Bad weather hits your part of the country and you find your land flooded, your house and possessions completely burned, or the area leveled by a tornado or flattened by a hurricane.
The plant closes and you are laid off. Between savings and credit cards you are able to keep food on the table, but you have missed a couple of mortgage payments. The credit line backing up your checking account is at its limit, as is the equity line of credit you intended to use for the kid's college education. You were injured at work and the insurance paid only part of the costs. You are facing constant calls and harassing letters from collection agencies and lawyers.
The scenarios described above are all too familiar these days. With the slow economic recovery and the threat of higher taxes, Americans feel as if their wallets are being wrung dry of that last dollar bill. Some people struggle for years and survive. Few get lucky and win the lottery. Some turn their fortunes around, but only after changing careers or leaving their homes for another part of the country.
There is an alternative, however, and it is one that our Founding Fathers thought was so important that they wrote it right into the main body of the Constitution of the United States. (They didn't even wait for the Bill of Rights to come along many years later.) That alternative is filing for bankruptcy.
Despite the negative connotations that have been associated with the word in the past, more and more Americans are finding that bankruptcy—and the fresh start it brings—empowers them to face the future with hope and the knowledge that they are productive citizens contributing to the good of their families and society. Consider the alternative that was practiced in England during the 17th century (from which our Founding Fathers came): debtors were thrown in prison until the debt was paid. Those who did not pay faced the prospect of "transportation"—that is, sailing in a prison ship to mean, nasty places like Australia, New Zealand, or America to work off the debt in "the colonies:'
We no longer have debtor's prison. What sense does it make keeping someone who wants to work from working? We also no longer have "transportation:" Where would the government send people? Siberia? Mars? Bankruptcy allows people to get a fresh start by keeping their existing creditors at bay and allowing industrious Americans to get back to work, pay their new creditors, pay their taxes, and join mainstream America as productive citizens once more.
The Stay and the Discharge
Bankruptcy allows people with more debt than they can presently repay (we'll call them "debtors") to take charge of their lives. The two most important aspects of bankruptcy are the first and last things that occur in a bankruptcy case—and are the things that allow a debtor to take control of his or her life. The first is the "automatic stay"; the second, the "discharge."
A "stay" is a stop order, which is put in place by the federal laws as soon as the first papers, called the "petition," are filed with the bankruptcy court. This stay is a federal stop order that freezes all the lawsuits and actions by creditors to collect debts. The stay stops evictions, foreclosure sales, and lawsuits. Perhaps best of all, it stops the nasty telephone calls. Collection agencies, when informed by the debtor that a petition has been filed, can no longer call or write to the debtor demanding collection of a debt. Instead, they must deal with the debtor's lawyer.
The stay may be permanent or temporary, depending on the circumstances of the case. But in any event, the automatic stay gives a debtor breathing room from his creditors by stopping all the actions that creditors may take against the debtor to enforce an outstanding debt.
The second most important aspect of a bankruptcy filing is the "discharge:" The discharge is the last—and most sought after—event that occurs in a bankruptcy case. When a debt is discharged, it is legally canceled. No person or entity can try to collect that debt in the future. The debtor can earn a living without the fear that creditors will attack his future paychecks, can save money without the fear that assets in bank accounts will be seized, and can plan for the future without fear that the past will make the future unbearable.
The theory here is that if debtors could not get relief from past debts, they would never try to earn a living in the future, for fear that future earnings would be taken.
The law encourages people to plan for a constructive future by allowing debtors in bankruptcy to discharge their past debts.
Keep in mind, however, that debts are not discharged unless they are "old," remaining unpaid for a tax return filed more than three years before the bankruptcy filing. Similarly, certain student loans will not be discharged unless the first payment on the loan was due more than seven years prior to the bankruptcy filing.
A third category of debts that will not be discharged are alimony and support payments. The property aspects of a divorce settlement may be discharged, but the alimony and support aspects may not be discharged. A fourth category of debts are those that are fraudulent. An example of fraud may include a material misrepresentation on a loan application—overstating one's income or assets, for instance.
Equity and Exemption
In many circumstances debtors can file a bankruptcy petition and be able to keep their house, household goods and furnishings, an automobile, and the tools of their trade, making a fresh start in life that much easier. Exactly which items a debtor may keep is determined by a combination of federal and state laws referred to as the "exemption" laws. The generally understood theory about bankruptcy is that a debtor must "liquidate," or sell all possessions and distribute the proceeds of the sale to creditors. But the federal bankruptcy laws exempt various types of property from the liquidation process, so long as the property does not exceed a certain value.
