The Differences between Chapter 7 and Chapter 13

Bankruptcy filings in the U.S. totaled 910,090 in 2014 and 1,032,572 in 2013.[1] Of those filings, the majority were either a Chapter 7 or Chapter 13 case. Each chapter is unique and offers its advantages and disadvantages. Therefore, choosing the correct chapter depends on your income, assets, debts, and your financial goals, all of which should be discussed with a qualified bankruptcy attorney

Chapter 7

Chapter 7 is often referred to as a liquidation bankruptcy. The goal of Chapter 7 is to wipe out all of your general unsecured debts such as credit cards, judgments and medical bills. To qualify for Chapter 7 bankruptcy, you must have little or no disposable income and qualify via the bankruptcy means test[2].

Bankruptcy laws allow you to keep certain property or portions of the value of property defined as exemptions. Property that cannot be exempted i.e. protected is called “non-exempt” property. How much property or value of the property you can keep, largely depends on what types of property you have, how much that property is worth, and the bankruptcy exemptions applicable. You should have little or no assets of great monetary value such as investment properties, expensive vehicles, jewelry or artwork; nor have a bank, savings or similar account with a large cash balance.

When you file for Chapter 7 bankruptcy, a Trustee is selected by the Court to overview your case. The Chapter 7 trustee’s job is to sell your non-exempt property to pay back as much money as possible to your creditors. If you don’t have any or very little nonexempt assets, your creditors receive nothing. As a result, Chapter 7 bankruptcy is typically for low income debtors with little or no assets who want to get rid of their debts.

In Chapter 7, you have no automatic right to voluntary dismiss your bankruptcy if you change your mind. Generally, the Judge will only allow you to dismiss your Chapter 7 bankruptcy if you have a good cause, which means you can’t dismiss your case simply because you don’t want the trustee to sell your nonexempt assets.

The Chapter 7 bankruptcy can delay the foreclosure process depending on the time of filing but will generally not lead to an agreement or dismissal of foreclosure. Saving your home in a Chapter 7 is generally not possible because the chapter 7 does not offer a repayment option nor does it allow you to “strip”[3] your past due Condominium / Homeowners Association dues or second mortgages. However, if your home or investment property has already sold at foreclosure auction or you completed a short sale, then a chapter 7 may be ideal to get rid of the deficiency.[4]

The Chapter 7 bankruptcy generally will lead to a discharge[5] and completion in approximately 3 to 5 months.

Chapter 13

Chapter 13 is a reorganization bankruptcy designed for debtors with regular income who can pay back at least a portion of their debts through a repayment plan. Many debtors choose to file for Chapter 13 bankruptcy because it offers many benefits that Chapter 7 bankruptcy does not.

In Chapter 13 bankruptcy, you get to keep all of your property including nonexempt assets. In exchange, you pay back as in most cases, only a small portion of your debts through a repayment plan. The plan amount you must pay back depends on your income, expenses and types of debt.

If certain conditions are met, you can use a Chapter 13 bankruptcy to cram down the loans on your investment properties[6] or your car. A “cramdown” in a Chapter 13 bankruptcy allows you to reduce the principal balance of a debt to the current value of the property. Cramming down your loans through a Chapter 13 bankruptcy may also allow you to reduce your interest rate and stretch your payments out over a longer term in order to lower your monthly payment.

Lien stripping is a powerful option in Chapter 13 that allows people who are upside down, meaning your mortgage exceeds the value of your house, to get rid of their junior liens such as second mortgages or past due association fees.  Through a lien strip, the bankruptcy court essentially takes your second mortgage and converts it to an unsecured debt, just like a credit card debt, by ordering the lender to remove its lien from the property and in essence eliminating their right to foreclose or reposes.

A chapter 13 also offers a “cure and maintain” option. In essence, you repay past due mortgage, HOA, tax debts, alimony or child support payments in a bankruptcy plan over a 3 to 5-year time period while at the same time making the ongoing future payments.

In Chapter 13, you do have the right to voluntarily dismiss your bankruptcy if you change your mind or can no longer afford payments.

The Chapter 13 bankruptcy generally will lead to a discharge[7] and completion in approximately 3 to 5 years.

[1] Data is derived from a calendar year of Jan. 1-Dec. 31; Statistics according to data provided to the American Bankruptcy Institute by Epiq Systems, Inc.

[2] The means test is a formula set by the bankruptcy code designed to limit the use of Chapter 7 bankruptcy. It is complicated formula deducting specific monthly expenses from your “current monthly income” to arrive at your monthly “disposable income.”

[3] Lien stripping in Chapter 13 bankruptcy refers to the process of eliminating your junior liens (such as second or third mortgages) from your real estate.

[4] If you have lost your home through foreclosure, you might still owe your mortgage lender money after the sale if the foreclosure sale price is less than the amount you owed to the bank. In most states, you are on the hook for a deficiency after a short sale or you might owe the IRS some money for the money you never paid the bank.

[5] A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts.

[6] You can use a Chapter 13 bankruptcy to cram down the mortgages on your investment properties. Investment property generally means any property other than your principal place of residence such as rental or commercial properties. You cannot use a mortgage cramdown to reduce the balance of your mortgages on your principal residence.

[7] A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts.