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What Is Chapter 7 Bankruptcy – Filing Rules & Means Test

By Kira Botkin

bankruptcy billsWhen you think of bankruptcy, you probably think of Chapter 7 bankruptcy. It is sometimes referred to as a “straight bankruptcy” or a liquidation. Chapter 7 bankruptcy allows most debts to be entirely forgiven without entering into a payment plan.

Your non-exempt assets are “liquidated,” or sold off, in order to pay for at least a portion of your debt. After the proceeds are distributed to your creditors, the remainder of  your dischargeable debt is forgiven.

Chapter 7 bankruptcy may be appropriate if you have significant debt you can’t currently pay and don’t foresee an ability to pay in the future. It is an extreme measure, but can offer a way out from an otherwise untenable situation.

Secured vs. Unsecured Debt

When filing for bankruptcy, your debt is divided into two “piles”: secured debts and unsecured debts.

Secured Debt

A secured debt uses property you own as collateral. For example, if you have a car loan, the car is the collateral and the loan is “secured” by the car. That is, the lender has the right to collect the collateral if you renege on payment.

If you have a secured debt, the lender can repossess, sell, or foreclose on the collateral in order to pay for the debt. They have “first dibs,” so to speak, to the proceeds from that particular piece of property. However, collateral used to secure debt may be protected from liquidation if it doesn’t make sense for the trustee to sell it.

For example, if you have an auto loan and owe more than the car is worth (i.e. upside down car loan), there will be little point for the bankruptcy trustee to force a sale of the car because its sale can’t even cover the underlying debt, not to mention additional unsecured debt. In that situation, you are generally allowed to reaffirm the debt (a concept discussed further below). By doing so, you keep both the debt and the car as long as you can afford to continue to make payments after your bankruptcy is complete.

However, this option only applies if you can afford to make the payments. If you can’t afford the payments even after other debts are discharged, it’s generally better for your credit score to try to sell the car or home yourself and repay the loan. But if the sale of such property will not allow you to pay off the underlying loan in full, you will need to seek permission from the lender to forgive the remaining debt in order to finalize the sale. This can be done outside of bankruptcy proceedings.

Lastly, if you can’t afford the payments or don’t wish to sell the car or property yourself, the only other option is to let it be repossessed or foreclosed.

Unsecured Debt

An unsecured debt, on the other hand, does not have property securing it. The most common type of unsecured debt is credit card debt. Medical bills are also a common type of unsecured debt. These debts get paid off through the sale of non-exempt assets as opposed to the repossession or liquidation of attached collateral. Because most people who file for Chapter 7 bankruptcy have few assets, many creditors who lend unsecured debt will not recoup very much, if anything.

bankruptcy glasses

Exempt vs. Non-Exempt Assets

Most people filing for Chapter 7 bankruptcy don’t have significant assets. But when assets do exist, the bankruptcy trustee will categorize them as either non-exempt or exempt in order to determine which will be sold and which are allowed to be kept.

Exempt Assets

Exempt assets are simply those that the trustee is not permitted to liquidate. Their description varies greatly by state but generally includes most personal items such as household furnishings, clothes, a car (up to a certain value), general items you need for daily life, and some retirement assets. If you took out secured debt using any of these items as collateral, however, they may be liquidated to pay that debt.

In addition, Roth IRA and traditional IRA accounts are generally considered exempt up to roughly $1 million. In other words, anything over that amount will be liquidated and paid out to creditors. However, the treatment of retirement plans can vary substantially by state. Some accounts may not be considered exempt, or are considered exempt up to an amount set by the state, or the exemption amount is determined during bankruptcy proceedings based on what the court thinks is reasonable. In other words, if you’re considering filing for bankruptcy and have a substantial amount in retirement accounts, check your state’s laws and consult an attorney.

Be aware that if you have significant equity in an asset that is otherwise considered exempt, the court may attempt to extract some of that equity, up to and including forcing the sale of the property. If the property was used as collateral on a loan, the lender will then be paid in full and the rest of the proceeds, if any, will be put into the pool to be divided among the other creditors.

Non-Exempt Assets

All other assets are considered “non-exempt” and can be sold by the bankruptcy court in order to pay creditors. Non-exempt assets can include some non-essential items like stocks or bonds, savings accounts, valuable collections of art, electronics, a second car, or a second home. All proceeds from the sale of these assets go into a pool of money from which creditors are paid according to whether their debt is secured or unsecured and how much they are owed.

Debt Payment Order

If you have non-exempt assets, the trustee will confiscate and sell them in order to create a pool of money out of which your creditors can be paid. Creditors are then paid according to whether the debt was secured or unsecured and how much you owe. If the trustee sold property such as your car or home that had a secured debt attached to it, that is paid first.

However, if the sale of your car or home didn’t pay off the auto loan or mortgage in full, the rest of the amount you owe becomes an unsecured debt. Any extra funds after a secured loan has been paid off will go into the pool of money to pay off your other creditors.

Since most people who file Chapter 7 bankruptcy don’t have much in the way of assets, creditors must often be satisfied with only a portion of what they are owed. In fact, approximately 85% of people who file for Chapter 7 have all their debt discharged without repayment.

Retirement Plan Loans

Loans from your 401k or other retirement plan are essentially money you owe yourself and therefore receive unique treatment during bankruptcy proceedings. After all, a loan from your 401k is a way to access the funds within it without paying taxes and penalties. These cannot be discharged in Chapter 7 bankruptcy since you’re only allowed to default on debts owed to others.

