How Chapter 13 Bankruptcy Works

I'll preface this article with a brief explanation of how a chapter 7 bankruptcy works.  When a debtor files for chapter 7 bankruptcy, she is seeking to "liquidate" her assets and discharge all of her dischargeable debt obligations, without having to pay any additional money to her creditors.  Exemptions in a chapter 7 usually allow a debtor to keep most or all of her property, so long as her assets are not great in value, thereby allowing a discharge of all dischargeable debt obligations without disgorging any property of paying any additional money to her creditors.  Chapter 7 bankruptcy does however have its limitations.  The primary limitation is that many debtors are ineligible for filing a chapter 7 due to excessive income, or the inability to pass the "means test" (more information on chapter 7 qualification can be found here).

Chapter 13 bankruptcy is often referred to as a "wage-earner" bankruptcy.  Debtors are required to fulfill a payment plan to the chapter 13 Trustee that lasts no longer than five years.  While a chapter 13 generally involves some kind of repayment, it also provides more options to the debtor.  For example, if a debtor is behind on her mortgage payment, no matter how behind (though assuming the property has not already been sold at a foreclosure sale), she may propose a chapter 13 plan that pays the arrears or amount past-due in full over a period of up to five years.  Meanwhile, any action to foreclose on the property by the lender will be prohibited pursuant to the automatic stay, an injunction imposed against the debtor's creditors, preventing them from seeking to collect on any debt.

Another way in which a chapter 13 can help has to do with non-dischargeable tax debts.  Only some tax debts are dischargeable.  Those that are not dischargeable are required to be paid in full.  If the debtor has a measurable non-dischargeable tax debt, she may pursue a chapter 13 and propose a plan that pays off the balance of the taxes over a period of up to five years, with interest.  Generally, such a plan is more attractive than any payment plan the debtor could obtain from the taxing entity outside of bankruptcy, and prevents the taxing entity from imposing any garnishments or liens.

Under some circumstances, a debtor may either reduce the balance owed on a car loan and/or reduce a monthly car payment. Payments on car loans are normally paid to the chapter 13 Trustee. If a car loan is due to mature BEFORE the completion of the proposed chapter 13 plan, the debtor may stretch out the payments over the longer period of the plan, thereby reducing the monthly payment, though accruing more interest.  If the vehicle was purchased more than 910 days prior to the date of filing, the debtor may seek to value the secured claim at the fair market value of the vehicle.  For example, a debtor who purchased a vehicle three years prior to filing, whose loan balance is $20,000.00 and whose value is $15,000.00, may only be required to pay $15,000.00 to pay off the loan; the remaining $5,000.00 would be treated as general unsecured debt and would be paid according to the debtor's disposable monthly income.

Chapter 13 bankruptcy also allows a debtor to strip junior voluntary liens (e.g., second mortgages), if the value of property is less than or equal to the aggregate of all senior liens and encumbrances.  More information on lien strips can be found here.

Although chapter 13 allows more flexibility in retaining secured debt assets and managing non-dischargeable debts, it does require the debtor to additionally pay all "disposable monthly income" to its general unsecured creditors.  Debtors are required to complete the Chapter 13 Monthly Disposable Income Test (Form 22C), which requires input of the debtor's gross monthly income, offset by reasonable expenses and payments on secured an priority unsecured debts.  If the balance is positive, the debtor must pay that additional amount in her chapter 13 plan to her unsecured creditors.  Thus, a chapter 13 debtor pays whatever portion of her unsecured debt she can reasonable afford, whether it is some, all or none.  Whatever cannot be paid is accordingly discharged.