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How Does a Chapter 7 Bankruptcy Work

The individual filing any bankruptcy case is called a “debtor”. A trustee is an individual that is assigned to review, administer and evaluate your case to determine whether you meet the chapter 7 bankruptcy law requirements entitling you to a discharge. The goal of a chapter 7 debtor is to obtain an order of discharge. This is a court order that reflects the elimination of debt. If the trustee believes that a debtor has met the requirements, the trustee recommends to the court and judge, that he/she receive an order of discharge. In general, a debtor’s lawyer should not file under this chapter unless the debtor meets the requirements. In general, an individual would file a chapter 7 for the purpose of discharging unsecured (i.e., credit card, health care, personal loan debt, etc.) debt.

You are required to disclose on the bankruptcy petition, all assets and liabilities, including all debt and creditors. You may not pick and chose which creditors to include. You must list all creditors and the law determines how you treat each type of creditor.

The chapter 7 laws specifies which debt is dischargeable (eliminated) and which debt is not dischargeable. Therefore, If you meet all of the requirements under a chapter 7, which is the best case scenario, there still may be certain debt that is not discharged (eliminated).The following is a partial list of dischargeable and non-dischargeable debt.

Dischargeable Debt ( debt that can be eliminated) :credit card, personal loan; doctor bills; health care bills; depending on the situation none, some or all income tax liability; mortgage, auto loan, if surrendering auto, etc.

Non Dischargeable Debt: (debt that cannot be eliminated)student loans insured by the government; depending on the situation none, some or all income tax liability, auto financing if keeping auto and sign a reaffirmation agreement; debt incurred by fraud, fines, etc.

Generally a person would file for chapter 7 bankruptcy protection because he/she is unable to pay their unsecured debt (credit card, personal loans, doctors’ bills, etc.). If an individual meets the chapter 7 requirements (explained below) at the time of the filing, you will be entitled to a discharge.

Generally, debtors’ are permitted to keep their house, if desired. However, if the fair market value of a house is substantially more than the liens, including the mortgage, the trustee may have a right to sell the house. Under this scenario, a debtor would not file a chapter 7, or in the alternative may wish to file a chapter 13.

If a debtor is not current with their mortgage payment, the chapter 7 will not protect them from the loss of their house, through foreclosure. If one files a chapter 7 and is behind with the mortgage, the court will permit the mortgage company to proceed with their mortgage foreclosure action and sheriff’s sale.

A chapter 7 will allow a debtor to surrender (give up) their house whether or not the individual is behind with the mortgage payments. If you surrender the house, and the house does not have substantial value (equity), the trustee will not sell the house, but rather allow the mortgage company to complete the foreclosure process.

Although unusual, in some situations, one may wish to allow the trustee to sell their house or other asset for the purpose of receiving a payment from the excess proceeds of the sale.

The above explanation with regard to saving your house, generally applies for an automobile, as well. You may wish to keep or surrender a financed or leased auto. If you are not current, a chapter 7 will not stop a repossession. You may keep your auto, if you are current with your auto finance / lease payments, and the auto does not have substantial value. However, with regard to keeping a financed auto, there is an additional chapter 7condition, that requires one to be able to make future monthly finance payments without undue hardship.

In general, the requirements that determine whether an individual is entitled to a chapter 7 discharge are as follows.

Assets : (first requirement)

The debtor is required to provide to the trustee and the court a list and value of all personal and real estate assets. This includes, but is not limited to the following: bank accounts; furniture; houses; autos; jewelry; investments; stocks; bonds; claims or law suits against others, etc. In general, retirement accounts are excluded and not considered.

Although unlikely, in general, if the debtor has an asset with a substantial value, in excess of liens, the trustee is permitted to sell the asset. What does this mean? The bankruptcy laws allow an individual to deduct specific amounts from the value of each asset. The specific amounts are called exemptions. The law provides specific exemption amounts for each type of asset. In general, if the exemption amount is more than the value of the asset minus the amount of the lien(s), if any, you may keep the asset.

In general, the court reviews the following analysis to determine whether you may keep your auto in a chapter 7. The court deducts from the replacement value of an auto, the financing payoff amount and any other liens. Thereafter, the court deducts the total amount of the allowable exemptions. If the balance after deducting these items is $0.00, you may keep the auto.

In general, the court reviews the following analysis to determine whether you may keep your house in a chapter 7. One must first obtain the fair market value of the house. The court deducts from this value: the mortgage(s) payoff, any other secured liens and an amount equal to10% of the estimated fair market value, representing costs. Thereafter, the court deducts the exemption amount for the residence. If the balance after deducting these items is $0.00, you may keep your house.

