Understanding Debts

Bankruptcy gives you a handle on your debts. There are different kinds of debts. It helps if you have a handle on these differences.

 

Debts in Bankruptcy

If you are thinking about bankruptcy there’s no more basic question than what it will do to each of your debts. Will it wipe away all your debts or will you still owe anybody? What about debts you would like to keep like your car or truck loan or your home mortgage? What help does bankruptcy give for unusual debts like taxes, or child and spousal support?

The Three Categories of Debts

At the heart of bankruptcy is the basic rule of treating all creditors within the same legal category the same. So we need to understand the three main categories of debts. You may not have debts in all three of these categories, but lots of people do. A basic understanding of these three categories will help make sense of bankruptcy, and make sense of how it treats each of your creditors.

The three categories of debts are “secured,” “general unsecured,” and “priority.”   

Secured Debts

Every single debt is either “secured” by something you own or it is not. A secured debt is secured by a lien—a legal right against—that property or possession you own.  

Most of the time you know whether or not a debt is secured because you voluntarily gave collateral to secure the debt. When you buy a car, you know that you are signing on to a vehicle loan in which the lender is put onto your car’s title as its lienholder. That lien on the title gives that lender certain rights, such as to repossess it if you don’t make the agreed payments.

But debts can also be secured as a matter of law without you voluntarily agreeing to it. For example, if you own a home and an unsecured creditor sues you and gets a judgment against you that usually creates a judgment lien against the title of your home. Or if you don’t pay federal income taxes you owe, the IRS may put a tax lien on all your personal property.

For a debt to become effectively secured, either voluntarily or involuntarily, certain steps have to be taken to accomplish that. Otherwise the debt is not secured, and the creditor does not have rights against the property or possession that was supposed to secure the debt.

In the case of a vehicle loan, the lender and you have to go through certain paperwork for the lender to become a lienholder on the vehicle’s title. If those aren’t done right, the vehicle will not attach as collateral to the loan. That could totally change how that debt is treated in bankruptcy.

Finally, it’s important to see that debts can be fully secured or only partly secured. This depends on the amount of the debt compared to the value of the collateral securing it. If you owe $15,000 on a vehicle worth only $10,000, the debt is only partly secured—secured as to $10,000, and unsecured as to the remaining $5,000 of the debt. A partly secured debt may be treated differently in bankruptcy than a fully secured one.

General Unsecured Debts

All debts that are not legally secured by collateral are called unsecured debt.  And “general” unsecured debts are simply those which are not one of special “priority” debts that the law has selected for special treatment. (See below.) So this category of “general unsecured debts” includes all debts with are both not secured and not “priority.”

General unsecured debts include every imaginable type of debt or claim. The most common ones include most credit cards, virtually all medical bills, personal loans without collateral, checking accounts with a negative balance, unpaid checks, payday loans without collateral, the amount left owing after a vehicle is repossessed and sold, and uninsured or underinsured vehicle accident claims against you.

It helps to know that sometimes a debt which had been secured can turn into a general unsecured one. For example, a second mortgage that was fully secured by the value of the home at the time of the loan can become partially or fully unsecured if the home’s value falls. Or a general unsecured debt can turn into a secured one. For example, a general unsecured credit card debt can become secured debt if a lawsuit is filed against you, a judgment is entered, and a judgment lien is recorded against your real estate.

Priority Debts

As the word implies, “priority” debts are ones that Congress has decided should be treated better than general unsecured debts.

Also, there’s a strict order of priority among the priority debts. Certain “priority” debts get paid ahead of the others (and ahead of all the general unsecured debts). In bankruptcy getting paid first often means getting paid something instead of nothing at all.

This has the following practical consequences in the two main kind of consumer bankruptcy:  

In most Chapter 7 cases there is no “liquidation” of your assets for distribution to your creditors. That’s because in the vast majority of cases, all the debtors’ assets are protected; they are “exempt.” But in those cases where there ARE non-exempt assets which the bankruptcy trustee gathers and sells, priority debts are paid in full by the trustee before the general unsecured ones receive anything. And among the priority debts those of higher priority are paid in full before the lower priority ones receive anything.

