I rarely advocate That clients file Chapter 13’s because they take too long and keep them under the thumb of the bankruptcy court for (usually) five years. So when does it make sense?
It makes sense when you want to keep your house but have junior unsecured liens stacked on top of the main mortgage. In Chapter 7, if you want to keep your house, you have to keep the lenders current. Not necessarily so in Chapter 13 when you have stacked loans secured by your home. Since 2006, the Heavy Question [see clever illustration below] has been: Can you dump a mortgage loan in Chapter 13? The short easy answer if you’ve ever read anything at all on my blog is that “it depends.”
First: Is it “secured” solely by your primary residential real estate? And by that I do not mean investment property or personal property. (Pay attention here because the terms and definitions matter.) That is, is the security agreement only applicable to your primary residence? If so, you have passed the first test.
Second: Is it WHOLLY unsecured? By this is meant that there is no security for the loan at all after consideration of all senior debt. Example: House valued at $750,000 With a first deed of trust (“DOT”) for $690,000, a second DOT for $170,000, and third DOT $75,000. Now what?
Well, the first is wholly secured because the value exceeds the loan balance by $60,000 ($750,000 minus $690,000.) Our hypothetical borrower can’t strip this lien because it is wholly secured.
The second is partially secured. It is secured to the extent of the $60,00 left after accounting for the first DOT right? $750,000 minus $690,00 leaves $60,000. Capiche? So because it is partially secured, you can’t strip it and the debtors will have to keep that lender current In order to keep the home.
But the third…Here’s where it gets interesting. After accounting for the first and the second, there is no security value left for the third at all. $690,000 plus $170,000 equals $860,000. But the house is only worth $750,000. Because the third is wholly unsecured, the borrower can “strip” this lien and shove the debt over to the unsecured column…Payable over the time of the Chapter 13 plan.
Why do we care? Because you can’t do this in Chapter 7. It only works in Chapter 13.
This concept as described also only works in parts of the country, so don’t go charging into your bankruptcy lawyer’s office telling him or her all about how you read on the web that you can dump your HELOC. There’s a bit more to it than the above, but this sort of scenario and fact pattern is a good example of when a Chapter 13 might make sense.
This is a question I’m frequently asked, usually in the context of a prospective client seeking a way to save fees and costs in a bankruptcy filing.
First, it is not a requirement that a debtor in bankruptcy be represented by a licensed attorney. A debtor may represents him or herself, or may be represented by counsel. However, in between those two alternatives is a third. A debtor may retain the services of a “Bankruptcy Petition Preparer” pursuant to the provisions of Local Rule 9029-1.
A Bankruptcy Petition Preparer (which we’ll abbreviate to “BPP”) is a non-lawyer who is allowed to assist a debtor with the preparation of the documents necessary to the filing of a bankruptcy case. Fees are limited to $150, and BPP are severely limited in what they can and cannot do. Most specifically, the cannot give legal advice. Below is an excerpt from the Northern California’s Local Guidelines listing very specifically what they are not allowed to do:
The bankruptcy petition preparer is not an attorney and is not authorized to practice law. Specifically, the bankruptcy petition preparer may not instruct or advise the debtor(s):
• Whether to file a bankruptcy petition
• Under which chapter of the Bankruptcy Code to file the voluntary petition;
• How to respond to the bankruptcy forms required in connection with the filing of the bankruptcy case;
• What exemptions should be claimed;
• Whether any particular debts are dischargeable or nondischargeable;
• The effect of a bankruptcy filing upon a foreclosure and whether the debtor(s) may keep a home.
• Whether the debtor(s) may avoid or eliminate any liens or recover any assets in connection with the bankruptcy case;
• Whether the debtor(s) may redeem property;
• Whether the debtor(s) may or should reaffirm any debts;
• Whether the debtor(s) is entitled to a discharge under the Bankruptcy Code, and what defenses the debtor may have to an objection to discharge; and
• Concerning the tax consequences of any aspect of the bankruptcy case.
