedules, Statement of Financial Affairs, Statement of Intentions, and Means Test. A typical completed bankruptcy is about 70 pages long. To properly prepare a bankruptcy, the Debtor needs to give their attorney a lot of information, including:
- A new credit report – try to get one from each of the 3 credit reporting agencies, they are free at www.annualcreditreport.com
- The names, addresses and account numbers of all debts using the mailing address used by the creditor in their two most recent pieces of correspondence, plus any collection agencies
- A list of personal property items and their current replacement values for their current age and condition
- Real property information, including deeds of trust, mortgage agreements, and property tax information, as well as a recent broker's analysis of the market value for the property or recent appraisal
- Copies of tax returns for the previous 3 tax years
- Paystubs and other income information, such as pension and social security payments, and profit and loss statements for self-employed Debtors.
- Lease and other contract information, such as car loans, rental agreements for commercial premises or residential rental agreements between the Debtor and their tenants
- Other necessary information.
Once the bankruptcy is prepared, it's reviewed, signed and then filed. Once filed, the Debtor is assigned a case number, a case trustee, and a hearing date for the Meeting of Creditors. An automatic stay goes into effect which prohibits creditors from contacting the Debtor, and any pending foreclosures, wage garnishments and lawsuits must be placed on hold. There are some exceptions to the automatic stay for persons who have previously filed 1 or more bankruptcies in the year before the present case. Another important factor of filing bankruptcy is that once the case is filed all of Debtor's property becomes part of the “bankruptcy estate” which is administered by the bankruptcy trustee. This means the Debtor cannot transfer or sell property without the trustee's permission until the estate closes. In a Chapter 7, the Debtor can normally do what they wish with their property so long as 30 days have passed since the conclusion of the Meeting of Creditors, but in some cases it is necessary to file a motion asking the trustee and the creditors to abandon certain assets.
About a month to 6 weeks after the case is filed, the Debtor will have a hearing with a bankruptcy trustee who's job it is to administer their bankruptcy case.
In a Chapter 7, the trustee spends usually less than 5 minutes asking the Debtor a few basic questions about the information in their bankruptcy paperwork under oath and before a live tape recorder. Some typical questions include: did you list all of your assets and all of your debts? Are you expecting anyone to die and leave you money or property in the next six months? Do you have a reason to sue anyone? The goal of the trustee is to determine whether the Debtor really cannot afford to pay their debts back and whether there are any unprotected assets that can be liquidated to pay creditors. Creditors can also show up at the hearing and question the Debtor for a limit of 5 minutes, but they rarely do.
If the Chapter 7 Trustee is satisfied that there are no assets to be administered and there is no income available for creditors, they will close their investigation and in approximately 2 to 3 months after the hearing the Debtor will receive their discharge.
In a Chapter 13, the trustee at the hearing will want to make sure the Debtor can afford the Chapter 13 Plan filed with the court and that the plan represents the Debtor's best efforts to repay their debt. If the Chapter 13 Trustee is satisfied that the plan represents the Debtor's best efforts to pay the creditors, and the plan is feasible, meaning it is something they can afford to do, they will confirm the plan. The Debtor then continues to send the trustee a money order every month until the end of the plan, with the first payment due within 30 days of the case being filed. Once the plan is completed, the Debtor will receive their discharge.
Which Chapter Should I file?
The first question to ask when deciding which chapter under the bankruptcy code to file under is: is there a choice? If a Chapter 7 is over and done with in usually less than 4 months and doesn't involve paying creditors, why wouldn't everyone simply choose to file Chapter 7 over Chapter 13? The reason is because there are limits as to who can file and what can be accomplished in a Chapter 7. Deciding which chapter to file requires a thorough examination of one's complete financial situation to determine whether they are excluded from filing a Chapter 7 for any of the various reasons listed below. If they are not, they may still choose to file a Chapter 13 because there are some things that can be accomplished in a Chapter 13 that cannot be accomplished in a Chapter 7 that may be extremely valuable depending on the particular circumstances at hand.
Why Not Chapter 7?
THERE ARE LIMITS ON WHO CAN FILE CHAPTER 7
- Has the Debtor filed a previous Chapter 7 bankruptcy within the previous 8 years? If so, they cannot file again now.
- Consumer Debtors – Is there room in the budget to pay creditors or does the Debtor not pass the “means test”? If so, they cannot file a Chapter 7 because it would be deemed to be an abuse under Section 707(b) of the bankruptcy code.
THERE ARE LIMITS ON WHAT PROPERTY CAN BE PROTECTED
Non-exempt property is liquidated in Chapter 7 but can be protected in a Chapter 13 so long as the creditors receive the equivalent of the unprotected portion of property over the life of the Chapter 13 Plan.
If a Debtor is behind on mortgage payments, they might lose their home in a Chapter 7 after the lender gets relief from the automatic stay from the Court.
Preferential payments to family and friends may be seized by a Chapter 7 trustee but a Chapter 13 plan can provide for the equivalent amount to be paid through the plan so the friends and family are protected.
A sole proprietor with employees should not file a Chapter 7 because the trustee will likely order them to shut down business during the pendency of the case. In a Chapter 13, Debtors with businesses who have employees are entitled to continue doing business as usual and are given independence in running their businesses so long as they stay current on their payroll taxes and other required obligations.
