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.
Three Chapters
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.
