Bankruptcy in a Nutshell

by James Sokolowski
Bankruptcy paperwork can be daunting, but the end result should be far fewer debts.

Bankruptcy paperwork can be daunting, but the end result should be far fewer debts.

Burke/Triolo Productions/Brand X Pictures/Getty Images

When debt becomes overwhelming, bankruptcy law offers individuals and businesses a fresh start. Bankruptcy is so important, in fact, that it’s mentioned in the U.S. Constitution. The process typically wipes out many debts, such as credit cards, car loans, mortgages and medical bills, but not child support or taxes. The debtor is left with a modest amount of resources with which to start rebuilding financially. Several types of bankruptcy exist and they're named after the chapters in the U.S. Bankruptcy Code.

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Types of Bankruptcy

Individuals usually file for bankruptcy either under Chapter 13, which establishes a plan for the debtor to repay some or all of his debts, or Chapter 7, which liquidates the debts. Companies can file under Chapter 7 if they plan to go out of business. Companies that want to stay in business can use Chapter 11, which is known as reorganization and is similar to Chapter 13. There also are lesser-known chapters, including Chapter 12 for farmers and fishermen, and Chapter 9 for cities and other government entities.

Chapter 7

Chapter 7 is for people of limited means, in that a debtor's income falls below the median for his state or he passes a “means test” showing he cannot afford to repay his debts. Depending on which state he lives in, the debtor can keep some property regarded as “exempt” under state or federal law. The federal Bankruptcy Code has its own list of exempt property but allows states to substitute their own list of exemptions. All states have created their own exemptions. In most states, debtors must use the state exemptions. In other states, debtors choose between state and federal exemptions when they file their petition for bankruptcy. However, debtors cannot use their state's exemptions if they have lived there less than two years. In that case, they may be able to use the exemptions of their previous state of residence, or they may have to use the federal exemptions, depending on the states involved. Exemptions usually include a certain amount of equity in a home, a modestly priced car and home furnishings. The bankruptcy trustee will sell the debtor’s nonexempt property and give the money to his creditors. In reality, though, most Chapter 7 cases don't have any nonexempt property. The bankruptcy court then discharges the debt; thereby, rendering the debtor no longer responsible for paying them. Certain types of debt cannot be discharged in Chapter 7, including student loans, alimony, child support, taxes where the tax return was due more than three years before bankruptcy was filed and debts for "willful and malicious injury" to someone else's property.

Chapter 13

Most people can file for Chapter 13, although they must earn enough money to pay at least a portion of their debts. Individuals are ineligible for Chapter 13 if their debts are too high. Although the limits change periodically, in general, the debtor cannot have unsecured debts more than roughly $360,000 or secured debts more than $1 million. An individual with debts above the limits could file Chapter 11 or Chapter 7, if eligible. For debtors who follow court procedures, there are no other significant restrictions on which individuals are eligible for Chapter 13, other than restrictions based on the individual's prior bankruptcy cases. The debtor proposes a plan to make monthly payments for three to five years, leaving himself enough income to live on. The law gives priority to certain types of debt, like child support and taxes. If the debtor makes all of his payments through the repayment plan, the court discharges whatever debts are left and the debtor is no longer responsible for repaying them. The types of debt that cannot be discharged in Chapter 13 are similar to the list for Chapter 7: student loans, alimony, child support and taxes where the tax return was due more than three years before bankruptcy was filed. However, Chapter 13, unlike Chapter 7, may discharge debts for willful and malicious injury to property as well as debts from the division of property in a divorce case.

Differences

Going through Chapter 7 is fast, by legal standards, often taking only four to six months. Chapter 13 takes at least three years. Additionally, Chapter 7 stays on your credit report up to 10 years, whereas a Chapter 13 reporting stays during the repayment period plus seven years. The damage that bankruptcy does to a person's credit score depends on how good her credit is. Bankruptcy will hurt a good credit score more than a bad credit score. Someone with a score of 780 will be lowered 220 to 240 points, while someone with a 680 will get hit by 130 to 150 points. But this drop may be countered by the benefits of bankruptcy eliminating debts, collection accounts and future late payments.

Filing Bankruptcy Twice

After bankruptcy, a debtor normally must wait a while before filing for bankruptcy again. If he first received a Chapter 7 discharge, he may have to wait eight years after filing the first case before filing Chapter 7 again or four years after the initial filing before filing Chapter 13. If his first discharge was Chapter 13, he may have to wait six years after filing the first case before filing Chapter 7 or two years after filing before filing Chapter 13 again. There are exceptions, though. For example, in some narrowly defined situations, a homeowner can file for Chapter 13 immediately after a Chapter 7 discharge to eliminate a lien from a second mortgage.