In a Chapter 13 case, your proposed payment plan must demonstrate how you will pay all priority debts in full within the 3 to 5 years of your case. Then after the bankruptcy judge approves your plan, you must in fact pay them before you can complete the case (and discharge all or most of your general unsecured creditors). There is more flexibility about when the priority debts are paid with those 3 to 5 years.

Here are the most common priority debts for consumers or small business owners, from higher to lower priority:

  • child and spousal support—the full amount owed as of the filing of the bankruptcy case
  • wages and other forms of compensation owed by the debtor to any of his or her employees—maximum of $12,475 per employee, for work done in the final 180 days before the bankruptcy filing or close of business, whichever was first
  • certain income taxes, and some other kinds of taxes—some are priority but others are general unsecured if they are old enough and meet some other conditions

The next blog posts will discuss how debts in these three categories are treated in Chapter 7 and Chapter 13. 

 

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Easily Preventable Mistakes to Avoid While Considering Bankruptcy

Words I hate to tell new clients: “If only you’d come to talk with me sooner.”


Bankruptcy attorneys are in this area of law because we really want to help people. What makes me want to come to the office every day is the privilege of listening to people’s tough stories and then giving them good news about how I can help make their life much better—how they can now get relief from their debts or a feasible plan to save their home, or a way to solve some other seemingly impossible situation, like a back child support or income tax garnishment. Every day I get to help intensely anxious people suddenly become hopeful as they learn about solutions they did not realize they had.

Not that it’s always so pleasant. Some goals are beyond reach even with the strong medicine of bankruptcy. Difficult choices sometimes have to be made. Life can be tough.

But the toughest situations are those in which the person took some action—usually not long before seeing me—which may have made some sense at the time but ended up being a mistake, a self-inflicted wound.

The goal of my next few blogs is to help you avoid these.

Here’s what we will be covering.

1) Preferences:  If within a certain amount of time before filing bankruptcy, a debtor pays any significant amount of money (or anything else of value) to someone she owes, the bankruptcy trustee could under certain conditions force that creditor to pay to the trustee whatever amount the debtor paid to the creditor. That creditor could be a relative or friend who had lent the debtor money, and the debtor felt a deep obligation to repay it before filing bankruptcy. This relative or friend could be sued by the trustee to make him or her “return” the money (but to the trustee, not to the debtor).

2) Wasting exempt assets:  New clients constantly tell me how they’ve borrowed against or cashed in their retirement funds in a desperate effort to pay their debts. Or they’ve sold a vehicle or some other precious asset. Then they learn that whatever they’ve sold or borrowed against would have been completely protected in their subsequent bankruptcy case. And the debts they paid with the proceeds would simply have been “discharged” (legally written off) in that bankruptcy. They have lost something of significant value in effect for no real benefit.

3) Surrendering a vehicle that could have been saved:  People often really need a vehicle but owe on it more than it is worth and can’t afford the payments. So they either voluntarily surrender it to the creditor, or wait to file bankruptcy until after it gets repossessed. Instead with a “cramdown,” they could well have been able to keep that vehicle by paying much lower monthly payments and paying much less for it overall.

4) Letting a creditor sue and take a judgment: If a debtor is sued by a creditor and waits until after a judgment is entered, in some situations, that judgment could make the debt harder to discharge in a subsequent bankruptcy case. 

5) Selling a home out of desperation:  Bankruptcy—and especially Chapter 13—provides some amazing tools for dealing with debts related to a home, including  the first mortgage arrearage, the second mortgage lien, judgment liens, income tax and child support liens, and other liens of all sorts. Homeowners may hurriedly sell their home because of pressure from any of these kinds of creditors. But if they do so, they could lose out on the opportunity to hold onto their home by saving tens of thousands—or possibly even hundreds of thousands—of dollars. Or at least they could likely sell it at a higher price with more market exposure and/or sell it when the timing is better for their family.

As you can see, doing what seems right and sensible can really backfire if you don’t get legal advice about these kinds of unexpected consequences. In the next few blogs I explain these in more detail so that these mistakes will make sense to you and you can avoid them.  

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