Chapter 7 Filings

April 13, 2006

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Traditionally, Chapter 7 has been the most common type of bankruptcy proceeding. It is available to individuals and business entities.

In a Chapter 7 (also known as a liquidation) bankruptcy, the debtor's assets are sold and converted to cash, with the proceeds going to pay the cost of administering the case and paying the filer's creditors. Debts that are not paid are discharged--that is, eliminated.

However, as of October 17, 2005, new federal bankruptcy laws limit a debtor's eligibility for Chapter 7 proceedings. At the heart of the measure is a means test, designed to force those debtors who have the ability to pay some of their debts into a five-year repayment plan (Chapter 13), as opposed to liquidating under Chapter 7 and wiping the slate clean.

Under the means test, a debtor at the low end of the income range would remain eligible for Chapter 7 relief if the amount of his or her income minus reasonable living expenses (per IRS rules) is less than $100 per month ($6,000 over five years). At the high end, a debtor would not be eligible for Chapter 7 if his or her net income is equal to or exceeds $166.67 per month ($10,000 over five years). In the income range between these extremes ($6,000 to $10,000 over five years), a repayment plan is required only if the debtor has sufficient income to pay back 25 percent of the unsecured debt. The means test does allow special accommodations for active-duty military personnel, low-income veterans and those with serious medical conditions.

In addition, the new bankruptcy law requires a debtor to complete a credit counseling course, unless he or she is incapacitated, disabled, or on active duty in a military zone.

Exempt assets are, of course, excluded from the assets that must be sold, up to the dollar amount of the particular exemption. Because consensual liens on assets, such as mortgages or car loans, cannot be eliminated even on exempt assets, debtors either continue to pay these debts or surrender the property. Usually, these consensual liens will encumber enough of the value of the property so that the remaining value will fit within an asset exemption.

A home may have mortgages and home equity loans that cover 90 percent of its value, and the remaining 10 percent may be protected by the homestead exemption. Thus, a sale of the asset would generate no proceeds for the other creditors. Accordingly, in typical cases, these assets are not sold, and in fact are retained by the debtor, who continues to pay off the liens.

With the exempt assets and encumbered assets removed from the pool, there are usually no assets available to the unsecured creditors who, in most cases, will be banks holding credit card accounts. The end result will be that these unsecured creditors will receive nothing, and the debts they are owed will be discharged.

Among the issues to be considered in a Chapter 7 filing:

Certain income and assets acquired after a Chapter 7 filing may be included in your bankruptcy estate if you do not plan properly.
Any recent transfers of assets will be examined, and may be undone, so you should proceed carefully.
Personal liability for some debts will never be dischargeable under current law.
Personal liability for most debts can be discharged, but most liens survive after the completion of a Chapter 7 filing.