Many different pieces of your financial picture can mean bankruptcy is not advisable. Some of them can be fixed.
As a consumer bankruptcy lawyer, I regularly advise people who need debt relief but for some reason shouldn’t file bankruptcy in their current situation. Sometimes we have to advise that bankruptcy is just not a good idea at present. But many times the problem can be handled with careful steps taken before filing, making it possible for the client to get the benefits of bankruptcy.
In this first of a series on overcoming the barriers to bankruptcy, we look at the problem of non-exempt assets.
First, let’s define our terms. Exempt property is everything you own that is protected from creditors by exemptions granted by the law. The property you can protect is usually determined by the law of the state where you live (or, if you have moved recently, the state where you previously lived). This protection is generally limited to certain kinds of property and certain dollar values for each kind. In South Carolina, for example, anyone who owns a home can protect up to $56,150 of its value, and the exemption for a motor vehicle is $5,625. These basic exemptions apply both in state court proceedings and in bankruptcy.
By contrast, any value you can’t protect is non-exempt. But this doesn’t mean property is at risk just because it is worth more that the exemption. Since mortgages and other liens usually survive in bankruptcy court, creditors, or trustees acting in their place, can only reach any value that exceeds the total of any senior liens on the property plus the exemption the debtor can claim. We refer to this excess value as non-exempt equity. Every time we advise a person about filing bankruptcy, we review his or her property and determine how much non-exempt equity, if any, the client has in any asset.
Non-exempt equity is important in both Chapter 7 and Chapter 13 but for slightly different reasons. In Chapter 7, the trustee is responsible for seizing any property with significant non-exempt equity and liquidating it to generate money for creditors. In Chapter 13, by contrast, the trustee doesn’t sell off property; instead, the debtor must pay unsecured creditors, through his plan, an amount equal to the non-exempt equity.
In either case, though, non-exempt equity is a problem for a potential bankruptcy debtor. So pre-bankruptcy strategy sometimes involves changes in the form of assets to maximize the exempt value and minimize the amount of property left unprotected — to the extent that can be done legally and ethically. We call this process exemption planning.
Exemption planning does not involve giving away property or parking it with a friend or relative. That’s called a fraudulent transfer, and it’s neither legal for the debtor nor ethical for an attorney to suggest. But exemption planning does permit the debtor to convert assets from one form to another that is better covered by the available exemptions.
Let’s look at an example. Charlie has a home that could be sold quickly for a net of $100,000 after sale costs are deducted. The home is subject to a first mortgage of $30,000 and a home equity line with a credit limit of $20,000, but the current balance on the equity line is $10,000. Right now, Charlie has equity of $60,000 in the home — more than his $56,150 homestead exemption. There is at least some risk a trustee would sell the home if Charlie filed Chapter 7 now.
But say Charlie has a car worth $10,000 that is subject to a car loan of the same amount. He could protect $5,625 of equity in the car, but he has no equity. So Charlie might consider drawing another $5,000 from the home equity line to pay down the car loan. He can now protect the $5,000 equity in the car and the $55,000 equity in the home, so the trustee can’t sell either. He’s not fraudulently transferring property to another person, and if not done to excess, it’s entirely legal and ethical. Charlie can now file Chapter 7 with no risk to his two most important assets.
Take another example. Dick just inherited $10,000 from his uncle, and it’s sitting in his checking account. Because of other property he must exempt, the only exemption he has available for this money is $5,000 in wild card exemption, which applies to any property including cash. If he files today, his trustee gets the other half of the money. But Dick owes $6,000 in income taxes from year before last, and recent tax debts are not dischargeable. So before filng, Dick pays the tax debt from his inheritance, getting a good benefit from that money. This reduces the bank balance to $4,000, which he can fully exempt. And because taxes are paid before other unsecured debt in bankruptcy, he hasn’t committed a preferential transfer that a trustee could later unwind. All Dick has done is to eliminate the commission a trustee would receive on the $6,000 so that every dollar goes to the IRS — and make his bankruptcy a shorter process.
These illustrations are somewhat simpler than we find in real life, but they illustrate the point that exemption planning can save assets and remove one important reason why someone might otherwise decide not to file bankruptcy.
Bankruptcy laws and court decisions impose special limits on exemption planning. Those limits are beyond the scope of this article. For this reason, though, no one should try to convert assets in order to maximize the benefit of exemptions without the advice of an experienced bankruptcy lawyer.