Bankruptcy Provides Options for a Fresh Start

If you are deeply in debt, bankruptcy may be an option to consider. There are several types of bankruptcy, each with different requirements and outcomes. To select the right type, you must consider your situation and the types of debt you have.

Bankruptcy can help you get a fresh start, either by liquidating your assets in a Chapter 7 proceeding or by creating a repayment plan under Chapter 13 (for personal debts) or Chapter 11 (for business debts.) Bankruptcy is only available in federal court: you cannot file for bankruptcy in state court.

In some cases, through bankruptcy, you may be able to discharge most or all of your unsecured debts, such as credit card debts, while preserving all of your assets. In addition, at times, the most efficient way to eliminate a portion of a lien may be to file a bankruptcy action.

Generally, the bankruptcy code follows the rules on eliminating liens that impair exempt assets. In addition, however, the bankruptcy code allows for the elimination of certain liens that impair exempt property that cannot be eliminated in a state court proceeding.

Chapter 13 Helps Those with Regular Income

In a Chapter 13 proceeding, an individual debtor with regular wages or income agrees to pay back a portion of his or her debts over a period of three to five years. One of the most common types of bankruptcy filings, Chapter 13 is available only to individuals. Sole proprietors can take advantage of Chapter 13, provided they meet the regular stream of income requirement, because the business is not considered a distinct entity from its owner.

Under Chapter 13, the debtor proposes a payment plan. The plan usually involves paying secured creditors the value of their liens, and paying unsecured creditors a fraction of their claims (e.g., 20 percent) or nothing at all. The plan must treat each creditor within a class (e.g., secured creditors) the same, but it may treat creditors in separate classes differently.

Why would a debtor choose Chapter 13? Traditionally, most debtors opted for completely eliminating their debts, rather than paying some portion off over many years. However, Chapter 13 gained popularity when the bankruptcy reform law went into effect on October 17, 2005. Debtors who want to choose Chapter 7 liquidation now must submit to a means test to determine their eligibility. If their income is above a certain threshold, debtors must go into a Chapter 13 repayment plan.

And, in some cases, Chapter 13 may be the better alternative. This is likely to be the case when the debtor has defaulted on secured loans (e.g., a home mortgage, or car loan) and is unable to make up the default, or pay off the lien, in one lump sum payment (as would be required in Chapter 7), but does not want to surrender the property to the secured creditor. In Chapter 13, the debtor can make up the default or pay off the lien over three to five years, rather than immediately in one lump sum.

Absent this one particular circumstance, Chapter 7 will almost always be the superior alternative. But according to new laws, many debtors will not be eligible for it. A major disadvantage of Chapter 13 is the fact that the debtor must account for all of the income or assets received during this three- to five-year period.

Chapter 11 Protects You While You Stay in Business

Among the types of filings, Chapter 11 is to business entities what Chapter 13 is to individual debtors. Chapter 11, or the business reorganization chapter, is used primarily by larger corporations that intend to continue operations after restructuring. A small business owner, or the business entity, is much more likely to be involved in a Chapter 7 proceeding or, in the case of the owner, a Chapter 13 proceeding.

Bankruptcy Offers Additional Options to Eliminate Liens

In a bankruptcy proceeding, it is possible to eliminate a non-purchase-money, non-possessory security interest liens on certain exempt property, as well as some mechanics' liens.

Mechanic's liens can be eliminated. A mechanic's lien that is filed within the 90 days before the bankruptcy action commences (or is for rent owed) can be eliminated as a "preference" under the bankruptcy code.

Non-purchase money, non-possessory liens on certain property can be eliminated. Using the bankruptcy laws, you may be able to eliminate a lien that you could not eliminate in state court.

A lien may be able to be eliminated if all the following conditions are met:

The lien must be:
- non-purchase-money and
- non-possessory
the property must be "personal effects," professional tools or health aids, as further defined, below.

A non-purchase-money security interest lien arises where the proceeds from the debt were not used to purchase the property. Loans involving purchase-money security interests are more common. This fact means lien elimination will not apply to very many loans.

The lien must also be non-possessory, which means that the debtor, as opposed to the creditor, must retain possession of the property. This condition will not usually be difficult to meet, except, for example, in the case of a loan from a pawn broker.

