Making Sense of Bankruptcy: When a Consumer Chapter 7 “Straight Bankruptcy” is Appropriate

Assuming you are a consumer who needs serious relief from your creditors, when should you do a Chapter 7 bankruptcy instead of a Chapter 13 one?

 

Here’s the sentence we’re explaining today:

If you qualify under the means test, consider filing a Chapter 7 case when you don’t need the extra help of a Chapter 13 case to protect your assets, deal with divorce debts, pay taxes you can’t discharge, catch up on your home mortgage(s) or property taxes, and/or reduce payments on your vehicle loan.

Qualifying under the Means Test

To file a Chapter 7 bankruptcy case your income needs to be low enough, or your expenses need to be high enough, to pass the “means test.” You can’t be a person or family with too much “means” or else you’re required to file a 3-to-5-year Chapter 13 payment plan instead.

Most people get over this hurdle very easily, by simply having income low enough. If your income is low enough for your state and family size, you pass the “means test” without needing to even look at your expenses. The income standards are based on published state by state “median income” amounts for various family sizes.

Determining these are trickier than they may sound because you include in “income” money you get from just about all sources (except Social Security), and the focus is on only on the income of the last calendar 6 months. So if your income is irregular, the amount for the purpose of the “means test” can shift month by month. So if your income calculates to be above the “median” amount, waiting a month or two to file your Chapter 7 case may allow you to get below the “median” and qualify to file.

Also, if your income is over the “median amount” so that you need to get into your expenses, this calculation is even more complicated because many expenses are determined based on amounts “allowed” for your part of the country, for your family size, etc.

The bottom line with the “means test” is that most people who want to file a Chapter 7 case qualify to do so, but determining whether you do generally requires you to see a competent bankruptcy attorney.

The Additional Tools of Chapter 13 Not Needed

Assuming you need bankruptcy relief and you qualify under the “means test,” the heart of the decision about whether you should file a Chapter 7 case is whether you instead need the specialized help of a Chapter 13 “adjustment of debts” payment plan. A Chapter 7 “straight bankruptcy” takes so much less time—usually less than 4 months from filing to finish—compared to the multi-year Chapter 13 that it’s the way to go unless you have one or more of the circumstances that makes Chapter 13 worthwhile. The following are some of the main circumstances that could make the extra time and effort of a Chapter 13 worthwhile.

Asset Protection

Most people who want to file a Chapter 7 case will not lose anything they own to their creditors in the process. That’s because you are allowed to keep all of your assets that fit within “property exemptions”—categories of assets, usually with dollar amount limits. These “exemptions” are usually different in different states. Regardless, people needing bankruptcy relief usually do not have more than what is “exempt,” and if they do there are usually strategies of dealing with it within Chapter 7.

But if you do have something, or a number of things, which do not fit within the allowed “exemptions” that you do not want to risk losing, a Chapter 13 can be a good way to keep those things. Depending on the circumstances, you may have to pay more to your creditors than you would otherwise through your Chapter 13 payment plan. But sometimes you just need to pay special debts that you would need to pay anyway, such as income taxes or past-due child/spousal support, without paying anything more to keep all of your assets.

Child and Spousal Support and/or Non-support Divorce Debts

If you are behind on your support payments, or if you owe a significant amount to your ex-spouse or to creditors you were ordered to pay in your divorce decree, those can be reason enough to file a Chapter 13 case instead of a Chapter 7 one. That’s because Chapter 7 generally doesn’t help with either of those situations.

If you are behind on support payments, your ex-spouse and/or the support enforcement authorities can be extremely aggressive in their collection techniques. Chapter 13 can give you relief from this pressure like no other legal tool, giving you time to catch up.

If you owe your ex-spouse or other creditors based on your divorce (or separation) decree on obligations not related to support, a Chapter 7 case will not legally write off (“discharge”) those debts. But Chapter 13 can, potentially even without those obligations requiring you to pay any more in your payment plan than you would be paying otherwise.

So if you are either being seriously pursued for support arrearage, or owe non-support debt, a Chapter 13 may well be worthwhile, especially if you have other reasons as well.

Pay Taxes While Protected

A major reason to file a Chapter 13 case is if you owe income taxes which would not be discharged in a Chapter 7 case. Income taxes can be discharged if they meet a number of conditions—mostly if they are old enough. And sometimes just because you owe some taxes which don’t qualify for discharge, filing Chapter 7 may still make sense if you could then afford to pay off those taxes through reasonable monthly payments paid over a reasonable period of time directly to the IRS and/or state.

But if the amount of non-dischargeable taxes you owe is too large, and you expect to have continued financial pressures, you may well need the flexibility and protection that comes from paying those taxes through a Chapter 13 plan. You would usually not need to pay additional interest and penalties, you would usually be able to pay other more urgent creditors (such as your vehicle lender and ex-spouse on a support arrearage, for example) ahead of the taxes. And if you have had a tax lien recorded against your home or possessions, Chapter 13 is often the best way to deal with that.  

Curing Mortgage and Property Tax Arrearage

Perhaps the biggest single reason—especially in the last several years—that people file uner Chapter 13 cases is to save their home from foreclosure, or the threat of foreclosure. In a Chapter 7 case, you are largely at the mercy of your home mortgage lender if you are behind on your mortgage and want to keep your home. There may be various options available, including mortgage “modifications,” but if those don’t work Chapter 13 forces the lender (and the property tax creditor) to give you up to 5 years to catch up on your back mortgage payments (and property taxes).

Chapter 13 may even allow you to “strip” a second or third mortgage off your home’s title, making a home that was not financially feasible to keep into one that would be. This is not available under Chapter 7. Chapter 13 also enables you to address other liens on your home—based on income taxes, divorce-based debts, etc.—often in ways much better than could be done under Chapter 7.

Vehicle “Cramdown”

If your vehicle loan is more than two and a half years old, and your vehicle is worth less than you owe, Chapter 13 will usually enable you to reduce your monthly payments on that debt, as well as reduce the total amount to be paid before your vehicle is free and clear. If that saves you enough money monthly and over the life of your vehicle loan, that may be reason enough to file a Chapter 13 case instead of a Chapter 7 one, or an extra reason along with others to make a Chapter 13 worthwhile.

Conclusion

Hopefully the sentence you saw at the beginning of this blog post now makes more sense, and bears repeating here:

If you qualify under the means test, consider filing a Chapter 7 case when you don’t need the extra help of a Chapter 13 case to protect your assets, deal with divorce debts, pay taxes you can’t discharge, catch up on your home mortgage(s) or property taxes, and/or reduce payments on your vehicle loan.