About Bankruptcy: Overview of Chapter 7 and Chapter 13.

The following is a general overview of the types of bankruptcy cases that consumers typically file.  It is not a comprehensive analysis of bankruptcy law or procedure.  See the Helpful Links for Consumers page if you wish to learn more about bankruptcy law.  You may also schedule a free consultation to discuss your individual circumstances.

Chapter 7

Chapter 7 bankruptcy, also known as liquidation, is by far the most common type of bankruptcy case filed. It is beneficial to debtors who have an excessive amount of unsecured debt, as well as debtors who are ready to be free from “under water” homes and other unaffordable debts.

The 2005 amendments to the bankruptcy code created new requirements intended to restrict chapter 7 cases to debtors who do not have the ability to make significant payments to unsecured creditors.  Essentially, the debtor must meet one of these criteria:

  • The debtor is a disabled veteran, and his debts were primarily incurred during a period of active duty or homeland defense activity
  • Less than 50% of the debts at issue in the case are consumer debts (debt incurred for personal, household or family purposes)
  • The debtor’s income for the last 6 months is below the median income in her state
  • If the debtor’s income is above the median income in her state, a means test calculation must establish that the debtor’s disposable income is less than a set amount or is insufficient to repay a significant portion of his unsecured debts.[1]

The means test was created by the 2005 amendments to the bankruptcy code.  Initially, it discouraged some people from seeking bankruptcy protection. However, it is essentially a matter of itemizing the allowed expenses (including allowed expenses that may have been omitted from the budget, such as health care costs and insurance) and arriving at a disposable income figure that is sufficiently low.  An individual who has a modest income and is barely able to cover necessary living expenses each month will nearly always qualify for chapter 7.

The means test may be an obstacle for a person whose income is well above the median.  However, if household expenses include a high mortgage payment, filing under chapter 7 may still be possible, because payment of secured debts are deducted from disposable income in the means test calculation.

In a chapter 7 bankruptcy, property that is not exempt can be liquidated to pay creditors. This means that the appointed trustee can take the non-exempt property, sell it, and distribute the proceeds. California exemptions are generous, and with careful analysis and planning, most filers keep all of their property. (Read about exemptions here.)

Chapter 7 debtors can usually keep their homes and cars (if that is desired), so long as all of the equity in the property is exempt.

Advantages of Chapter 7:  Many types of unsecured debts can be completely discharged in chapter 7, including: credit card debts, medical debts, old income taxes and unpaid rent.  Chapter 7 can eliminate personal liability for secured debts such as a mortgage, in the event that the debtor can no longer afford the payments.  The bankruptcy discharge is usually obtained in just a few months.

Chapter 13

If a person owns property that is not fully protected by exemptions, or is behind on mortgage payments, chapter 13 is generally preferable to chapter 7.  Chapter 13 is bankruptcy is known as reorganization or individual debt adjustment.

In chapter 13, the debtor proposes a plan to pay creditors over a period of 3 to 5 years.  The debtor must have sufficient regular income to pay secured debts and priority debts. The automatic stay (which prevents creditors from taking any type of action against the debtor) is usually in effect for the entire duration of the case.

Payments in chapter 13 plans are based upon individual circumstances, but they may include:

  • payments to secured creditors, as per the original repayment schedule
  • payments to secured creditors to make up for past-due amounts
  • payment of priority debts
  • payment of administrative fees and costs

The amount of payments to unsecured creditors is determined by the amount of disposable income that is available. Disposable income is determined by deducting all allowed expenses from the debtor’s gross income.

After the plan is confirmed, the debtor makes regular payments, often through the trustee.  Some payments are made directly to the creditor.

It is possible to modify the plan if debtor’s income or other circumstances change during the course of the plan.  At the conclusion of the case, if all plan payments have been made, the remaining unsecured, non-priority debts will be discharged.

Advantages of Chapter 13:  The following are some of the benefits of a chapter 13 case, which are not available in a chapter 7 case.

A chapter 13 case can prevent a foreclosure if the petition is filed before the foreclosure is completed, and the debtor has the necessary income to make plan payments that cover the mortgage plus amounts for priority debt payments.

In a chapter 13 case, a debtor can modify the rights of secured creditors.  In the context of home loans, the first mortgage that provided funds to pay for the home cannot be modified, but a second mortgage or home equity loan may be modified in certain situations. For example: if a debtor has first and second mortgages on his home, and the value of the home is less than the amount owed on the first mortgage, he may establish that the second mortgage is an unsecured debt.  In that case, the lien of the second mortgage holder is “stripped off” and that debt can be can be discharged.

If personal property (such as a car) is secured by a lien, the debtor can reduce the amount owed to the fair market value of the property.  For example: if a debtor owes more on his car than it’s worth, he can “cram down” the amount owed to the current replacement value, as long as the car was purchased at least 910 days prior to the bankruptcy.

A debtor can pay a tax debt over the course of the plan without being subject to any interest or penalties.

Additionally, chapter 13 contains a special provision that protects co-debtors.  A co-debtor is someone who is jointly responsible for the debt; that may be a spouse, another family member, or a business partner. Unless otherwise authorized by the court, a creditor may not seek to collect a debt a co-debtor.  This protection stays in effect throughout the chapter 13 case.

 


[1] An unsecured debt is one in which the creditor does not have a lien on any of the debtor’s property. Most ordinary debts are unsecured (e.g., credit card debt, medical bills). Generally, unsecured debts may be discharged, or eliminated, in bankruptcy. Student loans are unsecured debts but are generally not dischargeable in bankruptcy.

A priority debt is an unsecured debt that receives priority over others during distribution of the debtor’s assets. The most common priority debts are: child support, alimony, wages owed to employees and recent taxes.

A secured debt is a debt that is secured by a lien on the debtor’s property (such as a home mortgage or auto loan).