Still, if you have a 401k loan, you’ll need to include it in your debts. You will be required to make payments even after the bankruptcy is complete and all other debts are discharged. As a side note, in Chapter 13 bankruptcy, 401k loans can be made part of the payment plan and some of the amount can be wiped out.

Non-Dischargeable Debt

Even bankruptcy proceedings cannot discharge certain types of debt including student loan debt, child support, alimony, income taxes, property taxes, and fines imposed for criminal activity.

Keeping Your Home

A common concern among homeowners who want to declare bankruptcy is whether their home will have to be sold. In Chapter 7 bankruptcy, all of the debtor’s non-exempt assets are fair game for bankruptcy court. In many states, if you have equity in your home, a “homestead exemption” permits you to keep a portion of it as part of your exempt assets. Your homestead exemption is usually set as a fixed amount of money that is determined by the state, and has no relation to the amount of equity you actually have. However, this doesn’t mean you keep the home itself. The bankruptcy trustee in most states is permitted to force the sale of your home if you have equity above the homestead exemption in order to use the excess to pay your unsecured debts.

However, if you have little equity in your home, it probably doesn’t make sense for the trustee to sell it to satisfy your other debts. This is because after your home is sold, any proceeds will first go to pay off the mortgage, then to pay off home equity lines of credit, and then toward any remaining liens on the home. Creditors of unsecured debt get paid off last when there likely may not be any remaining funds from the home sale. Since costs associated with selling a home can be significant, the trustee will only look to home equity as a source of money if you have a lot of equity in it. Generally, your mortgage company would prefer that you reaffirm your debt and keep the home, rather than have the trustee liquidate it or go to foreclosure.

foreclosed home bankruptcy

Reaffirming a Debt

When you reaffirm a debt, you can keep the original loan intact despite declaring bankruptcy and having other debts discharged. This is frequently done when you want to keep the property that the reaffirmed debt is secured by, such as a home or a car. If you have other debts wiped out, you are usually in a better position to afford paying the remaining loan, which is why lenders often agree to this plan for a debtor who is otherwise not a risk.

For example, if your home has low or no equity and you are not at risk of foreclosure because you’ve kept current on your payments, Chapter 7 bankruptcy may actually help you keep your home because once your other debts are wiped out, you can more easily make mortgage payments. If you want to continue paying on your mortgage, and can afford to do so, the trustee and lender may agree to let you “reaffirm” the debt. In fact, you’re likely to be a better credit risk after your bankruptcy because you don’t have other debts and your credit score is too low to allow you to take on additional debt for at least a few years.

The Automatic Stay

If you’re considering bankruptcy, you’ve probably received a lot of unwanted attention from your creditors, and foreclosure proceedings may have already begun on your home. Once you file for bankruptcy, however, an “automatic stay” measure is activated which requires all lenders to immediately stop their collection attempts. They must wait until bankruptcy proceedings conclude to get paid.

The automatic stay can also prevent a foreclosure from moving forward. That said, the lender can ask for an exception if foreclosure proceedings were already underway or the lender was prepared to start on foreclosure when the bankruptcy was filed. If the lender can prove they are the legal owner of the mortgage and have good reason to foreclose, the exception is frequently granted. But proving legal ownership can be a difficult task especially considering that most mortgages are sold and resold multiple times.

The Means Test

An alteration to the Chapter 7 bankruptcy rules in 2005 added a “means test.” This change was made in response to a large number of bankruptcies declared by people who had significant assets. These individuals took advantage of loopholes that shielded substantial assets from bankruptcy proceedings; assets that could have been used to pay off their debts. The result was that some people were able to walk away asset rich and debt-free after declaring bankruptcy. Since bankruptcy was never intended to help the rich get richer, so to speak, the means test was introduced. Now, people with significant assets cannot declare Chapter 7 bankruptcy, but instead must file for Chapter 13 bankruptcy where they are required to repay at least some of their debts.

Fortunately, you do not have to be completely broke to qualify for Chapter 7 bankruptcy. The means test is fairly generous and is meant to weed out those who make more money or have more assets than the average person in their state. Also, only those who file for Chapter 7 bankruptcy on account of consumer debts need to pass the means test. Those who file because of business debts do not.

The means test first requires you to determine your current monthly income (calculated by averaging your income each month over the past six months) and compare it to the median income for the same size household in your state. You can find current information by going to the U.S. Trustee Program at the Department of Justice website. Select the most recent period in the drop-down menu and click the link in Section 1. This will give you the median yearly income for your area, broken down by number of household members. Divide that number by 12 to get a comparable monthly income. If your income is less than the median income for your state, you have passed the means test.

If your income is larger than the median, you may still be able to pass the means test, but the calculations become much more complex. You must show that you have little or no disposable income left after paying your debts, bills, and an allowed amount of living expenses. An online calculator can help you determine if you can still pass this test. If you are unable to pass the means test due to a high income or assets, but have decided that declaring bankruptcy is a good choice or a necessity, you will be required to file Chapter 13 bankruptcy instead of Chapter 7.

Final Word

While filing for Chapter 7 bankruptcy can be a godsend for some, carefully consider whether it will make your financial situation better or worse. It has a significant effect on your credit score, especially for the first few years. Plus, you may be required to give up sentimental assets, such as a nice car or a home you’ve lived in for many years. Further, certain debts such as child support, alimony, and student loans can’t be discharged and you can’t file again for quite some time. Because it is a time-consuming process with long-ranging consequences, make sure you’ve fully considered the alternatives before you decide to file.

What are your thoughts on Chapter 7 bankruptcy? Have you ever considered filing?

(photo credit: Shutterstock)

Kira Botkin
Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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