How Chapter 7 Works

Most people have heard of chapter 7 bankruptcy. In this posting, I want to explore how it works.

Chapter 7 is based on the idea that you cannot afford to make any payments on your debts. To put it another way, even if you had no debts, your living expenses alone leave you broke by the end of the month. The court doesn’t take your word for this. You have to prove you can’t pay your debts. You submit a statement of your monthly income and living expenses. You must provide proof of earnings and tax returns as well. People with above-median income have additional requirements.

If you successfully prove you meet the income and expense test, you qualify for chapter 7 discharge. But there is a catch. The law limits the assets you retain in chapter 7. If your assets exceed those limits, you lose them to your creditors. Basic assets are protected, such as ordinary household furnishings and clothes. Other exemptions protect home and vehicle equity, but only up to a point. If an asset is worth a lot more than the amount you owe on it, you can lose it.

Can you transfer valuable assets before you file for chapter 7? No. The law permits the court trustee to cancel transfers that occur within the prior year. If you transfer a valuable asset, you may have to wait a year or longer before filing a case.

Another common problem in chapter 7 cases is paying loans from relatives. If you make payments of more than $600 within the prior year, it can cause problems. The court trustee can sue the relative that receive the payments.

Debts are treated differently in chapter 7. Credit cards, loans, utility bills, and medical debts are normally discharged. Student loans are never discharged. Income taxes older than three years might be discharged depending on certain factors. House and vehicle payments continue if you want to keep the house or car. The creditor can require you to be current in payments before they agree to let you keep the loan. The court discharges the debt if you give up the house or vehicle.

Chapter 7 is a powerful tool for getting rid of debts. It does require some planning. You need to qualify by proving you are broke just paying living expenses. It does require planning ahead with your lawyer to make sure you don’t lose assets or subject relatives to lawsuits over loan payments.

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