Overview of Chapter 7 and 13 Bankruptcy
Chapter 7 bankruptcy, also known as liquidation, is by far the most common type of bankruptcy case filed. It is beneficial for consumer debtors who have excessive unsecured debt, as well as debtors who are ready to be free from “underwater” homes and other unaffordable obligations.
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 the following criteria:
- The debtor is a disabled veteran, and debts were primarily incurred during a period of active duty or homeland defense activity
- Less than 50% of the debts at issue are consumer debts (debt that were incurred for personal, household or family purposes)
- The debtor’s income for the last 6 months is below the median income in her state
- Where the debtor’s income is above the median income, a means test calculation must establish that the debtor’s disposable income is insufficient to repay a significant portion of his unsecured debts.
The means test was created by the 2005 amendments to the bankruptcy code. It was designed to establish that the debtor does not have the means to pay a significant portion of debts that are owed to unsecured creditors. An individual who has a modest income and is barely able to cover necessary living expenses each month will almost always “pass the means test.”
The means test may be an obstacle for a person whose income is above the median. However, if household expenses include a mortgage payment, a chapter 7 case 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 may be liquidated to pay creditors. The appointed trustee can take possession of 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 (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, unpaid rent, and most types of civil judgments. Chapter 7 can eliminate personal liability for secured debts such as a mortgage, in the event that the debtor can no longer afford the mortgage payments. The bankruptcy discharge is typically issued three to four months after the case is filed.
If a person owns property that is not fully protected by exemptions, or is behind on mortgage payments, a chapter 13 case may be needed to protect the debtor’s non-exempt or secured assets. Chapter 13 is bankruptcy is known as reorganization. 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 enforcement action against the debtor) is usually in effect from filing through conclusion of the case.
Payments in chapter 13 plans may include:
- payments to secured creditors, per original payment schedule
- payments to secured creditors to make up for past-due amounts
- payment of priority debts (such as domestic support obligations and income taxes)
Payments to unsecured creditors is determined by the amount of disposable income available after the required amounts are designated for all other types of debts (secured debts, priority debts and administrative fees and costs).
After the plan is confirmed, the debtor makes regular payments, often through the chapter 13 trustee. Mortgage payments may be made directly to the creditor or loan servicer.
At the conclusion of the chapter 13 case, if all plan payments have been made, any amounts still owed for non-priority unsecured debts will be discharged. (Under Section 523 (a) of the Bankruptcy Code, there are 19 types of debts which are “excepted” from discharge in a typical case that proceeds without litigation.)
Advantages of Chapter 13: The following are 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 payments that cover current mortgage payments as well as past-due amounts, to be made during the 3-year or 5-year plan.
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 (HELOC) may be modified in certain situations.
If personal property (such as a car price) is secured by a lien, the debtor can reduce the amount owed to the fair market value of the property.
A debtor can pay a tax debt over the course of the plan without being subject to any interest or penalties.