The Two Different Bankruptcy Paths: Liquidation and Rehabilitation, Part 2

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This post is the second part of an article about the differences between liquidation and rehabilitation in bankruptcy. To summarize the first part of the article posted last week, Chapter 7 liquidation wipes out dischargeable debt and nonexempt assets in a single flush, while rehabilitation chapters of the Bankruptcy Code like Chapter 13 involve multiyear plans to leverage future income to get out of debt. Because Chapter 7 is generally faster, cheaper, and does not involve future income, liquidation tends to be attractive to debtors. But Chapter 13 has some important advantages over Chapter 7. I will cover a few of them. For starters, it’s easier to qualify. Debtors who file under Chapter 7 when they should not are often booted to Chapter 13.

Second, Chapter 13 and other rehabilitation chapters let debtors breathe more deeply. Liquidation is a more of a gasp– flush out nonexempt assets and discharge debt in a quick huff. In Chapter 13 and other rehabilitative plans, the debtor pays off debts over time. The debtor may be able to hold on to their assets longer, peer into the future, and come up with a plan to use future income to pay the debt off valuable property. The debtor dedicates all their projected disposable income over the plan period to pay off debt. The meaning of disposable income is a question of judicial disagreement, particularly when it comes to making contributions to retirement. On June 1, 2020, the Sixth Circuit Court of Appeals allowed a Chapter 13 debtor to continue to make same contributions to his 401(k) plan as he did before bankruptcy. This opinion is the first appeals court opinion on the issue. With Chapter 13, a person has the ability to spread their payments out over time, while keeping enough income to get by.

Third, Chapter 13 accounts for changes in an individual’s financial situation. This can work both ways. If circumstances improve, the debtor may be required to pay more, even after the debtor’s plan gets confirmed. But this also acts as an insurance policy. If the debtor runs into some unforeseen event, like medical problems, the debtor may be able to receive a reduction of monthly payments to creditors.

Fourth, Chapter 13 may be uniquely helpful in shaking off the impact of mortgage debt. The reason boils down to a distinction between actions against the person (in legalese “in personam”) and actions against the property (in legalese “in rem”). Most of the time, when you sue, you sue the person. It’s the person who becomes liable. The person may be consequently be required to give up their things (usually money), but it is still the person on the hook. But sometimes, the defendant is a thing-a person’s property. This happens commonly in forfeiture actions. On a practical level, it’s really the owner of the thing that may wind up feeling sad. Things do not have feelings, but their owners do. But in in rem actions, on the legal level, it’s the thing that gets named as the defendant. In a mortgage, the bank actually has both an in personam interest and an in rem interest. A Chapter 7 discharge only eliminates the bank’s claim against the person. To shake off a bank’s separate claim against the property, it may become necessary to go through Chapter 13.

Fifth, for vehicles purchased over 910 days ago, Chapter 13 allows debtors to “strip down” car loans to the retail value of the car.

Courts cannot agree on when liquidation under Chapter 7 and rehabilitation under Chapter 13 are mutually exclusively. Some courts have allowed some debtors to go through both, dubbing this procedure “Chapter 20” (7 + 13). This one-two punch strategy allows some debtors to discharge their mortgage liability as a person under Chapter 7, and then use Chapter 13 to eliminate the independent interest the bank has in the house itself (in rem).

This list is just a small sampling of the wide world of bankruptcy. Depending on individual circumstances, the selection of different bankruptcy paths can make a difference in a person’s ability to keep houses, cars, and other property. Different tax consequences may result. Strategy in selecting the optimal bankruptcy chapter will impact the debtor’s bottom line-how much debt they still have, and what assets they get to keep.

Debtors face a barrage of often competing considerations: tax consequences, credit rating consequences, effects on mortgages, impacts on leases, the risk of an unanticipated deterioration of circumstances, and the potential opportunity to file a second bankruptcy. The situation can be even more befuddling because the selection of the the bankruptcy chapter is not the only aspect of bankruptcy strategy. Timing and residential history also have an impact on bankruptcy. If you are in debt, you do not need to face this alone. I help plot the best course forward for recovery. For a bankruptcy strategy tailored to your individual goals and financial situation, please contact me. My practice, J Haskins Law, is a debt relief agency. J Haskins Law helps people file for bankruptcy relief under the Bankruptcy Code.

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