So what can they really do? Type. That’s it. Do not make the mistake of thinking that just because a BPP knows which papers to prepare and file, that they know anything about bankruptcy, provide legal advice, or protect you. They cannot appear for you in Court or at the 341 Meeting of Creditors. They cannot respond to requests for information from trustees, or draft motions.
I advise against using these folks, mostly because they promote a false sense of comfort.They’re not lawyers and they really can’t do much for you. In other words, for $150, you get what you pay for.
But if you are going to use a BPP, make sure that that you avoid unrealistic expectations and realize that they are not lawyers. The best way to educate yourself is to make sure they give you–and that you read–the Notice to Debtors About Bankruptcy Petition Preparers, and that you have reviewed the Northern California Bankruptcy Petition Preparer Guidelines.
As this dog-tired economy continues to drag on, with no relief in sight and no bounce-back in home prices appearing anywhere on the horizon, the single question I am asked most frequently is “Should I walk away from my mortgage, and if I choose to do that, what are my options?”
Usually it comes in the following form. “We bought our house in 200_, for $_______. It’s now worth less than what we paid, and less than the outstanding loan amount. We’re considering our options, but are not sure what to do.”
Sometimes this question comes up because someone has lost a job, or is in the real estate business and hasn’t been able to generate much commission income in the past 2 to 4 years, although sometimes it’s just the economics themselves that trigger the inquiry.
The question about what to do, however, is less a legal decision than it is an economic decision. Of course, once you decide to walk away, then the follow-through becomes a purely legal act, and should only be undertaken after consulting with legal counsel and obtaining a full understanding of what is likely to happen.
First, should you? That all depends on where you think housing prices are going to go in the future, how long you’re willing to tough it out and what your other housing options look like. Obviously, you have to live somewhere, so if you’re not going to own, then you have to have a good understanding of what your rental options are Example: A family of four, with two teenagers, living in a 1,500 square foot house in an expensive neighborhood is going to be looking at a very different set of concerns than a childless couple living in a 4,000 SF home in an affordable location. That seems obvious, but to many folks it apparently isn’t.
So it’s not a straight dollars and cents analysis. Just because your home is worth 20% less than the balance on your loan, no lawyer can advise you on whether you should keep the house and keep paying, or let it go and brave the consequences. All a lawyer can do is tell you what is likely to happen under any particular course of action.
Next, if you do decide to walk away, what is going to happen? Well, we all know that such a decision is going to cause significant credit problems. It’s inevitable: If you walk away from a home loan, your credit is going to suffer. But what else?Fortunately, we don’t have debtor’s prison, so despite the loss of the house to foreclosure–another inevitability although the timing may vary depending on circumstances–you may get sued. Obviously that’s no fun, and is something that you should try to avoid, but whether that is likely to happen or not is a very good question to take up with a lawyer. We’re lucky in California as there are very powerful anti-deficiency laws, about which I have already blogged rather extensively. (See California anti-deficiency rules and statutes: When can a mortgage lender in California recover a deficiency after foreclosure?, California Mortgage Deficiencies: What is a Purchase Money Security Interest? and Second Mortgages in California: Deficiencies Not Usually an Issue for full treatment of the subject.)
Last, what about staying and trying to complete a mortgage modification? I’m sorry to say that I’m a cynic on this subject. The process seems capricious and arbitrary at best, and since my experience leads me to the unshakable and firm conviction that, as a class of people, consumer bankers are among the dumbest clowns wandering the planet, the percentage likelihood of any one homeowner or family successfully completing a mortgage modification is nearly microscopic. This is especially true here in Northern California where incomes and home prices are among the highest in the country. They’re not much interested in modifying mortgages for people with six figure incomes and seven figure home prices. And of course, whether that is right or not is beside the point, but you need to understand the reality if you’re going to test the water.