Believe it or not, the tax laws in bankruptcy also help a debtor keep his house. If the trustee sells the house, the trustee must pay the federal income taxes resulting from the sale. In our example, if the house had been purchased by a couple 20 years ago for a mere $50,000 and sold this year for $150,000, the taxes on the capital gains of $100,000 (approximately 1/3 of that amount, or $33,000) would have to be paid by the trustee out of the sales proceeds. So the trustee will not force the sale of a debtor's house worth $150,000 unless the equity after payment of the mortgage is more than the combination of the debtor's exempt equity ($15,000), the transaction costs (estimated at 10 percent, or $15,000 in our example), and the capital gains tax ($33,000 in our example). In our example of a house with a fair market value of $150,000, the available equity would have to exceed $63,000 before the trustee forces a sale. Therefore, a debtor with a large mortgage may be able to keep his house, despite the filing of bankruptcy.
In most cases, in order to keep a house, the mortgage must be current. If payments are not current, the mortgage holder may apply for permission to begin a foreclosure based on the debtor's failure to pay currently. So if faced with the choice of paying a mortgage payment or paying other creditors, the debtor would make sure that the mortgage is paid.
Many of us have heard about different "chapters" in bankruptcy, including Chapter 7, Chapter 11, and Chapter 13. So far we've been discussing Chapter 7, also referred to as a "straight" bankruptcy. A Chapter 13 is a "workout" for individuals. A Chapter 11 is a "workout" for corporations or individuals with large debts.
A workout differs from a straight bankruptcy by allowing a debtor to make payments over time. This is particularly useful if a debtor is behind on a mortgage or equipment loan and wants to keep the property or equipment. A workout allows a debtor to make current payments and catch up on the back payments over a period of time, usually three to five years. If the workout provisions are deemed fair by the court, the creditors may be forced to accept the plan, even if they don't agree with all of its terms. The ability to propose a workout is a powerful tool to help a debtor keep his or her house.
Like a repossession or foreclosure, the filing of a bankruptcy is shown on a debtor's credit report. So why would anyone choose bankruptcy over foreclosure or repossession? The difference is this: there can be no more lawsuits or late charges on old debts after the date of the bankruptcy filing. After a foreclosure, the creditor may obtain a judgment against the debtor, which can be effective against the debtor for a long period of time. A bankruptcy filing after the foreclosure or repossession cuts off the ability of the creditor to take assets for such an extended period of time.
What About My Credit?
Will a person who files for bankruptcy ever again be able to get a credit card or mortgage? The answer here is surprisingly, and overwhelmingly, yes! Consider this: The day before filing for bankruptcy, the debtor has huge debts piled up, has no ability to make monthly payments, and has the ability to file bankruptcy and get the debts discharged. A creditor views this situation as an unreasonable risk.
On the other hand, the day after the discharge is granted, the debtor has no debt (it has all been discharged), has the ability to make current payments on new debt (if he has a job), and usually cannot file bankruptcy for another six years (thus allowing new creditors at least six years to seek satisfaction of new debts). In other words, the debtor is much more "credit worthy" the day after declaring than he was the day before. Part of the idea behind the fresh start is to wipe clean the debtor's credit report. The big myth is that we all have ratings and that they're just like a school report card. Individuals do not have a credit rating. What they have is a "credit history."
Reported by several companies nationally, including TRW, this history sets a person's payment history: the record of whether the individual made monthly payments or not and whether the payments were made in a timely manner. A person with perfect credit has a credit report that shows that all monthly payments were made currently. A late payment is shown with a number, showing the number of months late the payment was made. The greater the number of late payments, the worse the credit report. Events such as foreclosures and repossessions are also noted.
So while the fact that a person filed for bankruptcy may appear on a credit record for as long as 10 years, a person may be able to reestablish credit to obtain a mortgage within two years. Of course, normal underwriting requirements must still be met, but, if after filing bankruptcy a debtor managed to save a large-enough down payment, established a good credit rating, and had a good job, he or she would stand a good chance of qualifying.
Finally, debtors often ask about the moral obligations associated with filing for bankruptcy. Clearly the decision is very real and personal. I remind clients they are free to repay clients later, when business gets better and the prospect of losing one's house or business passes. The difference is you send the check or money order when you have the ability to do so, not when someone else demands payment.
There is no one solution for debtors in this rapidly changing age. Bankruptcy may not be the answer to all of your problems. But more and more often it is being accepted as a reasonable alternative in this changing world.