A few of the exemptions are as follows:

  • Furnishings and household goods, collectables and clothing
  • Furs and Jewelry
  • Auto
  • Residence
  • Any property
  • Any property (unused exemption from your residence)
  • $10,775.00
  • $1,350.00
  • $3,225.00
  • $20,200.00
  • $1,075.00
  • $10,125.00

An example of a residence analysis is as follows:

  • house value
  • mortgage balance
  • no liens
  • cost of sale 10% of $100,000.00
  • exemption for one person
  • value minus mortgage, minus
  • exemption, minus cost of sale
  • $100,000.00
  • $70,000.00
  • $0.00
  • $10,000.00
  • $20,200.00
  • $200.00
    In this example, the
    debtor may keep the house
    because the exemptions
    reduce the value to
    less than $0.00.

From my experience, approximately 90% percent of the individuals considering chapter 7 are able to keep all of their property. If a particular asset is not fully exempt and protected, the trustee may sell that particular asset. However, if there is a nominal amount available after subtracting the exemptions, the trustee may decide to not sell the asset. Prior to filing, the debtor should be advised of this matter, so as to make an informed decision as to whether to file. If property is not fully exempt, one may possibly keep the property by filing a chapter 13.

Means Test (second requirement)

The Means Test is the most significant new requirement under the recent bankruptcy reform.

The debtor(s) gross (before tax) household income for the six months prior to the bankruptcy filing is compared to the average gross income of a household of the same size in the same state where the debtor resides. If the debtor(s) household’s gross income is lower than the average gross income of a household of the same size, the debtor meets this requirement. If the debtor meets this requirement, the law presumes that the bankruptcy filing, is filed in good faith.

In the event that the debtor(s) household’s gross (before tax) income for the six months prior to the bankruptcy filing is in excess of said average gross income, the filing may or may not meet this requirement. If the gross household income is in excess of said average, the bankruptcy is filed in good faith, only if the debtor’s monthly household income results in “0” or less than “0” after deducting the following items from the gross household income: 1. income taxes; 2. allowable pay stub deductions; 3. allowable living expenses, based on the Internal Revenue Service’s laws, such as: allowable household expenses; allowable food and living expenses, allowable transportation expenses, allowable clothing expenses, allowable auto operating expenses; 4. insurance payments; 5.mortgage payments, 6. auto finance payments or lease payments; etc. Please note that this list of expenses is not complete and may vary. Also, these expenses may not be your actual expenses, but the expenses that are allowable under the I.R.S. guidelines.

If after deducting these allowable items from gross income results in an amount in excess of $0.00, the chapter 7 is deemed to have been filed in bad faith. If the case is deemed having been filed in bad faith, the individual would be unable to file for chapter 7 protection.

With regard to the relevant income period, the six month period starts on the first pay of the sixth month prior to the month filed and ends with the last pay of the month prior to the filing. Therefore, if the petition is filed in February of 2008, the six month period would start on August 1, 2007 and end with the last pay for January of 2008. Also, please note that certain types of income may not be included.

The Means Test and its application has not yet been clarified and clearly defined by the courts and trustees. Therefore, the application may vary based on the trustee and judge who is assigned to your case.

One issue that has not been settled is which individuals represent the household. There may be people living in the house that must be included and others whom are not included in the test. If an individual contributes income to the household on a continuous and monthly basis, this contribution must be included in the test, as gross income. Please note that in every case, if the husband and wife live together and are not separated, the income of both spouses are included, even though only one spouse files.

The IRS average income is based on the U.S. Census Bureas for each state. The IRS National Standards govern such items as food, clothing, personal items, housekeeping supplies, and entertainment. The IRS. Local standards govern housing, utility and transportation costs. The IRS standards may be found at www.irs.gov.

Present Income and Expenses (third requirement)

To meet this requirement, your present household monthly net (after tax income) income must be less than or almost less than your monthly necessary, actual, but reasonable expenses. The expenses include your living expenses only and not payments to your unsecured (credit card debt, personal loans, doctors’ bills) creditors. The monthly expenses include, but are not limited to the following: mortgage, rental, real estate taxes, housing insurance, food, clothing, water, sewer, medical, auto, transportation, auto insurance, support, child care, etc. All expenses must be reasonable based on the number of individuals in the household and other special circumstances. Similar to the means test, the household income includes the husband and wife’s income and expenses, no matter if one or both spouse’s are filing.

There are two basic differences between this and the means test requirement. The first difference is that the means test includes the expenses that are allowable under the IRS laws, based on the number of household members, and under this requirement, the expenses represent the actual, but reasonable expenses for the household.

The second difference is that under the means test, household income represents the household income for the six months prior to the filing and under this requirement, income is based on the amount earned immediately prior to and as of the time of the filing. The trustee may also consider the debtor’s foreseeable future income. This requirement may not include household members’ income that is included under the means test.