How Different Types of Debt are Treated in Bankruptcy

How Different Types of Debt are Treated in Bankruptcy

If you’re considering filing for bankruptcy, you should know that not all debts are treated equally. For example, certain debts cannot be discharged, or forgiven, and must be repaid in full. Other debts, however, can be completely discharged either immediately or after a few years depending on if you file a Chapter 7 or Chapter 13 bankruptcy.

Also, some debts can be modified so that you can afford the payments and keep the property the debt is attached to, such as a car or home. How your debt will be treated during a bankruptcy will indicate what you have to gain from filing one.

While most debts can be included in a bankruptcy petition, there are several that will not actually be discharged. These are referred to as “priority debts” because they take priority over other debt. When filing Chapter 7 bankruptcy, priority debtholders will be the first to receive the proceeds from the sale of your assets, and these debts can’t be discharged even if you have no assets with which to pay them down. When filing a Chapter 13 bankruptcy, there must be provisions in the payment plan for these to be paid in full.

Priority debts include:

In order to discharge tax debt, all of the following conditions must be met.

Be aware, the IRS can place liens on your property for unpaid tax debt, which cannot be wiped out in a bankruptcy even if the tax debt itself met these requirements and was forgiven. In other words, once your bankruptcy concludes, the lien will still be in place.

You are considered upside down on a loan if you have a car, a home, or other asset that is worth less than what you owe on it. This would be the case if you purchased a car for $10,000, but the car is currently worth $7,000 and you still owe $8,000 (i.e. upside down car loan).

However, in a Chapter 13 bankruptcy, you can qualify for what is called a “cram-down” modification, in which the loan is reduced such that the balance and the asset’s current value match. This results in either a smaller monthly payment or shorter loan term.

In this example, the loan balance would be reduced to $7,000, or the current value of the car. However, there are limits on what you can use a cram-down modification for. For example, you can’t use it on a car loan when you purchased the car within 30 months of your bankruptcy filing or on loans for other personal property purchased within 12 months of your bankruptcy filing.

If creditors can recoup more via this modification than a repossession or foreclosure, they are more likely to accept it. That said, you can only perform a cram-down modification if you file a Chapter 13 instead of a Chapter 7 bankruptcy.

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Since a Chapter 7 bankruptcy requires that you sell your assets in order to pay off your debts, you may wish to keep certain debts in order to keep the asset attached to it. For example, if you will be able to pay missed mortgage payments and continue monthly payments once your other debts have been discharged, you may be able to “reaffirm” your mortgage.

Reaffirming a debt means that, with the lender’s permission, the debt will be set aside during the bankruptcy and will not be discharged. In exchange for continuing to make payments as agreed, you are able to maintain ownership of the asset – your home in this example.

Some lenders are quite willing to do this since it’s likely you’ll be in a better position to make payments once your other debts are discharged. As an aside, if your home is nearing or already in foreclosure, filing bankruptcy will temporarily halt the process via an “automatic stay.”

It is also common to reaffirm an auto loan since this benefits both the debtor and the lender. The debtor gets to keep their car and the lender avoids having to repossess and sell the car for what is likely to be less money than the loan is worth.

Even though there are many types of debt that won’t ultimately be included in your bankruptcy, it is still advisable to list all your debts when you first file, even ones you wish to continue paying. In this way, you can work out with the bankruptcy trustee exactly which debts you can and cannot include. Moreover, since bankruptcies often proceed differently in different states, it’s best to complete a course of credit counseling before filing to determine how your debts will be treated and the best course of action to pursue.

Categories: Bankruptcy, Credit and Debt

Kira is a longtime blogger and serial entrepreneur who enjoys gardening, garage sales, and finding stray animals. She lives in Columbus, Ohio, where football is a distinct season, and by day runs a research study for people with multiple sclerosis. She hopes that the MoneyCrashers team can help you achieve your goals and live a great life.

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How Different Types of Debt are Treated in Bankruptcy

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