Well, you know by now that the answer is: It depends.
If you file Chapter 7, and either are current or get current with your mortgage(s), then you can most likely keep your home. (Assuming you don’t have an equity interest that exceeds the homestead exemption. As to which, see this blog post: California Homestead Exemptions Increased as of January 1, 2010. Other California Bankruptcy Exemptions will increase on April 1, 2010.)
If however, you are in arrears, and are not able to bring the loan current, then–unless you can complete a mortgage modification that allows you to stay–you are likely lose the home.
On the other hand, if you file Chapter 13, and are able to successfully get a payment plan approved by the Court, then you may be able to stay. This is because in a Chapter 13, you can take the outstanding mortgage arrearages, and pay them back through the Chapter 13 plan over the 3 to 5 year commitment.
But don’t try to do this analysis yourself. Talk to a bankruptcy lawyer before you get too excited. There are lots of nit-picky little rules that can torpedo an otherwise possible successful Chapter 13. You need to do the analysis up front.
Most of my clients know that I am not a fan of Chapter 13. This is mostly because I think that it keeps people in the bankruptcy process far too long (3 to 5 years), and that as a result, makes that “fresh start” promised by Congress so elusive. Nonetheless, there are times when it is either advisable or flatly unavoidable.
So here, without fanfare or editorial, is what the federal government would like you to know about Chapter 13. Like my prior post on Chapter 7, it is simply a reprint of the information found on the United States Bankruptcy Court’s website.
The attacks on the Mortgage Electronic Registration System (“MERS”) continues unabated at all levels. In the case MERS v. Johnston (Rutland County Superior Court case no. 420-6-09 Rdcv) another Court had held that MERS doesn’t have standing to complete a foreclosure of a mortgage which did not specifically name it as the mortgagee, or which secures a promissory note that didn’t specifically name MERS as payee. The opinion relied heavily on the Landmark National Bank v. Kesler decision from the Kansas Supreme Court that was issued in September of this year. The Kesler decision, in turn, relied heavily on the 2005 Nebraska Supreme Court decision Mortgage Elec. Reg. Systems v. Nebraska Dept. of Banking, 270 Neb. 529, 530, 704 N.W.2d 784 (2005).
It is still unclear just how much damage this line of cases will do to the infrastructure of the MERS nominee system. But at least one Federal Court has seemingly upheld the MERS system for at lease some purposes. On September 24, 2009, the US District Court for the District of Arizona handed down its trial court decision in Cervantes v. Countrywide (Case No. CV 09-517 PHX-JAT) in which the trial court determined that MERS is “not a sham,” as had apparently been alleged by the plaintiffs. This Arizona decision is only a trial court decision, however, and is not binding on any other court.
After letting the world flounder for a year on what the Mortgage Forgiveness Debt Relief Act actually means, and how it intends to help taxpayers wade through the issues, the IRS has finally issued some insights. I don’t believe this is the last word on this issue, and, for reasons I discuss elsewhere on this site, I suspect that this is just the start of many problems to come. My crystal ball says that we won’t really understand the depth of this problem until 2013 or 2015 when the audits of taxpers from 2007 through 2010 start being conducted and wind through the courts.
NOTICE: This isn’t my post; It is a verbatim reproduction of the IRS’s FAQ on the Mortgage Forgiveness Debt Relief Act.
If you owe a debt to someone else and they cancel or forgive that debt, the amount of the canceled debt may be taxable.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
The following are the most commonly asked questions and answers about The Mortgage Forgiveness Debt Relief Act and debt cancellation:
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
- Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
- Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
- Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
These exceptions are discussed in detail in Publication 4681.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007 (see News Release IR-2008-17). Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence.
What does exclusion of income mean?
Normally, debt that is forgiven or cancelled by a lender must be included as income on your tax return and is taxable. But the Mortgage Forgiveness Debt Relief Act allows you to exclude certain cancelled debt on your principal residence from income. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
Does the Mortgage Forgiveness Debt Relief Act apply to all forgiven or cancelled debts?
No. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing
Does the Mortgage Forgiveness Debt Relief Act apply to debt incurred to refinance a home?
Debt used to refinance your home qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. For more information, including an example, see Publication 4681.
How long is the relief offered by the Mortgage Forgiveness Debt Relief Act in effect?
It applies to qualified principal residence indebtedness forgiven in calendar years 2007 through 2012.
Is there a limit on the amount of forgiven qualified principal residence indebtedness that can be excluded from income?
The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately for the tax year), at the time the loan was forgiven. If the balance was greater, see the instructions to Form 982 and the detailed example in Publication 4681.
If the forgiven debt is excluded from income, do I have to report it on my tax return?
Yes. The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return.
Do I have to complete the entire Form 982?
No. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), is used for other purposes in addition to reporting the exclusion of forgiveness of qualified principal residence indebtedness. If you are using the form only to report the exclusion of forgiveness of qualified principal residence indebtedness as the result of foreclosure on your principal residence, you only need to complete lines 1e and 2. If you kept ownership of your home and modification of the terms of your mortgage resulted in the forgiveness of qualified principal residence indebtedness, complete lines 1e, 2, and 10b. Attach the Form 982 to your tax return.
Where can I get IRS Form 982?
If you use a computer to fill out your return, check your tax-preparation software. You can also download the form at IRS.gov, or call 1-800-829-3676. If you call to order, please allow 7-10 days for delivery.
How do I know or find out how much debt was forgiven?
Your lender should send a Form 1099-C, Cancellation of Debt, by February 2, 2009. The amount of debt forgiven or cancelled will be shown in box 2. If this debt is all qualified principal residence indebtedness, the amount shown in box 2 will generally be the amount that you enter on lines 2 and 10b, if applicable, on Form 982.
Can I exclude debt forgiven on my second home, credit card or car loans?
Not under this provision. Only cancelled debt used to buy, build or improve your principal residence or refinance debt incurred for those purposes qualifies for this exclusion. See Publication 4681 for further details.
If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.
I lost money on the foreclosure of my home. Can I claim a loss on my tax return?
No. Losses from the sale or foreclosure of personal property are not deductible.
If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?
Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or canceled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt canceled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case. An exclusion is also available for the cancellation of certain nonbusiness debts of a qualified individual as a result of a disaster in a Midwestern disaster area. See Form 982 for details.
If the remaining balance owed on my mortgage loan that I was personally liable for was canceled after my foreclosure, may I still exclude the canceled debt from income under the qualified principal residence exclusion, even though I no longer own my residence?
Yes, as long as the canceled debt was qualified principal residence indebtedness. See Example 2 on page 13 of Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
Will I receive notification of cancellation of debt from my lender?
Yes. Lenders are required to send Form 1099-C, Cancellation of Debt, when they cancel any debt of $600 or more. The amount cancelled will be in box 2 of the form.
What if I disagree with the amount in box 2 of IRS Form 982?
Contact your lender to work out any discrepancies and have the lender issue a corrected Form 1099-C.
How do I report the forgiveness of debt that is excluded from gross income?
(1) Check the appropriate box under line 1 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to indicate the type of discharge of indebtedness and enter the amount of the discharged debt excluded from gross income on line 2. Any remaining canceled debt must be included as income on your tax return.
(2) File Form 982 with your tax return.
My student loan was cancelled; will this result in taxable income?
In some cases, yes. Your student loan cancellation will not result in taxable income if you agreed to a loan provision requiring you to work in a certain profession for a specified period of time, and you fulfilled this obligation.
Are there other conditions I should know about to exclude the cancellation of student debt?