The property must consist of:

household furnishings, household goods, wearing apparel, appliances, books, animals, crops, musical instruments, or jewelry held primarily for the personal, family or household use of the debtor or a dependent of the debtor
implements, professional books, or tools of the trade of the debtor or a dependent of the debtor
professionally prescribed health aids for the debtor or a dependent of the debtor

Exemption amounts are limited to $5,000. The bankruptcy code imposes one other condition on this rule. If the debtor uses the state's exemptions, rather than the federal bankruptcy code exemptions, and the property exempted consists of implements, professional books, or tools of the trade of the debtor or a dependent of the debtor, or farm animals or crops of the debtor or a dependent of the debtor, then the lien cannot be eliminated to the extent the value of such implements, professional books, tools of the trade, animals, and crops exceeds $5,000.

This cap exists because a state's exemptions can be far more generous than the federal exemptions for these types of property.

It's important to note that the courts have typically interpreted this $5,000 limitation as a cap on the amount of the lien that can be eliminated. However, a Texas bankruptcy court has ruled that this limitation actually means the debtor must be left with a minimum equity in the property of $5,000.

The difference between the two interpretations can be significant, when the loan exceeds the value of the property.

John Smith personally owns office furniture valued at $20,000 with a non-purchase-money, non-possessory lien against it in the amount of $80,000. Thus, Smith has no equity in the furniture.

Smith files a bankruptcy action and elects his state's exemptions, so that the $5,000 limitation applies (due to the federal cap). Further, Smith's state exemption for the office equipment makes it completely exempt.

Under the most common interpretation, Smith can eliminate $5,000 of the lien, and he still owes $75,000. He still will have no equity in the furniture.

Under the recent interpretation by a Texas bankruptcy court, the balance of the loan will be reduced to the difference between the value of the property, $20,000, and the $5,000 limitation. Here, that amount is $15,000. In this way, the debtor is left with a minimum equity of $5,000 in the property.

Thus, in this example, under the second interpretation, Smith's loan is reduced to $15,000, and he has $5,000 equity in the furniture ($20,000 less $15,000).

Under this second interpretation, Smith saves $60,000 (lien of $75,000 vs. lien of $15,000).

Lien Stripping Reduces Obligation to Pay Creditors

A small business owner faced with mounting debts and liens against his property may at some point find it necessary to consider filing bankruptcy. Therefore, every small business owner should have an understanding of some bankruptcy basics.

Lien Stripping Can Help Protect Assets

The bankruptcy code contains a protection for debtors that is not found in state laws regulating liens. This is the option to "bifurcate" or "strip" liens against your assets. This can be a very significant asset protection tool for debtors in a bankruptcy proceeding.

This rule applies to both exempt and nonexempt property, as only the excess above the value of the property is eliminated. Lien bifurcation applies only in bankruptcy proceedings--it is not available in state court actions.

Liens that are attached to a specific piece of your property are considered to be secure. The most common example is a car loan. However, for a small business owner, your equipment might be financed with the equipment as security for the loan.

Under the bankruptcy code, a lien, other than one secured solely by your personal residence, is considered to be secured only to the extent of the value of the property, at the time of the bankruptcy filing. Any excess balance is deemed unsecured and is "stripped away."

The lien in this situation is not eliminated. It is still be valid, but it is secured only to the extent of the full value of the property; the remainder is unsecured debt. Thus, even if the lien is of a type that cannot ordinarily be eliminated, the excess of the debt above the value of the property, the unsecured portion, will be discharged.

In short, the effect of this provision will usually be to reduce, but not eliminate, liens that impair both exempt and nonexempt assets. Liens in either case will be reduced to an amount equal to the value of the secured property. Therefore, bifurcation can result in significant savings.

John owns a car with a value of $20,000, which is subject to a lien of $28,000 for a car loan.

In a bankruptcy proceeding, the loan will be bifurcated. This is, the lien will capped at the value of the car,$20,000. The balance of the lien, $8,000, is "stripped" away. As a result, the creditor holds a secured loan in the amount of $20,000, and an unsecured loan for $8,000.

This excess is not automatically eliminated. Instead, it is simply no longer secured by the car. Because the excess ($8,000) is unsecured, it usually will be eliminated in a bankruptcy proceeding. However, John is still on the hook for the $20,000, secured, portion of the debt.

When a loan is bifurcated, the debtor must either relinquish the property or pay back the secured portion of the debt, either in one lump sum in a Chapter 7 bankruptcy, or over three to five years in a Chapter 13 bankruptcy. Because most debtors can't raise the required lump sum payment, and do not want to surrender the property to the creditor, bifurcation of liens takes place most often in a Chapter 13 filing.

