Each year, more than 700,000 people in the U.S. file for bankruptcy, according to the United States Courts. Many of these people likely look at bankruptcy as a chance to erase their debt and start over. Although that’s true for some bankruptcy cases, you should know that not all debts are treated equally.
How different types of debt are treated in bankruptcy depends on whether you file a Chapter 7 or Chapter 13 bankruptcy, and whether your debt is classified as secured debt, priority unsecured debt, or nonpriority unsecured debt.
Secured debt is backed by collateral that the lender can take if your debt is not paid.
Some examples of secured debt include:
- Car loans
- Home mortgages and home equity lines of credit
- Personal loans with collateral
- Secured credit cards
A Chapter 7 bankruptcy can eliminate your obligation to pay back a secured loan. However, if you want to keep the property backing the loan, you need to be able to keep up with your monthly payments.
If the payments are more than you can afford, or you’re so behind on payments you won’t be able to catch up, you may be able to surrender the property to the creditor and then have any remaining debt discharged through bankruptcy.
In a Chapter 13 bankruptcy, you may be able to make payments on secured debts through your Chapter 13 plan.
What About Upside-Down Home and Auto Loans?
You are considered “upside-down” on a loan if the underlying asset is worth less than what you owe on it. For example, you would have an upside-down car loan if you purchased a car for $10,000, but the car is currently worth $7,000 and you still owe $8,000.
In a Chapter 13 bankruptcy, you can qualify for what is called a “cram-down” modification, in which the loan is reduced such that the balance and the asset’s current value match. This results in either a smaller monthly payment or shorter loan term.
In this example, the loan balance would be reduced to $7,000, or the current value of the car. However, there are limits to using a cram-down modification. For example, you can’t use it on a car loan when you purchased the car within 30 months of your bankruptcy filing or on loans for other personal property purchased within 12 months of your bankruptcy filing.
If creditors can recoup more via this modification than a repossession or foreclosure, they are more likely to accept it. Just keep in mind you can only perform a cram-down modification if you file a Chapter 13 instead of a Chapter 7 bankruptcy.
Priority Unsecured Debts
Priority unsecured debts are not backed by an asset, but they typically cannot be discharged because they take priority over other debts under federal law.
The reason they have that priority status is public policy — the courts have determined that ensuring these debts are paid benefits society.
When filing Chapter 7 bankruptcy, priority debt holders are first in line to receive the proceeds from the sale of your assets. If you don’t have enough assets to pay them down, they can’t be discharged.
In a Chapter 13 bankruptcy, the payment plan must include paying for priority unsecured debts in full for the court to approve it.
Priority debts include:
- Fines, penalties, or fees owed to any government unit. For example, tax penalties, fines on overdue speeding tickets, and vehicle registration fees will not be discharged in a bankruptcy.
- Most student loans which are guaranteed or funded by the government. Student loans directly provided by the government or a government-affiliated institution, such as Sallie Mae, cannot be discharged unless you can show that repaying them would cause you “undue hardship.” However, this is an extremely difficult standard to meet. That said, most providers have hardship programs that lower your payments or extend the term of your loan. Moreover, since many “private” student loans have some sort of government guarantee, most student loans cannot be discharged.
- Benefit overpayments. For example, if you received unemployment benefits, but were sent too much money, you may be required to repay the excess. However, if you’re unable to pay, it becomes a debt that can’t be discharged.
- Loans from a 401(k) plan or other tax-advantaged retirement plan. Bankruptcy court doesn’t discharge debts you owe to yourself. Since this is exactly what a retirement plan loan is, it won’t be forgiven if you file for Chapter 7, and it must become a part of your repayment plan if you file Chapter 13.
- Debts related to “willful and malicious injuries to person or property.” If a court has ordered you to pay damages for intentional injury to a person or their property — including damages incurred while driving under the influence — filing bankruptcy will not clear or reduce this debt. You may be able to restructure this debt in a Chapter 13 filing, but you still won’t be able to eliminate it.
- Alimony, spousal support, or child support debts. These debts cannot be included in a Chapter 7 bankruptcy at all. However, they can be included in a Chapter 13 bankruptcy, as long as they become part of the payment plan with a provision that overdue payments will be satisfied in full and current payments will be continued.
- Taxes you owe to a local, state, or federal government. Current tax liability, past tax debts from previous years, and any fees or penalties, plus other kinds of tax, such as payroll taxes, are considered priority debt. Most cannot be forgiven in a bankruptcy. If you are unable to pay a current or recent tax bill, deal with the IRS separately, outside of bankruptcy court, since they do offer hardship plans and even forgive debts in extreme circumstances. In some cases, years-old income tax debt can be forgiven in bankruptcy. We’ll discuss that option below.
Nonpriority Unsecured Debts
Nonpriority unsecured debts aren’t backed by collateral and don’t have any priority. After your bankruptcy trustee liquidates any eligible property and pays administrative expenses, secured claims, and priority unsecured claims, any nonpriority unsecured creditors split the remaining funds (if any).
Some examples of nonpriority unsecured debts include:
- Credit card debts
- Private student loans
- Unsecured personal loans
- Some utilities
- Medical bills
Typically, any amount not paid through bankruptcy will be discharged.
When Can You Discharge Tax Debt?
In order to discharge tax debt, all of the following conditions must be met.
- The debt is from income taxes only, and does not include fees, penalties, or other taxes, such as payroll or sales tax.
- You did not file a fraudulent tax return or otherwise intentionally avoid paying taxes.
- The income tax debt is at least three years old. If you have more current income tax debt, you can usually work out a payment plan or an offer in compromise with the IRS directly. But you can’t include recent income tax debt in a bankruptcy.
- You filed the tax return that generated the income tax bill on time and at least two years ago. You can’t wait several years to file your taxes, then file multiple years all at once in order to declare bankruptcy and avoid paying a large tax bill.
- You must have owed these taxes for at least 240 days prior to filing your bankruptcy petition.
Be aware, the IRS can place liens on your property for unpaid tax debt, which cannot be wiped out in a bankruptcy even if the tax debt itself met these requirements and was forgiven. In other words, once your bankruptcy concludes, the lien will still be in place.
Reaffirming Debt in a Chapter 7 Bankruptcy
Since a Chapter 7 bankruptcy requires that you sell your assets in order to pay off your debts, you may wish to keep certain debts in order to keep the asset attached to it. For example, if you will be able to pay missed mortgage payments and continue monthly payments once your other debts have been discharged, you may be able to “reaffirm” your mortgage.
Reaffirming a debt means that, with the lender’s permission, the debt will be set aside during the bankruptcy and will not be discharged. In exchange for continuing to make payments as agreed, you are able to maintain ownership of the asset — your home in this example.
It’s also common to reaffirm an auto loan because this benefits both the debtor and the lender. The debtor gets to keep the car and the lender avoids having to repossess and sell the car for what is likely to be less money than the loan is worth.
Some lenders are quite willing to agree to reaffirm a debt because you’ll likely be in a better position to make payments once your other debts are discharged.
Federal bankruptcy law requires anyone who files for bankruptcy to get credit counseling before filing a bankruptcy petition. You can find a list of approved credit counseling agencies via the U.S. Department of Justice.
Your credit counselor can help you list all of your debts and figure out exactly which ones can and can’t be discharged by bankruptcy.
Were you aware that different types of debt are treated differently in bankruptcy? Were any of these categories surprising to you?