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Bankruptcy and its Effects ADRE Course No. C1070 - 3 credit hours in Real Estate Legal Issues BANKRUPTCY OVERVIEW Most people file bankruptcy to get a "discharge." A "discharge" is a court order which states that certain debts do not need to be repaid. Certain types of debt are non-dischargeable, including: (i) most taxes; (ii) child support/alimony; (iii) student loans; (iv) debt incurred as the result of fraud; (v) court fines and criminal restitution; and (vi) personal injury damages caused while under the influence of a controlled substance. There are several different "Chapters" of the U.S. Code, which extend bankruptcy protection to individuals and businesses. For example, Chapter 12 is for family farmers and family fishermen. In addition, Chapter 11 cases are sometimes discussed in the news (Bashas', K-Mart, Circuit City, the airline companies). However, for most people, the two types of bankruptcy that really matter are Chapter 7 and Chapter 13. I. Chapter 7 ("Liquidation") A. Overview: i. The BK Court discharges all unsecured creditors (credit card companies, medical bills, deficiencies, etc.). ii. In exchange for the discharge, the BK Court will sell all of the debtor's "non-exempt" assets and distribute the proceeds to their creditors who file claims. iii. Many of the things that people own are exempt. For example: your home (up to $150,000 in equity); one vehicle (up to $5,000 in equity—doubles if you're married); household furniture and appliances (up to $4,000 of "garage sale" value—doubles if you're married); ERISA-compliant retirement accounts; wedding rings; tools of the trade; and the list goes on. iv. There are some things that are not exempt, typically luxury items. For example: equity in extra vehicles (RVs, motorcycles, ATVs, boats, jet skis, cars, etc.); investment property; business interests; bank accounts (in excess of $150 on the day you file—doubles if you're married); personal injury claims; tax refunds not yet paid; and the list goes on. B. What else should I know? i. In order to qualify for Chapter 7, a debtor must pass the "Means Test." Two prongs to the Means Test: a. if the debtor makes less than the median income for the state in which they live, then they pass the "Means Test" b. If the debtor makes more than the median income for the state in which they live, then the debtor's income must be compared to their monthly family expenses. i. Median Income for Arizona: One $42,603 Two $55,404 Three $59,659 Four $67,113 Five and up: add $7,500 for each additional ii. The whole process takes approximately 5 months, from filing to discharge. iii. It will "hit" the debtor's credit score approximately 125 points. iv. It takes most of our clients 2 years to rebuild their credit score. v. You can keep any secured property in a Chapter 7. How? a. If you continue to pay on your secured debt, you can keep the secured property. The debtor can't be behind on payments for any secured property they keep in a Chapter 7 (unless the lender agrees to a modification). b. What happens to a second loan if their home is worth less than their first loan? The debt is discharged, but the lien remains intact. II. Chapter 13 ("Reorganization") A. Overview: i. A Chapter 13 bankruptcy involves making a monthly Chapter 13 Plan payment to a Trustee for 3-5 years. ii. The Trustee makes payment to the debtor's creditors for the 3-5 years (both secured and unsecured creditors). a. One Exception: In Maricopa County, the debtor typically makes their house payment directly to the lender. iii. The amount paid to unsecured creditors who file claims in a Chapter 13 Plan often amounts to pennies on the dollar. iv. At the end of the 3-5 year period, all of the debtor's unsecured debts are discharged. B. First the "Good News.".. i. If a debtor's home is worth less than their first mortgage, then the second mortgage lien can be voided and the debt is placed in the same category as credit card debt (remember, they only get a few cents on the dollar). ii. If a debtor has owned the same vehicle for at least 2 1/2 years before the date of filing, then the debtor has the option to force the lender to accept payment based on what the vehicle is currently worth, not what remains to be paid on the loan. iii. A debtor's bankruptcy-related attorney's fees can be paid through the Chapter 13 Plan. iv. A Chapter 13 Plan can stop the accrual of penalties and interest on unpaid taxes. v. Arrearages on secured property can be included in the Chapter 13 Plan payment. C. Now for the "Bad News" i. A Chapter 13 Plan can last anywhere from 3-5 years. The debtor's credit is not hit by the discharge until the end of the Chapter 13 Plan. ii. If income goes up, your plan payment goes up, and vice-versa. iii. It is difficult to save money and to get credit while a Chapter 13 Plan is in effect. iv. There are limitations to the amount of debt one may have in order to file a Chapter 13: No more than $360,475 in unsecured debt; and No more than $1,081,400 in secured debt. III. Chapter 11 ("Business Reorganization") A. Overview: i. For companies (LLC's and corporations), and also for individuals. ii. No debt limits. iii. Time limit very flexible (2-7 years). iv. This Chapter works for individuals who do not qualify to be in a Chapter 13, because they have too much debt, and who have too many assets to sacrifice in a Chapter 7. v. Relatively expensive. Most attorneys work on an hourly basis for Chapter 11 cases, and the fees can total from $10,000 to $20,000 for a small case. Typically, a retainer is at least $10,000. IV. Means Test The Means Test was first used in the Bankruptcy Code in 2005. It basically requires that any individual with consumer debt, must "qualify" in order to file a Chapter 7 bankruptcy case. This is addressed above in Paragraph 1(b)(i). It is essential to note that the Means Test does not apply if the debt is "primarily" non-consumer debt, i.e., business investments, deficiencies on commercial properties and rentals, and the like (as opposed to residential mortgage balances, vehicle loans, and consumer credit cards). V. Automatic Stay When a person or business files bankruptcy, Federal Law imposes an automatic "stay" on all collection activities against that person or entity. If there is a Trustee's Sale set for a house to be sold, for instance, a bankruptcy filing postpones that Sale, if the bankruptcy is filed before the Sale takes place. Lawsuits are put on an immediate hold, and creditors cannot even send letters or make telephone calls to collect on a debt, once the automatic stay is in place. While the court gives notice fairly promptly of the automatic stay, under operation of law, it takes effect immediately upon filing, whether or not the creditor knows about it. One important exception to this is the eviction process. If the court has already entered an order on a forcible detainer, the automatic stay does not stop the creditor from proceeding to evict. Similarly, divorce actions not related to money are exempted from the stay. VI. Tax Effects Many people receive a 1099 when their house forecloses, for the balance that was not paid when the property sold. There are three exceptions to that general rule that realtors should be aware of: the personal residence exception, the insolvency objection (when the total amount of debt exceeds the total amount of assets at the time of the sale), and bankruptcy. All three of these use the same publication (IRS Publication 4681) and tax form to be submitted with the tax return (Form 982). Properly completed, 982 "trumps" a 1099 resulting in no taxes owed on the imputed gain for a forgiveness of debt. VII. Dischargeable Debts Certain debts are not discharged, such as recent debts, i.e., less than 3 years (income taxes, sales taxes, payroll taxes, and anything arising out of a divorce decree—not only child support or spousal maintenance, but any debt owed to an ex-spouse). Debts incurred shortly before a bankruptcy filing, or debts incurred mal-intent, as well as student loans. |