Yes, your student loan must have been made by:
(a) the federal government, or a state or local government or subdivision;
(b) a tax-exempt public benefit corporation which has control of a state, county or municipal hospital where the employees are considered public employees; or
(c) a school which has a program to encourage students to work in underserved occupations or areas, and has an agreement with one of the above to fund the program, under the direction of a governmental unit or a charitable or educational organization.
Can I exclude cancellation of credit card debt?
In some cases, yes. Nonbusiness credit card debt cancellation can be excluded from income if the cancellation occurred in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See the examples in Publication 4681.
How do I know if I was insolvent?
You are insolvent when your total debts exceed the total fair market value of all of your assets. Assets include everything you own, e.g., your car, house, condominium, furniture, life insurance policies, stocks, other investments, or your pension and other retirement accounts.
How should I report the information and items needed to prove insolvency?
Use Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) to exclude canceled debt from income to the extent you were insolvent immediately before the cancellation. You were insolvent to the extent that your liabilities exceeded the fair market value of your assets immediately before the cancellation.
To claim this exclusion, you must attach Form 982 to your federal income tax return. Check box 1b on Form 982, and, on line 2, include the smaller of the amount of the debt canceled or the amount by which you were insolvent immediately prior to the cancellation. You must also reduce your tax attributes in Part II of Form 982.
My car was repossessed and I received a 1099-C; can I exclude this amount on my tax return?
Only if the cancellation happened in a title 11 bankruptcy case, or to the extent you were insolvent just before the cancellation. See Publication 4681 for examples.
Are there any publications I can read for more information?
(1) Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals) is new and addresses in a single document the tax consequences of cancellation of debt issues.
(2) See the IRS news release IR-2008-17 with additional questions and answers on IRS.gov.
I get a lot of questions about bankruptcy basics: What’s the difference between Chapters 7, 11 and 13: What is a discharge? What can I keep? What will I lose?
Here, without fanfare or embellishment, is how the federal government describes the process. All in all, I think it’s a pretty good presentation, though of course, it lacks the “inside baseball” reality from the trenches that you can get from an attorney who spends a lot of time in the Bankruptcy Court. For that, you’ll have to pick up a phone.
I do not claim authorship of the following: It is extracted verbatim from the Federal Court’s website, and the link to the original is here. I have omitted sections relating to Chapters 9 and 12 as they don’t apply to the vast majority of people. If you have been told that they might apply to you, then check the link above.
Over the coming weeks I will also reprint some of the specific information on Chapters 7 and 13.
Article I, Section 8, of the United States Constitution authorizes Congress to enact “uniform Laws on the subject of Bankruptcies.” Under this grant of authority, Congress enacted the “Bankruptcy Code” in 1978. The Bankruptcy Code, which is codified as title 11 of the United States Code, has been amended several times since its enactment. It is the uniform federal law that governs all bankruptcy cases.
The procedural aspects of the bankruptcy process are governed by the Federal Rules of Bankruptcy Procedure (often called the “Bankruptcy Rules”) and local rules of each bankruptcy court. The Bankruptcy Rules contain a set of official forms for use in bankruptcy cases. The Bankruptcy Code and Bankruptcy Rules (and local rules) set forth the formal legal procedures for dealing with the debt problems of individuals and businesses.
There is a bankruptcy court for each judicial district in the country. Each state has one or more districts. There are 90 bankruptcy districts across the country. The bankruptcy courts generally have their own clerk’s offices.
The court official with decision-making power over federal bankruptcy cases is the United States bankruptcy judge, a judicial officer of the United States district court. The bankruptcy judge may decide any matter connected with a bankruptcy case, such as eligibility to file or whether a debtor should receive a discharge of debts. Much of the bankruptcy process is administrative, however, and is conducted away from the courthouse. In cases under chapters 7, 12, or 13, and sometimes in chapter 11 cases, this administrative process is carried out by a trustee who is appointed to oversee the case.
