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The Divorce Encyclopedia

Term Definition Bankruptcy - a legal proceeding in which a person who is financially insolvent requests the federal bankruptcy court to determine his or her debts and use his or her assets to pay those debts.
Application in Divorce The premise of bankruptcy is the very American idea of a fresh start in a new place -- a line in the sand, so the speak, beyond which creditors and lenders may not hound the debtor who is now free to "enjoy a new opportunity in life with a clear field for future effort..." Such is the theory. In practice, that fresh start is the beginning of a difficult march across rough terrain that lasts for years until the bankrupt reestablishes himself or herself as creditworthy.

For some divorcing couples, the so-called housing crisis increases the woes and worries associated with the collapse of a marriage. "The traditional reasons for bankruptcy -- illness, divorce and job loss -- have not gone away," said one expert and personal finance. "With houses no longer A.T.M. [automated teller machine] for paying bills, that escape route is gone."

Grim as it may be to contemplate, many couples will face not only marital collapse but also financial ruination at a time when the housing bubble of first decade of the new century continues to deflate and leaves in its wake declining housing prices that press overextended owners in the vise of negative equity. Moreover, when a couple put the marital home on the overstocked market, it may be some time before a buyer comes along -- and one in a position to buy at a much lower price than they imagined.

That said, bankruptcy is fact of modern life, and many people find relief from bad decisions and just plain bad luck in a bankruptcy court.

Depending on the type of filing, in bankruptcy debts are completely removed through liquidation, as in the case of Chapter 7, or partially and/or temporarily though rehabilitation and reorganization, as in the case of Chapters 11 and 13. Chapter 7 is the so-called "fresh start," by which debtors free themselves of many unsecured liabilities like credit card debt and medical bills. Chapter 13 can be used to save house and automobiles from creditors, but it is more expensive to file and takes longer to work out.

As a result of legislation pushed by the finance industry in 2005, more and more people now file Chapter 13 because they are ineligible to file under Chapter 7. People who make more than their state’s median income must pass a means test to file Chapter 7, although it is rare that people with less than $100,000 to not pass the means test. For those who do not pass the means test, Chapter 13 may be the only remedy, particularly for wealthy bankrupts who own houses worth less than they owe or who have unmanageable unsecured debts.

The legal fees of a Chapter 7 bankruptcy must be paid upfront in cash. "You can be too poor to go bankrupt," said one bankruptcy lawyer.

And some debtors who seek reorganization under Chapter 13, which has debt limits, may not be able to get one. "Some considering bankruptcy will be shocked to find they may not be able to get a clean slate under the new law [of 2005]," said one San Francisco real estate lawyer.

For those who cannot use Chapter 7 or Chapter 13, Chapter 11 is the only recourse, but it is intended for business and more expensive than chapters 7 or 13.

Property in bankruptcy is administered for the benefit of the bankrupt person’s creditors. Some forms of bankruptcy seek to discharge all debt if there are no assets to distribute to the creditors.

Most individuals and couples forced into bankruptcy go through Chapter 7 or 13. Chapter 7 is a "straight" liquidation in which the debtor turns over all his or her assets to an appointed trustee, who analyzes them for recoverable equity through sale. If value exists, it is recovered and the proceeds are distributed to the creditors in a certain statutorily decreed pecking order. The bankrupt is permitted what are called "debtor’s exceptions," which vary by state. After all this is done, which normally takes less than six months from filing to completion, the debts are said to be discharged.

In Chapter 13, individuals or couples reorganize and repay in a routine known as an "adjustment of debts of individual with regular income" over a three-to-five-year period. Secured creditors are paid first, unsecured creditors last.

In both cases, however, once the bankruptcy petition is filed, the court has jurisdiction all the debtor’s debts, including collections suits, divorce actions and postjudgment motions to collect under the terms and conditions of a divorce decree. Alimony, child support, student loans and attorney fees cannot be discharged by bankruptcy.

As long as the marital property has not been divided, "[t]he entire community comes into the bankruptcy estate even if one spouse files after the martial statis has been severed..."

Some special considerations must be held in mind. Generally pensions, including plans subject to ERISA, Keogh plans, Spendthift trusts, IRAs, 403(b) Retirement Plans are not subject to bankruptcy proceedings.

In divorce actions, spouses must contemplate the impact of a possible bankruptcy on the settlement because a bankruptcy after a divorce can derange the terms of the agreement. Herein is a danger to the financially dependent spouse who waives support in exchange for his or her partner’s agreement to pay outstanding debts, such as mortgages or credit cards. Suppose, for example, Rufus and Rhonda agree that he will annually pay a sum plus interest as part of her share of their jointly owned marital property, which is a business. This arrangement makes that payment a debt; he is a debtor and she is his creditor. And assuming that Rufus can file a valid and nonfradulent bankruptcy petition, he can discharge that debt through bankruptcy. Furthermore, an automatic stay prohibiting any actions against the debtor takes effect immediately upon the filing. Once again, alimony and child support are exempt from the stay. This means that when Rufus throws in the sponge (either in good faith or otherwise) Rhonda has no immediate recourse and must wait the working of the bankruptcy action.

Before 1994, only spousal and child support payments were not dischargeable through bankruptcy. Since then, a debt incurred in divorce or separation is not dischargeable "unless the debtor does not have the ability to pay the debt from income or property or discharging the debt would result in a benefit to the debtor that outweighs the detrimental consequences to the spouse."

In dealing with the discharge of property settlement claims through bankruptcy, the courts use a two-prong test: 1) the so called "disposal income tax" (Does the debtor have the income to pay?) and 2) the "balancing test" (Does the benefit to the debtor outweigh the consequences to the former spouse?) But even if Rufus’s bankruptcy is valid and legitimate (as opposed to an attempt to defraud Rhonda), she could be a very hard place. In this situation, Rhonda would be wise to negotiate language in the separation agreement stipulating that bankruptcy is a change in circumstance that gives her a legal basis to ask for alimony.

Sometimes, bankruptcy courts have imposed equitable liens when it is clear that a former spouse, acting in bad faith, seeks to avoid compliance with a property division by bankruptcy.

Bankruptcy is a course of last resort because it can take years for a bankrupt to restore his or her credit rating.

Resources: Consumer Credit Counseling is available all over the United States. Check the yellow pages.

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