If you’re considering filing for bankruptcy, you should know that not all debts are treated equally. For example, certain debts cannot be discharged, or forgiven, and must be repaid in full. Other debts, however, can be completely discharged either immediately or after a few years depending on if you file a Chapter 7 or Chapter 13 bankruptcy.
Also, some debts can be modified so that you can afford the payments and keep the property the debt is attached to, such as a car or home. How your debt will be treated during a bankruptcy will indicate what you have to gain from filing one.
While most debts can be included in a bankruptcy petition, there are several that will not actually be discharged. These are referred to as “priority debts” because they take priority over other debt. When filing Chapter 7 bankruptcy, priority debtholders will be the first to receive the proceeds from the sale of your assets, and these debts can’t be discharged even if you have no assets with which to pay them down. When filing a Chapter 13 bankruptcy, there must be provisions in the payment plan for these to be paid in full.
Priority debts include:
- Mortgages, car loans, or other secured debts. “Secured debt” means that the loan is secured by an asset, such as a car or home, which can be repossessed if you don’t make your payments. In most Chapter 13 bankruptcies, these loans are restructured so that any missed payments and penalties are included in the payment plan. In Chapter 7 bankruptcy, you may be able to keep the loan and the underlying asset if you can make up the missed payments and continue to make regular payments after your bankruptcy is complete.
- 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 401k 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. However, if you file Chapter 13, you may be able to restructure this debt, 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 and 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. That said, years-old income tax debt may sometimes be forgiven via a bankruptcy. This is discussed further below.
When Can You Discharge Tax Debt?
In order to discharge tax debt, all of the following conditions must be met.
- The debt must be from income taxes only, and 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 (i.e. tax evasion fraud).
- 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.
Upside Down Home and Auto Loans
You are considered upside down on a loan if you have a car, a home, or other asset that is worth less than what you owe on it. This would be the case if you purchased a car for $10,000, but the car is currently worth $7,000 and you still owe $8,000 (i.e. upside down car loan).
However, 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 on what you can use a cram-down modification for. 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. That said, you can only perform a cram-down modification if you file a Chapter 13 instead of a Chapter 7 bankruptcy.
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.
Some lenders are quite willing to do this since it’s likely you’ll be in a better position to make payments once your other debts are discharged. As an aside, if your home is nearing or already in foreclosure, filing bankruptcy will temporarily halt the process via an “automatic stay.”
It is also common to reaffirm an auto loan since this benefits both the debtor and the lender. The debtor gets to keep their 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.
Even though there are many types of debt that won’t ultimately be included in your bankruptcy, it is still advisable to list all your debts when you first file, even ones you wish to continue paying. In this way, you can work out with the bankruptcy trustee exactly which debts you can and cannot include. Moreover, since bankruptcies often proceed differently in different states, it’s best to complete a course of credit counseling before filing to determine how your debts will be treated and the best course of action to pursue.