Top 10 Misconceptions About Bankruptcy

By Neil E. Colmenares

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1. The debtor must be flat broke to file for bankruptcy. Wrong. With limited exceptions, the only requirement to file for bankruptcy is that the debtor cannot pay bills as they come due. A “debtor” is an individual or entity that owes money. The Bankruptcy Act of 1898 (replaced by the Bankruptcy Code of 1978) substituted the term “bankrupt” for “debtor.” One reason for this change was to help remove some of the social stigma involved in filing for bankruptcy. Most people are debtors, but not all are bankrupt.

Once a “flat broke” debtor would complete the bankruptcy process, she would in all likelihood become a public charge because she has nothing left to live on. To avoid this burden on the government, Congress has permitted exemptions that allow debtors to keep a certain amount of property despite filing for bankruptcy. A person filing for bankruptcy in New York is permitted to have, among other things, up to $2,500 in cash, $2,400 of equity in an automobile, and unlimited funds in a qualified 401(k) plan. (For a complete list of exemptions for New York State debtors domiciled in New York, see the New York CPLR sections 5205 and 5206, New York Debtor and Creditor Law Sections 282–284, and the New York Insurance Law sections 3212–3213.)

Finally, because individuals and businesses often wait until they are flat broke to seek bankruptcy advice, this delay limits their options, some of which may help them reorganize their finances and keep part or all of their property. For example, an individual normally waits until the day before a foreclosure sale to seek bankruptcy advice; had he sought advice earlier, his chances of losing the property would have been diminished significantly.

2. An individual who files for bankruptcy will not qualify for credit in the future. Wrong. The fact that an individual files for bankruptcy will appear on an individual’s credit report for up to 10 years, which may seem draconian but is not permanent.

Any individual considering filing for bankruptcy probably has poor credit already. Filing for bankruptcy may be the best bet to “get good credit” again, because when a debtor files for bankruptcy under Chapter 7 of the Bankruptcy Code and receives a discharge (a court injunction relieving the debtor of the obligation to repay most debts and preventing creditors from collecting for the same), the debtor cannot receive another discharge under Chapter 7 for at least six years.

Consider, for example, a credit card company that receives two applications, identical with one exception: one applicant filed for bankruptcy three months ago. Who should it extend credit to? Applicant #1, who never filed for bankruptcy and who could file for bankruptcy at any moment after using the credit card company’s money? Or Applicant #2, who filed for bankruptcy three months ago and who recently received a discharge under Chapter 7, thereby ensuring that the loan cannot be discharged under Chapter 7 for at least the next six years? This scenario, in practice, often results in an individual who filed bankruptcy last week receiving dozens of new credit card offers.

3. An individual who files for bankruptcy cannot buy a house. Wrong. Like all lending institutions, mortgage lenders are willing to take risks with a debtor as long as the lender has enough security. This generally means charging higher interest rates and requiring personal guarantees. If a person who had filed for bankruptcy in the past applies for a mortgage and can fund a sufficient down payment, most banks will approve a mortgage loan.

4. A homeowner who files for bankruptcy will lose her house. Yes and no. In New York State, under what is called the “homestead exemption,” an individual is allowed to keep the first $10,000 in equity in her home above all liens and encumbrances despite the bankruptcy filing (the exemption is $20,000 for joint debtors).

For example, consider an individual who is current on his mortgage payments, has little equity in the property, and has a lot of credit card debt. Assume that the property is worth $250,000 and the mortgage is $240,000. In this instance, the individual can file for Chapter 7 and keep the house.

Assume, however, that the same individual has a $200,000 mortgage on the property. After taking into consideration the $10,000 homestead exemption, the individual is left with $40,000 in nonexempt equity. If this individual files for Chapter 7, the trustee in the case will sell the property and the individual will be given the first $10,000 from the proceeds. (A trustee is a person appointed by the court to administer the debtor’s estate. The trustee’s main function is to sell the debtor’s nonexempt property and use the proceeds to pay creditors.) The point is that the individual will lose the house under Chapter 7 unless, after filing for bankruptcy, he can come up with $40,000 to pay the trustee the nonexempt equity. These funds can come from a post-petition mortgage or from a loan by family or friends.

Now consider an individual who is behind on her mortgage, has substantial equity in the property, and has a lot of credit card debt. In this scenario, assuming the individual has a regular source of income and, after paying her regular monthly bills (i.e., mortgage payment not including arrears, food, and utilities), any money left over can satisfy the arrears on the mortgage over a period of not to exceed five years, the individual may be able to keep the house in Chapter 13. Although Chapter 13 is complicated, the principle is simple: As long as an individual repays the debt, she can keep the property.

5. Taxes cannot be discharged in bankruptcy. Wrong. Certain taxes are dischargeable in bankruptcy, such as personal income taxes that are more than three years old. As a general rule, fiduciary taxes are not dischargeable. The Bankruptcy Code’s provisions relating to taxes are complex, and differ by chapter.

6. Student loans are nondischargeable. This is generally true, but with exceptions. If the debtor can prove certain hardship, student loans may be dischargeable.

7. An individual can file for bankruptcy but not include certain creditors. Untrue, unlawful, and fraudulent. One principle behind the Bankruptcy Code is to treat similarly situated creditors equally. When a debtor does not list a creditor in bankruptcy and decides to pay back that creditor, that debtor is necessarily prejudicing the other creditors. When a debtor does this, the court considers this fraud, and the debtor risks losing the discharge and, in extreme circumstances, may face jail time and substantial fines.

8. Family members who loaned money to the debtor will lose out. Wrong. Although a debtor must list all creditors in the bankruptcy, in certain instances the debtor can repay certain creditors after the bankruptcy is filed. This is commonly known as a reaffirmation agreement. All reaffirmations are subject to court approval. Most debtors agree to pay back a debt they have no legal obligation to pay so as to maintain an existing business relationship. The court would probably approve the reaffirmation if the debtor lives with the creditor and may be forced to leave if he does not repay the debt.

9. Signing an agreement stating that a debt cannot be discharged in bankruptcy makes the debt nondischargeable. Wrong. Although there are extremely limited exceptions, these bankruptcy clauses are unenforceable and are a tactic used to scare debtors into not filing bankruptcy.

10. A person can lose his job if he files for bankruptcy. Wrong. The law states that if an individual can prove that an employer fired an employee solely because the employee filed for bankruptcy, the employee can sue the employer. If the debtor/employee looks for another job after filing for bankruptcy, however, a potential employer can use the bankruptcy filing as a factor (not the sole factor) in deciding whether to employ that individual.

Colmenares can be reached at 718-888-3108, 516-739-7272, 212-563-2222, or help@nycounselor.com.