What Is Bankruptcy? Part I

Whether you're up to your neck in loans, out of work or stretching one small paycheck to meet ever-growing obligations, nearly everyone occasionally flirts with the idea of ditching their debt.

While the reasons to file for bankruptcy vary, statistically speaking, 33 percent of debtors cite job or income loss as one of the reasons or even the number one reason they filed, says John Ulzheimer, vice president of the After Bankruptcy Foundation, a nonprofit organization that helps people recover from bankruptcy. Another 37 percent cite medical and job-related reasons and 24 percent cite medical-only reasons for filing.

But the reality of bankruptcy is that it's a complicated legal procedure that will trash your credit rating.

Reforms in 2005

And, bankruptcy laws are now even more complicated thanks to new reforms that went into effect Oct. 17, 2005. The changes in the laws make it harder to qualify for bankruptcy and even exclude some people from filing Chapter 7 altogether.

The new reforms require that a person filing for bankruptcy must get credit counseling from a government-approved credit counseling agency. The debtor must go to counseling within 180 days before filing for bankruptcy. There are some exceptions, such as the lack of qualified agencies to provide counseling and certain emergencies.

What's more, before any debt can be discharged under Chapter 13, debtors have to take a government-approved financial management education program. If debtors fail to complete the course, debts will not be discharged.

After these programs are completed, a person may file for bankruptcy. Most people opt for either Chapter 7 or Chapter 13. While rules vary widely from state to state, here's a general rundown on each, along with the new stipulations:

Chapter 7

Commonly known as liquidation, Chapter 7 usually takes four to six months from the date of filing to the final discharge. You can file only once in six years. This form of bankruptcy basically allows filers to give up assets in exchange for discharge of their debts. This is frequently the option for people who have few or no assets, often little or no income, and a lot of debt.

"You would use a Chapter 7 if you don't have assets of value that the trustee would try to sell," says David Greer, a partner with Williams Mullen in the real estate section, whose practice covers bankruptcy.

New rules affect eligibility

Some new bankruptcy rules will make it harder to qualify for Chapter 7:

Debtors must pass the "means test," meaning when they file, their income must be less than the median income in their state. If a debtor's income is above the state's median and the person can afford to pay $100 per month toward paying off debt, then the filer will be forced to file under Chapter 13.

Whether someone can afford to pay $100 per month is based on a formula that includes monthly income, expenses, and total amount of debt. Check your monthly income against your state's median income.

Ulzheimer says the means test will punish those who make too much money. Some people who need to file for Chapter 7 (and thus discharge most of their debts) won't be able to. By forcing people to file for Chapter 13, filers will end up paying more money -- not just to creditors, but to the person managing the payments.

Documentation needed

Good so far? Stay on your toes. Failure to provide the following documents within 45 days after the petition has been filed results in automatic dismissal of the case. However, debtors can apply for a 45-day extension.

Debtors must provide:

• A list of creditors
• Schedules of assets and liabilities
• Income and expenses
• Certificate of credit counseling
• Evidence of payment from employers, if any, received 60 days before filing
• Statement of monthly net income and any anticipated increase in income of expenses after filing
• Tax returns or transcripts for the most recent tax year
• Tax returns filed during the case including tax returns for prior years that had not been filed when the cases began, and;
• Photo I.D.

What you can keep

Chapter 7 stops most garnishments, although it depends on why you're being garnished. What you will be allowed to keep will depend largely on your state laws. Some states allow you to keep all of the equity in your home, while others exempt a certain amount. In some places, individuals may keep their household goods. Some states, such as Virginia, allow filers to keep wedding and engagement rings. "Well over 90 percent are considered no-asset cases," says Henry J. Sommer, president of the National Association of Consumer Bankruptcy Attorneys and editor in chief of "Collier on Bankruptcy."

If you manage to hang onto a home or car after a Chapter 7, you must keep up payments if you want to keep the property. Since Chapter 7 is obviously an option of last resort, check carefully to see what assets you can keep and what you stand to lose before you even consider filing.

At filing, the individual provides a list of all assets and obligations. A bankruptcy trustee goes over the list and decides whether to sell any unprotected assets to pay outstanding debts. Creditors can object on several grounds, including sudden disappearance of assets and lies in the bankruptcy filing.

Some debts not forgiven

While you may able to keep some assets, you also keep some debt. Certain debts, no matter what state you live in, cannot be discharged. For instance, any debt owed to a single creditor totaling more than $500 for luxury items bought within 90 days of filing are non-dischargeable; cash advances of $750 within 70 days are also non-dischargeable.

Chapter 7 also won't stop or even postpone some debt collections and lawsuits. New bankruptcy laws have dropped the following "automatic stays" of bankruptcy:

• Evictions
• Actions to withhold, suspend or restrict a driver's license
• Actions to withhold, suspend or restrict a professional or occupational license
• Lawsuits to establish paternity, child custody or child support
• Divorce proceedings, or
• Lawsuits related to domestic violence.

What's good about Chapter 7?

According to the Administrative Office of the United States Courts, individual debtors walk away from most debts in 99 percent of Chapter 7 cases, with the exception of cases that are converted or dismissed.

"Financially, it's easier to recover under Chapter 7 because you can walk away virtually debt-free," says Ulzheimer. However, from a credit-scoring perspective, this option will be more damaging than a Chapter 13 filing because it will stay on your credit report for 10 years. Chapter 13 will take seven years to fall off your credit report.

The impact will vary depending on how recently the bankruptcy occurred and how many debts were discharged.

"The more accounts, the more impact," says Ulzheimer. As the bankruptcy gets older, even though it remains on the report, the "impact will diminish," says Ulzheimer.

Leslie Hunt contributed to this story.