To the extent you do not pay off your debts during a Chapter 13 payment plan, the remaining balance is usually legally written off forever.
Our last two blog posts were about how Chapter 7 “straight bankruptcy” deals with “general unsecured” debts. But how about Chapter 13 “adjustment of debts”? What happens to those simple debts, which are neither secured by a lien on something you own nor are not a “priority” debt?
“Priority” and “General Unsecured” Debts
Let’s go back and distinguish these two kinds of debts. The distinction is crucial because of how they are treated under Chapter 13. You have to pay “priority” debts in full during the course of the 3-to-5-year payment plan. You generally only have to pay “general unsecured” debts to the extent you have money to pay them.
So what’s the difference? Simply, “priority” debts are specific categories of debts that Congress has decided must be treated specially. They are debts that the law says that in a Chapter 13 case you must pay in full before paying the “general unsecured” debts anything.
The “priority” debts are all on a list in the Bankruptcy Code. If a debt is not one of the kinds on that list, then it’s a “general unsecured” debt. The main “priority” debts in consumer Chapter 13 cases are recent income taxes and past-due child and spousal support.
The Discharge of “General Unsecured” Debts
People file Chapter 13 usually not because of their “general unsecured” debts. Chapter 13 provides extremely helpful tools for dealing with secured debts like home mortgages and vehicle loans. And it gives you time to pay “priority” debts while being protected from creditors like the IRS or state tax department, and from your ex-spouse or the support enforcement agency.
Still, what happens to your “general unsecured” debts in a successful Chapter 13 case? What happens is that after paying these debts as much as your budget allow you to pay them (after paying any secured and “priority” debts), the remaining balance, no matter how little or how much, is discharged—legally written off.
Here’s how this works in practice.
Assume that, based on your income from a steady job, you qualify for a 3-year Chapter 13 bankruptcy. You have $110,000 in a combination of credit cards, medical bills, and personal loans. As long as there is no collateral tied to any of those debts, they are very likely “general unsecured” debts.
You are also $8,000 behind on your home mortgage on a home you want to keep. That’s a secured debt you must pay. Under Chapter 13, the home mortgage lender is usually required to let you catch up on the mortgage over the 3-year life of the payment plan.
And you owe $6,000 in income taxes for the last two tax years. That’s a “priority” debt you must pay. The IRS/state is required to give you that time to pay the “priority” debt. Plus, as long as the IRS/state has not recorded a tax lien, you don’t pay any ongoing interest or penalties.
In this example, based on your budget, after paying your monthly mortgage and all other reasonable living expenses, you can afford to pay $450 per month to all your creditors.
$450 per month for 36 months totals $16,200 paid into your Chapter 13 payment plan. That is enough to catch up on the $8,000 mortgage arrearage and pay off the $6,000 tax debt. There’s $2,200 left over.
(The Chapter 13 trustee (who administers the distribution of money to the creditors and otherwise oversees the case) gets paid a certain percentage. And if you didn’t originally pay your bankruptcy lawyer in full you can pay the balance through the plan payments. But to simplify the math here, let’s exclude these “administrative fees.”)
The End Result
So what happens to the $2,200 left over after you catch up on the mortgage and pay off the taxes? It’s paid on your “general unsecured” debts, distributed pro rata based on the amount of each debt. Overall you would pay $2,200 of the $110,000 owed on these debts, or 2% of the “general unsecured” debts.
And what would happen to the remaining 98% of those debts? After you successfully complete the 36-month payment plan, the bankruptcy judge enters a court order legally discharging those debts.
You’d have caught up on your mortgage, paid off the tax debt, and paid 2% of the “general unsecured” debts. Other than the regular payments on your mortgage, you’d be debt-free.