A debtor’s involvement with the bankruptcy judge is usually very limited. A typical chapter 7 debtor will not appear in court and will not see the bankruptcy judge unless an objection is raised in the case. A chapter 13 debtor may only have to appear before the bankruptcy judge at a plan confirmation hearing. Usually, the only formal proceeding at which a debtor must appear is the meeting of creditors, which is usually held at the offices of the U.S. trustee. This meeting is informally called a “341 meeting” because section 341 of the Bankruptcy Code requires that the debtor attend this meeting so that creditors can question the debtor about debts and property.
A fundamental goal of the federal bankruptcy laws enacted by Congress is to give debtors a financial “fresh start” from burdensome debts. The Supreme Court made this point about the purpose of the bankruptcy law in a 1934 decision:
[I]t gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.
Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). This goal is accomplished through the bankruptcy discharge, which releases debtors from personal liability from specific debts and prohibits creditors from ever taking any action against the debtor to collect those debts. This publication describes the bankruptcy discharge in a question and answer format, discussing the timing of the discharge, the scope of the discharge (what debts are discharged and what debts are not discharged), objections to discharge, and revocation of the discharge. It also describes what a debtor can do if a creditor attempts to collect a discharged debt after the bankruptcy case is concluded.
Six basic types of bankruptcy cases are provided for under the Bankruptcy Code, each of which is discussed in this publication. The cases are traditionally given the names of the chapters that describe them.
Chapter 7, entitled Liquidation, contemplates an orderly, court-supervised procedure by which a trustee takes over the assets of the debtor’s estate, reduces them to cash, and makes distributions to creditors, subject to the debtor’s right to retain certain exempt property and the rights of secured creditors. Because there is usually little or no nonexempt property in most chapter 7 cases, there may not be an actual liquidation of the debtor’s assets. These cases are called “no-asset cases.” A creditor holding an unsecured claim will get a distribution from the bankruptcy estate only if the case is an asset case and the creditor files a proof of claim with the bankruptcy court. In most chapter 7 cases, if the debtor is an individual, he or she receives a discharge that releases him or her from personal liability for certain dischargeable debts. The debtor normally receives a discharge just a few months after the petition is filed. Amendments to the Bankruptcy Code enacted in to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 require the application of a “means test” to determine whether individual consumer debtors qualify for relief under chapter 7. If such a debtor’s income is in excess of certain thresholds, the debtor may not be eligible for chapter 7 relief.
Chapter 13, entitled Adjustment of Debts of an Individual With Regular Income, is designed for an individual debtor who has a regular source of income. Chapter 13 is often preferable to chapter 7 because it enables the debtor to keep a valuable asset, such as a house, and because it allows the debtor to propose a “plan” to repay creditors over time – usually three to five years. Chapter 13 is also used by consumer debtors who do not qualify for chapter 7 relief under the means test. At a confirmation hearing, the court either approves or disapproves the debtor’s repayment plan, depending on whether it meets the Bankruptcy Code’s requirements for confirmation. Chapter 13 is very different from chapter 7 since the chapter 13 debtor usually remains in possession of the property of the estate and makes payments to creditors, through the trustee, based on the debtor’s anticipated income over the life of the plan. Unlike chapter 7, the debtor does not receive an immediate discharge of debts. The debtor must complete the payments required under the plan before the discharge is received. The debtor is protected from lawsuits, garnishments, and other creditor actions while the plan is in effect. The discharge is also somewhat broader (i.e., more debts are eliminated) under chapter 13 than the discharge under chapter 7.
Chapter 11, entitled Reorganization, ordinarily is used by commercial enterprises that desire to continue operating a business and repay creditors concurrently through a court-approved plan of reorganization. The chapter 11 debtor usually has the exclusive right to file a plan of reorganization for the first 120 days after it files the case and must provide creditors with a disclosure statement containing information adequate to enable creditors to evaluate the plan. The court ultimately approves (confirms) or disapproves the plan of reorganization. Under the confirmed plan, the debtor can reduce its debts by repaying a portion of its obligations and discharging others. The debtor can also terminate burdensome contracts and leases, recover assets, and rescale its operations in order to return to profitability. Under chapter 11, the debtor normally goes through a period of consolidation and emerges with a reduced debt load and a reorganized business.