THERE ARE LIMITS ON WHAT DEBTS ARE DISCHARGABLE
Some debts are not dischargeable in a Chapter 7 but can be discharged in a Chapter 13 under Section 1328(a) of the Bankruptcy Code. For example, if a Debtor has used a credit card to pay taxes, that debt will not be dischargeable in a Chapter 7 but can be discharged in a Chapter 13. Also, debts ordered to be paid pursuant to a divorce settlement cannot be discharged in a Chapter 7, but can be discharged in a Chapter 13.
THERE ARE LIMITS ON WHAT YOU CAN ACCOMPLISH
While personal liability for secured debts like a home or a car can be discharged in Chapter 7, so long as the Debtor remains in possession of the collateral, the lender can exercise their rights over the security, including foreclosure of the home or repossession of the car if payments are not current. While judicial liens can be avoided if they impair the Debtor's exemption of the equity in the property, under current law there is nothing that can be done about voluntary liens, such as mortgages and car loans, in Chapter 7. In Chapter 13, however, if a home appraises for a value that is less than the amount of the first mortgage, any junior liens like second mortgages and home equity loans can be “stripped off” provided the Debtor successfully completes their Chapter 13 Plan. In a Chapter 13, a car loan can be “crammed down” to it's fair market value on the day the bankruptcy is filed and the creditor is then paid a reduced amount through the plan, so long as the other criteria for cramming down a vehicle loan provided for in Section 506 of the Bankruptcy Code have been met. The same is true for property purchased on store credit cards for which the lender retains a security interest. These things cannot be done in a Chapter 7.
THERE ARE LIMITS TO PROTECTION FROM CREDITORS
In a Chapter 7, the Debtor normally receives their discharge after a relatively short period of time after which the creditors of the non-dischargable debts are free to begin collecting again. However, in a Chapter 13, a Debtor can benefit from a lengthy period of protection from the creditors of their non-dischargable debt during which time they can repay the debt at an affordable rate. Also, co-debtors (other persons also obligated for the debts, such as cosigners), are not protected in a Chapter 7 and the creditors are free to go after them for payment on the debt. In a Chapter 13, however, Section 1301(a) of the Bankruptcy Code provides for a lengthy “co-debtor stay” in Chapter 13 cases that protects the co-debtors from creditors so long as the case is open, during which time the Debtor can make payments on the debt for which the co-debtor would otherwise be liable.
Limits on Chapter 13
But, just as there are limits on who can file Chapter 7, there are also limits on who can file Chapter 13.
THERE ARE LIMITS ON WHO CAN FILE CHAPTER 13:
Only individuals can file Chapter 13 – not business, and they must have regular income sufficient to pay all debts that must be paid through the plan, while at the same time staying current on your monthly obligations such as mortgage, child support, and regular living expenses.
To file a Chapter 13, a Debtor must have filed all tax returns required to be filed for the preceding four tax years per Section 1308 of the Bankruptcy Code. There is no corresponding requirement in Chapter 7.
There are also limits on the amounts of debt a person can have in order to file Chapter 13. These limits are found in Section 109(e) of the code and are as follows:
Unsecured Debts < $419,275
Secured Debts < $1,257,850
THERE ARE LIMITS ON WHO CAN OBTAIN A DISCHARGE IN CHAPTER 13
A Debtor cannot receive a discharge in any Chapter 13 case filed within 2 years of a previous Chapter 13 filing, or within 4 years of a previous Chapter 7 filing.
Thorough Interview Required
It is crucial for the bankruptcy attorney to conduct a thorough interview of their client who is seeking to file bankruptcy. The first questions should determine what sort of deadlines there are – is the Debtor being sued? Are their wages being garnished? Are they facing a foreclosure sale? That will dictate whether the attorney is even available to take the case and how much time they have to prepare it. In an emergency, the Debtor can file what is called a “skeleton” bankruptcy – you only have to file certain sections of the bankruptcy and have 15 days after that to file the remaining portions
The next group of questions should pertain to assets – what kind of assets are we dealing with? A home? Several homes? What are their goals with respect to the homes- do they want to keep them or surrender them? If they want to keep them, are they current on the mortgages or behind? If behind, Chapter 7 is probably not an option. What are the approximate values of the homes? Are they collecting enough rent to cover the mortgages and other expenses on any rental properties? If not, they may have a hard time obtaining a discharge in Chapter 7 if the trustee believes they are squandering money on non-performing assets. Are there only single mortgages on each property or are there multiple mortgages? Are any of the mortgages possibly unsecured and might be stripped in a Chapter 13? How much is the total secured debt? Over $1,081,400.00? Chapter 13 is not an option. If the Debtor cannot file Chapter 7 because they would lose their property or because they do not meet the threshold requirements for filing, they may consider filing a Chapter 11 instead, or forgo filing bankruptcy altogether.
** The above synopsis is to give a general idea of some of the issues involved in filing a bankruptcy to the residents of the State of California only, and is not to be construed as legal advice, nor the creation of an attorney-client relationship between this office and any third party. Results are dependant upon the individual facts present in the case.
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