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Chapter 7 or Chapter 13?

So, you finally realized that you're not going to be able to pay off your debt in your lifetime. Bankruptcy is the only way you are going to be able to eventually buy a house, car and send your children to college.

But should I file under Chapter 7 or Chapter 13? What’s the difference? These are the most important questions that I have when I first speak with a potential bankruptcy client. File under the wrong Chapter and you could end up paying a lot more than necessary or worst, lose your home.

First, it is important to explain the difference between the two Chapters (7 & 13). Chapter 7 is a liquidation of the debtor’s assets that are not exempt (allowed to keep). The vast majority of these cases actually end up as “no asset” cases and the debtor keeps everything they own and there is no liquation. Chapter 7 cases normally take approximately 3 months and afterwards all the debts that are allowed to be discharged are gone.

A Chapter 13 is an organized re-payment plan the last from 36-60 months. In this Plan, the debtor pay the trustee what she can afford (disposable income after normal expenses) for the length of the Plan and the trustee pays the debts off in the order that the bankruptcy code directs. After the last Plan payment, the remaining unpaid debts are discharged just like in a Chapter 7.

For me, in my 20 years of experience, a person should ALWAYS file under Chapter 7 unless they have one (or more) of the 4 reasons to file under Chapter 13. Here are MY four reasons:

1. Your household gross income and/or disposable income is above the medium income for your state and household size. This is colloquially called the “Means Test”. High income people are prohibited from filing under Chapter 7. For obvious reasons, this is something that I want to know right away, but it is not always simple to calculate and may require a detailed examination of your income over the past 6 months and your expenses. See Resources for a link to the current means test numbers.

2. You will lose assets that you don’t want to lose in a Chapter 7 liquidation. This is why so few cases in Chapter 7 involve actual liquidation – debtors avoid it by filing under Chapter 13. In most cases, the principal asset that is at risk is the home. If your equity is too high, than in a Chapter 7 case the trustee is going to seek to sell the house to capture the unexempt value. In Chapter 13, you are not subject to the liquation of the house, but you will have to pay into the Chapter 13 Plan the amount that would have been captured by the Chapter 7 trustee.

3. You are behind in secured debt payments and you wish to keep the property while catching up on the back payment. This is one of the most powerful and useful tools of the Chapter 13. If you are behind on mortgage payments (often facing a foreclosure situation) a Chapter 13 case will allow you the time (up to 5 years) to catch up on back payments while also taking case of all your other debt problems.

4. You are not allowed a discharge because you have previously received a discharge in the last 8 years. If you previously filed a Chapter 7 case and received a discharge, you have to wait 8 years to file again to receive another discharge. Unfortunately, creditors are not very accommodating and often make life to miserable to wait for protection under in bankruptcy. A Chapter 13 case can be filed to get the protection the debtor needs until they get to the date in which they are eligible for a discharge. Often the Chapter 13 case is convert to a Chapter 7 case once the 8 year threshold is past.

Some lawyers might have other reason for filing under Chapter 13 but be VERY careful. A Chapter 13 case is much more expensive and complex than a 7 and, as such, the attorney makes a lot more money. Make sure the attorney is not steering you to a 13 for his own sake.

Additionally, when saving secured property through a Chapter 13 by catching up on arrears the debtor needs to make a rational and financially reasonable decision. Generally, it will not be prudent to try and catch up on back payments if the secured property is not worth the amount is owed on it. Chasing negative equity is a recipe for future financial hardship. This will normally occur in vehicle loans. Home loans usually do not have this problem today (back in 2008 this was a problem) as most homes have some positive equity and, unlike most vehicles, homes appreciate in value.

If you have questions, please send my and email or call and we can discuss the finer points of this topic. It is my goal to make each one of my clients completely comfortable with the course of action that is taken. Knowing the cost, benefits and risks of filing bankruptcy is critically important to getting the best fresh financial start.

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