The bankruptcy process is complex and relies on legal concepts like the “automatic stay,” “discharge,” “exemptions,” and “assume.” Therefore, the final chapter of this publication is a glossary of Bankruptcy Terminology which explains, in layman’s terms, most of the legal concepts that apply in cases filed under the Bankruptcy Code.
The Wall Street Journal recently ran an article about how, when small businesses are forced to file for bankruptcy protection, the inevitable result is that it usually takes the owners down with it. This is extremely common, and far more frequently the rule than the exception.
Why does this happen? Why, if the proprietor has gone through the expense and trouble to create a corporation or a limited liability company (“LLC”) do these things wind up being just so much superfluous window dressing right at the moment when you really need them to step up and do their job? (Their job being to protect your assets when things go sour.) Because the corporation or limited liability company formed for the needs of the of the small business owner usually doesn’t have adequate assets or resources to give any comfort to creditors–bank lenders most commonly–and so the lender wants as much security for the loans as possible. Enter the concept of the personal guaranty.
If ABC Corp. wants to borrow $1 million for an operating loan but only has assets of $50k of office furniture, computers, fixtures, etc., the bank is going to want some other security. And if ABC Corp’s sole shareholder has a few hundred thousand dollars in equity in his home, then the bank is going to want a security interest in that. Plus whatever else the owner may own. So the bank demands a personal guaranty from owner, which are usually so broad in what they cover that they renders the entire concept of the LLC or the corporation almost completely useless. And it happens with such efficient thoroughness and with such frequency, that it’s probably safe to say that if a personal guaranty is involved, then don’t even bother with the corporation or LLC. (Except maybe for tax or accounting purposes but we won’t go into that here.)
Another place where this pops up is in the single purpose LLC formed for the purpose of owning real property. I have taken quite a few people through Chapter 7s recently who had a bunch of LLC’s (or the increasingly popular Delaware “Series LLC”) that had been formed to own real estate. The problem is that banks won’t lend money for investment real estate to an LLC on the same terms that then will lend for owner-occupied residential property. They usually want 30% to 40% down depending on the asset. Why? Because the bank wants the owner to have “skin” in the game so that he won’t walk away.
So here’s what happens. (Or what was happening until things crashed in 2007.)
California resident finds great deal on 3br new construction home in Anytown, Utah (for example only). His real estate broker hooks him up with a loan broker to line up the financing. Owner has nothing to put down, and has read somewhere that investment real estate should be owned by an LLC to “protect his assets.” So Owner goes out and pays some lawyer $1,500 to form a fancy “Delaware Series LLC” for the purpose of owning the investment real estate in Utah. But here’s where the fancy plan derails: Bank won’t lend100% to an LLC, and the loan broker is usually too 1.) greedy 2.) stupid 3.) dishonest 4.) clueless to properly advise Owner. So Owner gets the stack of loan docs, all of which show that it is Owner as an individual, not Owner’s Delaware Series LLC that is the actual borrower on the loan. Deal closes and Owner gets his house. At this point Owner may transfer title to the LLC in the misguided belief that he is actually using this fancy legal device that he paid the lawyer $1,500 to create for him. After that Owner installs tenant, hires management service, and sits back to starts to collect the rent.
Things go great until 2007 or 2008 when the when the world comes crashing down. The house that Owner bought for $265,000 is now worth about $200,000 or less, the tenants have moved out, and because of the crash in housing prices, Owner can’t rent the property for enough to cash flow the loan, taxes and other expenses. Owner is now officially upside down (or under water) and is having to send checks form California every month just to meet the expenses. So Owner goes to a new lawyer. In many cases, this is me.