The Bankruptcy Code has a list of exempt property that basically serves as a model for state laws. In some states, debtors can apply these federal exemptions to their property; in other states, debtors must use the ones provided under state law. There is an important caveat. If the property has a loan against it, the owner must continue making payments according to the agreed-upon terms, because secured moneylenders do not care if their current customers file bankruptcy or not. If the payments stop, they will ask the judge for permission to go around the automatic stay and repossess the property, and judges nearly always grant special permission in these cases.
The law varies by jurisdiction, but most states allow debtors to keep their homes if they do not have more than a certain amount of equity; that amount is typically between $25,000 and $50,000. Unless they have been in their homes for more than eight or ten years, most people do not have more equity than that in their homes. And, quite frankly, homeowners with large amounts of home equity probably do not need to file bankruptcy to eliminate their debts.
Debtors list their houses, and any other similar assets, on Schedule A. In addition to the property, debtors must also declare a value. This is where it gets a little tricky, because the value that the county tax assessor uses is generally not the same as the home’s fair market value. Tax appraiser values are often slightly inflated, so the taxing jurisdictions obtain a little more revenue.
Moreover, according to the Bankruptcy Code, debtors must list their assets’ “garage sale value.” So, the question is not so much fair market value, but how much the house would be worth in a non-inspection, as-is cash sale. Most home investors will not pay more than 60 percent of fair market value in such transactions, and their initial offers are typically much lower than that. If there are issues with the amount of equity, this fact could well come into play.
Assume Dora Debtor owns a house that is valued at $200,000 on the tax appraiser’s website and her loan balance is $150,000. At first blush, she appears to have $50,000 in home equity and therefore, depending on where she resides and whether she uses federal or state exemptions, Dora may run afoul of the equity limit. But the $200,000 figure on the website is not the fair market value, and it is also not the as-is cash sale value. In fact, the “garage sale” value is arguably $120,000, because that is what a home investor would pay Dora for the house. So, although she may have $50,000 after a list sale, she might be saddled with $30,000 of negative equity in an as-is cash sale.
Debtors should be very careful when listing the value of assets, because substantially under-valuing them means a red flag to the trustee at best and a bankruptcy fraud prosecution at worst.
In many households, a 401(k), IRA, or other retirement savings plan is the family’s largest asset. The Bankruptcy Code expressly states that these accounts are exempt, and the United States Supreme Court recently reaffirmed this principle in Clark v. Rameker (2014). That case involved a debtor who inherited a $450,000 IRA from her mother; by the time the heir filed Chapter 7 bankruptcy, the account balance was about $300,000, because unless the new owner was the original owner’s spouse, monthly payments are the only disbursement option in inherited IRAs. Although Clark went against the debtor, the holding applies only in the handful of cases that involve inherited IRAs. The important thing is that the Supreme Court accepted the Bankruptcy Code as gospel truth on this issue, and reaffirmed that these accounts are 100 percent exempt in most cases, even if the balance is several hundred thousand dollars.
In addition to a primary residence and a retirement account, most other personal assets, including motor vehicles, furniture, tools used in business, and even cash in some cases are exempt. However, some assets are often clearly non-exempt, such as boats, weekend vacation cabins, and debtor-owned rental property. Many times, these assets are at least partially exempt, and even if they are not, the “garage sale” value principle discussed above once again comes into play.
Assume David Debtor has a non-running project car in his garage. Once the car is finished, it will probably have a substantial dollar value. But for now, it is only worth about $1,000. Moreover, the car is clearly non-exempt under both the federal and applicable state bankruptcy exemptions.
David is afraid that the bankruptcy trustee will seize the car, sell it, and distribute the proceeds among the creditors, meaning that all the work and money David poured into the car would be gone. But if the trustee did take David’s car, the bankruptcy estate would incur significant expenses. After the car is seized, stored, cleaned up, and a sale price is negotiated, there may be few or no proceeds to distribute.
As a result, in situations like the project car, bankruptcy trustees often elect to let debtors hang onto non-exempt property. The same logic applies to fishing boats that need some work, rental properties that prior tenants trashed, and so on.
Most middle-class families fall into one of two categories: households that confront their debt problems and households that hide their debt problems.
That’s because most families have essentially no savings and over $130,000 in secured and unsecured debt. So, when life’s financial storms hit, families must juggle payments instead of drawing on savings. This approach is often effective for a month or two, but putting off bills has a snowball effect. Three or four months down the road, a budget that was once barely feasible will essentially fall apart, and the financial news will more than likely only get worse.
Credit cards and medical bills are the two biggest unsecured debt categories, because the moneylender extends credit or provides services based solely on a written or oral promise to pay. Payday loans are also unsecured in most cases, although the moneylender would like for you to believe otherwise. Some furniture companies issue revolving-debt cards, like MasterCard and Visa, to allow customers to buy furniture on credit; these debts are also typically unsecured.
The procedural differences between a Chapter 7 and Chapter 13 are discussed below, but for now, suffice it to say that both these chapters eliminate these unsecured debts.
Home mortgages and vehicle loans are secured debts, because a third-party lender agreed to advance the purchase money for the property in exchange for a security interest in the collateral. In addition to monthly or periodic payments, security agreements often have other provisions as well, such as maintaining property insurance.
From a bankru
ptcy perspective, most secured debts are dischargeable. However, although a bankruptcy judge has the power to discharge the debt, the judge does not have the power to discharge the borrower’s obligations under the security agreement. So, if the borrower defaults on payments or otherwise breaches the agreement, the moneylender can seize the collateral. The automatic stay, which is discussed below, often comes into play regarding secured debts.
Special Category Debts
Not all debts are dischargeable with no strings attached, and most of the special category debts are somehow tied to state or federal governments:
• Domestic service obligations, including child support and spousal support, are almost never dischargeable in bankruptcy, regardless of the debtor’s circumstances.
• Income tax debt is dischargeable only if it adheres to the 3/2/9 rule. First, the taxes must be at least three years past due. Second, the returns must have been on file for at least two years. Third, the debt must not have been assessed in the last 240 days. In most cases, that means the taxpayer has not received a collections letter in the past nine months. These rules are very strict.
• Student loans, whether or not they were government-guaranteed, are likewise only dischargeable in cases that involve a “hardship.”
• Rent. If a judge has not signed a writ of possession, the automatic stay applies. If the judge has signed a writ, the automatic stay only applies if the tenants deposit one months’ rent with the bankruptcy court and confess that they owe the amount of delinquent rent stated in the writ or judgment. Furthermore, the tenants must pay the entire delinquent amount within thirty days, or the landlords can enforce their writs.