New Law Changes Bankruptcy Rules

A new federal law will change the landscape for bankruptcies, generally making it more difficult for consumers to eliminate their debts and shield assets from creditors. The bill was signed into law on April 20, 2005, but most of its provisions don’t go into effect until 180 days later, meaning that people can still file under the old law if they act quickly.

Until the new law, bankruptcy laws had stayed more or less the same for the last 27 years, but bankruptcy rates skyrocketed in that period. In the last ten years alone, bankruptcies have almost doubled. Studies have shown that most of these bankruptcy proceedings are triggered by loss of employment, high medical bills, or some other life-changing event.

The new law will make it more difficult for people to qualify for Chapter 7 bankruptcy (and thus eliminate all of their debts), and more difficult for people to exempt their homes from the bankruptcy proceedings.

If you have been thinking about filing for bankruptcy, talk to your lawyer sooner rather than later. You may want to fast track your application for bankruptcy so that your bankruptcy is dealt with under the old bankruptcy regime.

Chapter 7
Most individuals currently file for bankruptcy under Chapter 7. Under this form of bankruptcy, debtors have to sell their non-exempt assets. The money from the sale of assets is used to pay off as much debt as possible. However, debtors may keep all exempt assets, which are defined differently in each state. Exempt assets may include much of the debtor’s personal property, a car, some jewelry, and tools of the debtor’s trade. In practice, almost all people filing for bankruptcy wind up having no assets that are sold.

Debts are prioritized in a bankruptcy. Secured debts—such as auto loans, some loans to buy furniture, and mortgages on property—are debts that creditors are entitled to collect by repossessing and selling assets of the debtor if payments are missed. In a bankruptcy, creditors can repossess and sell secured assets after the bankruptcy proceedings are over. Debts to unsecured creditors (bills for department store credit cards, medical bills, and the like) are paid with the proceeds of sale of unsecured assets. Since many Chapter 7 filers don't have enough assets to cover what they owe, credit card companies and other creditors sometimes get nothing. In fact, over 95 percent of Chapter 7 filings are “no-asset filings”—that is, filings in which there are no non-exempt assets with value left for unsecured creditors after the exempt assets have been claimed and the secured assets returned to the creditors.

Some kinds of debt—for example child support, taxes, and debts arising from fraud—cannot be wiped out under a Chapter 7 bankruptcy. But with those exceptions, all debts people cannot pay after sale of their assets are discharged. This means that the debts are forgiven, and never need to be paid. Under the current system, creditors have no right to the bankrupt’s future earnings. A Chapter 7 bankruptcy wipes the slate clean, and enables people to have a fresh financial start.

Chapter 13
Some people file for bankruptcy under Chapter 13. This form of bankruptcy enables people to keep most of their assets. In return, they have to pay off an agreed portion of their debts over a period of three to five years. Chapter 13 is available to almost anyone with a steady income. Chapter 13 bankruptcy is not a quick way to wipe off debts, but it does give people a way to preserve non-exempt and secured assets—such as the family home.

The New Law
Under the existing bankruptcy law, debtors can choose whether to seek relief under Chapter 7 or Chapter 13. Most consumers choose to file under Chapter 7 so that they can wipe away all their debt and start afresh. However, the court has the discretion to deny relief under Chapter 7 if it finds the debtor is trying to abuse the system and avoid paying off debts that the debtor could afford to pay.

Under the new law, debtors will not have the same freedom of choice. If a debtor earns less than the median income in her state, she will be automatically eligible for Chapter 7 bankruptcy. However, if a debtor earns more than the median income in the state, then courts will apply a means test to determine whether she is eligible to file under Chapter 7.

In applying the means test, the court starts with the debtor’s current monthly income. It deducts living expenses, which are determined by IRS guidelines. If the debtor still has enough money available per month to pay off a substantial amount of the debt over time (which can be as little as $100 per month), then the court will presume that the debtor is abusing Chapter 7 and will not allow her to file under Chapter 7. Instead, the debtor will have to seek bankruptcy under Chapter 13—and pay back some of the debt over several years.

The debtor can dispute the court’s presumption that she is abusing Chapter 7, but this will require the debtor to bring evidence before the court to show why the disposable income is not as high as calculated, or that there are special circumstances. Such proceedings could cost substantial time and money.

Tougher Homestead Exemptions
Under the current bankruptcy law, a debtor may exempt some or all of the value of her home. Home exemption laws are different in every state. In Florida, your home may be entirely exempt, which means you do not have to sell it if you go bankrupt—you can keep it if you’ve paid off the mortgage or as long as you keep up the mortgage payments. In Nevada you can exempt up to $200,000 of the value of your home. In Georgia, you can only exempt $5,000.

For example, imagine you own a home worth $250,000, and you have $45,000 of equity. If you lived in Nevada, creditors would only be able to access $5,000 of the value of your home ($250,000-$200,000-$45,000). In practice, you would be likely to be able to keep your home, because it wouldn’t be worth the creditor’s while to force you to sell it. In Georgia, creditors would be able to access $200,000 of your home’s value ($250,000-$5,000-$45,000), and would almost certainly require you to sell the home.

Under a provision of the new law that is already in effect, if you bought your home less than 40 months before filing for bankruptcy, then you may only exempt up to a maximum of $125,000 in your home, regardless of the law in your state.

Time Between Bankruptcies
Under the current law, a person can file for bankruptcy again within six years after the last filing. Under the new law, a person must wait eight years between filings.

Credit Counseling
Anyone seeking to file for bankruptcy under the new law must undergo credit counseling through a non-profit credit counseling agency in the six months before filing. This counseling session can take place over the phone or online.

What Can You Do?
Many consumer advocates are advising people who are considering bankruptcy to act now, before the new law comes into effect. If you think you might be heading down the path towards bankruptcy, talk to your lawyer about your options, soon.

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