Valuation of Property. As a result of a Supreme Court ruling, the value of the property for purposes of bifurcation is the replacement value, not the property's current fair market value or even it's initial cost.

Because most debtors end up keeping the property by paying the stripped down amount of the lien, the appropriate value, the court reasoned, should be replacement value, because this is the cost the debtor would pay if he or she lost the property to the creditor, and then had to replace it.

Loans Secured by Personal Residence Cannot be Stripped

The lien stripping provisions under federal bankruptcy law do not apply to liens secured solely by a personal residence.

Debtors in bankruptcy who intend to keep their home can not avoid any portion of a lien secured by it, even when the amount owed on the loan greatly exceeds the value of the residence. Lien bifurcation is not available for residential mortgages. The full amount of the loan must be repaid. (Of course, if the owner gives up the home, the excess debt above the value of the home will be discharged as unsecured.)

The small business owner will frequently consider funding a business through a second mortgage, or a refinancing, on a personal residence. However, lien bifurcation is not permitted for a residential mortgage, you would be wise to heed this advice: Don't do it, or at least do it only after serious consideration of the possible consequences.

Specifically, consider this option only if you are completely sure you can pay the mortgage (without a return from your business) or you are prepared to lose your house. In this worst-case scenario, the small business owner would lose the home to foreclosure. You could then file a Chapter 7 bankruptcy proceeding to eliminate any deficiency (balance left after sale of the home), and thus be completely free of any remaining portion of the mortgage.

The rule to remember is this: Be prepared to pay the full balance of the mortgages, or you will lose your home.

Exceptions Exist to Prohibition on Lien Stripping of Residential Mortgages

Despite the general rule, two exceptions may apply to allow lien stripping of a mortgage on a personal residence.

Loans based on a home plus other collateral. Lien stripping is prevented only when the lien is secured "solely" by a personal residence. Court decisions have made it clear that when the debtor has given other collateral (in addition to the personal residence; e.g., office equipment) as security for the mortgage, lien stripping will be allowed.

Therefore, if you will be taking out a second mortgage or refinancing your home, you should consider offering additional collateral, such as furniture, as security for the loan. This can be done under the guise of seeking better terms from the lender, such as a lower interest rate.

Some second mortgages. Many (but not all) bankruptcy courts follow a rule that makes a second mortgage totally unsecured if the first mortgage balance equals or exceeds the value of the personal residence. This exception will not apply in the case of a refinancing of a mortgage, since in a refinancing the new mortgage pays off the first mortgage.

The exception is predicated on there being two distinct mortgages (a first and a second mortgage). For this reason, if you have the option of financing your business through a second mortgage or refinancing your first mortgage, the second mortgage may be the better choice, especially where the amount of the first mortgage is close to the value of the home.

If you own a small business, you must consider a number of different factors in deciding how to finance it. Be especially wary of misleading advertisements regarding second mortgages or refinancing.

When financing a business, a second mortgage or refinancing can offer a lower interest rate than a credit card. However, this is not always the case, and there are other considerations. For a "125 percent home equity" loan, expect to see an interest rate double the rate available on a conventional mortgage.

Even where the rate on a new mortgage is lower than that on a credit card, you need to weigh this benefit against the risks engendered by the mortgage: Credit card debt is unsecured and fully dischargeable in a bankruptcy proceeding, while the mortgage, of course, is not.

Overall, however, the inability to strip and thus reduce the lien, or eliminate the lien against a homestead exemption, in or out of bankruptcy, is one of the most important factors to consider.

This factor, alone, should give you pause before considering a second mortgage or refinancing as a source of funding for a business. A conventional second mortgage, which when added to the first mortgage typically doesn't exceed 80 to 90 percent of the value of the home, may offer advantages, including a low interest rate, low monthly payments and a tax deduction for the interest paid. These advantages must be weighed against the risk of foreclosure and loss of the home.

There is one other situation where a second mortgage on a home may represent an excellent exemption planning strategy: namely, where the value of the home exceeds the amount of the homestead exemption in your state. In that case, a second mortgage can bring your equity in the home below the exemption amount, thus making the home judgment-proof. Even here, however, all of the above factors must still be weighed against the benefits of this form of exemption planning. In this respect, a 125 percent home equity loan presents a very risky alternative. A conventional second mortgage, however, might be an attractive choice in this situation.

Not a personal residence. In addition, remember that the general rule applies only to a lien secured solely by a personal residence. Thus, lien stripping will be allowed for a mortgage on a building used in a business.