Bankruptcy Considerations in Divorce

I recently agreed to speak on the topic of bankruptcy considerations in divorce at a seminar for family law attorneys.  This is a copy of my portion of the outline to be included in the materials.  It’s choppy because it’s just an outline, but hopefully will have something you will find useful.

Options for dealing with inability to sell or pay for marital residence:

1. Keep:  If the payment can fit in a budget, KEEP is an option.  Benefits are usually that kids get to stay in the home and school district and credit scores do not get damaged as long as the payments are maintained.  This is often not the best solution, however, if the home value is significantly less than its liens.  It is also just delaying the pain that will eventually come if the goal is not to keep the home long-term.  Loan modification can always be attempted, but highly unlikely that the lender will release the other spouse’s personal liability on the debt.
2. Short Sale:  Selling the home for less than what is owed with the consent of the lender.  Benefits include:  Home is sold and both parties are free to find new homes and are no longer connected by that long term debt.   Negatives:  Credit score(s) will be damaged for a while and purchase of a new home with financing may have to wait for a couple of years.  Lender(s) may want to be paid extra money in exchange for their consent and lien release.  There is also some potential for tax consequences.
3. Foreclosure: Keeping the home until the day the bank takes it back.  Benefits include staying in the home rent-free until the last minute and having the opportunity to save money.  Negatives:  Damaged credit ratings, possible deficiency judgments or tax consequences; New home purchase with financing will not be likely for several years; Potential personal property loss/damage.

How to handle particular debt problems: credit cards, student loans, medical debt:

1. Identify the debt:
   • General Unsecured debt is anything that is not secured to collateral, guaranteed by or owed to a government body or a student loan.  (credit cards, medical bills, repossession balances, unsecured lines of credit)
   • Secured debt is any debt that has collateral or has a lien.
   • Student Loans are defined in the bankruptcy code as:  (A)(i) an educational benefit overpayment or loan made, insured, or guaranteed by a governmental unit, or made under any program funded in whole or in part by a governmental unit or nonprofit institution; or (ii) an obligation to repay funds received as an educational benefit, scholarship, or stipend; or  (B) any other educational loan that is a qualified education loan, as defined in section 221(d)(1) of the Internal Revenue Code of 1986, incurred by a debtor who is an individual;
   • The most common “Priority debt” is some taxes and most court ordered obligations (support, criminal restitution & fines) see 11 USC 507 for the whole list.
2. Identify liability:  This can often be done easily with a credit report.  It is important to know whether just one or both parties are legally responsible for each particular debt.
3. Divide responsibility:  When possible, the easiest way to divide the debt is to assign responsibility to each party for debt in their own names.  If you have to start sharing liability, the recommended way to start assigning (and hopefully avoid as many complications due to someone’s bankruptcy later) would be Secured Debt, Student Loans and/or Priority Debt then General Unsecured Debt in that order.  If you have the party who is likely to file bankruptcy and is wanting to avoid as much liability as possible despite what they agreed to in the MSA, then go the other way on the list.
4. If someone does file bankruptcy after the MSA has been ratified:
   • In Chapter 7:  11 USC 523(a)(5) prevents discharge of an obligation “for a domestic support obligation”  (a)(15) of the same statute prevents discharge “to a spouse, former spouse, or child of the debtor and not of the kind described in paragraph (5) that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit;  This is only relevant in Chapter 13 if the debtor receives a hardship discharge before completing their 3-5 year plan.
   • In Chapter 13:  Only domestic support obligations, student loans and Priority debt are non-dischargeable if the debtor completes their plan.  Domestic support obligations must be current with no arrearage due at the end in order to get a discharge.  11 USC 523(a)(15) debt is dischargeable in Chapter 13 bankruptcies when the plan is completed.

Check List for when to refer for bankruptcy review:

Negative Equity Property/Real Estate

Unsustainable debt payments in the budget

Negative Income/Household budget

Likelihood of other party to honor their debt obligation

Income/Health deterioration for one/both parties

Use WWW.NACBA.ORG as a referral source if you don’t know anyone personally.

If one or both decide to file bankruptcy:

1. Do they file together?  Often this is the best out of a series of undesirable options.  Benefits include less stress and cost in the divorce, less cost to share a bankruptcy petition as a married couple.  This may not be possible if one or both are above-median earners.
2. Attorney’s fees: how does the divorce attorney get paid?  Any unpaid billing as of the time of the petition filing is most likely dischargeable unless it was previously properly leined.  If you get the feeling bankruptcy may be in the cards, try to stay paid as you go.  A large lump sum payment on older billing before a bankruptcy may become the subject of a preferential transfer action by the Trustee.  Always file a Proof of Claim (electronic versions can be found on the court’s website) in a case for monies owed to you by a debtor.  There is always the chance the Trustee could recover something for creditors and you will not get anything if there is no timely filed Proof of Claim.
3. Timing Issues: Bankruptcy and divorce cases often go well together when done simultaneously. Once a divorce is done, a debtor now responsible for joint debt may end up with obligations only remedied by Ch. 13.
4. What marital debts are dischargeable in bankruptcy? If both file, then everything except priority debt and student loans are dischargeable.  If only one files after the divorce court entered its Order ratifying the MSA or after trial, then everything except priority debt and student loans are dischargeable only if a) the debt was not assigned to the debtor in the divorce or b) the ex-spouse is not a joint account holder on the debt that was assigned to the debtor in the divorce.  If the Court has not ratified the MSA or otherwise entered an order assigning responsibility for debt, one spouse may file bankruptcy and discharge their obligations for joint debt that would otherwise have been assignable to them.  MSA’s not ratified by the family court judge may be avoidable in bankruptcy.

The MSA: What a Chapter 7 Trustee looks for:

Chapter 7 Bankruptcy is the liquidation bankruptcy.  Chapter 7 Trustees will look for disclosure of “recent litigation” on the Statement of Financial Affairs section of the bankruptcy petition and often request copies of final orders and settlement agreements from a divorce.  If a Settlement Agreement has been made but not yet ratified by court order, the Chapter 7 Trustee will look to see if there is any inequitable division or transfer of property that may be recoverable for the benefit of the debtor’s creditors.  If they believe they have an inequitable distribution, they can ask the Bankruptcy Court to void the Settlement Agreement.

If the Settlement Agreement had been ratified by the divorce judge prior to the bankruptcy, the Trustee will still have the option of bringing an Adversary Proceeding in bankruptcy against the ex-spouse to recover any preferential transfer under 11 USC 547 and 548.  Such actions are difficult, time consuming and expensive, so often the only time you should worry about one coming would be if a transfer was significant under the circumstances, had little or no consideration and could in no way be perceived as support.

Trustees will also look to see if the property itemized and assigned to the debtor matches the itemization of property and values listed in the bankruptcy petition schedules.  Payments being made to the debtor by an ex-spouse for property or debt division may become property of the bankruptcy estate and payable to the Chapter 7 Trustee.