Chapter 13 of the United States Bankruptcy Code is entitled “Adjustment of Debts of an Individual with Regular Income.” More common names for Chapter 13 bankruptcy are Wage Earner Reorganization or Consumer Reorganization. As the names implies, Chapter 13 restructures the debts of persons with a regular income and allows them to make payments over time. Why would a person choose to pay back debt when he could simply walk away from debt in a Chapter 7? There are several reasons:
1. MORTGAGE ARREARS
The primary reason Chapter 13 cases are filed is to cure mortgage arrears. This is particularly true for home mortgage arrears. In a Chapter 13 case, a debtor can provide to cure the amounts which are past due on their home mortgages and repay these past due amounts over the term of the plan, which is 3 to 5 years. This will not only stop a foreclosure, but will also provide a mechanism for the debtor to ultimately become current, all without the necessity of obtaining the mortgage company’s consent.
2. TOO MUCH INCOME
In some cases, debtors will make too much income to qualify for a Chapter 7. To determine whether a debtor makes too much income to qualify for Chapter 7, an attorney will have to use a formula called a “means test,” which takes into account average income for six months as well as certain deductions for debt payments and living expenses.
The protection of equity in non-exempt assets in another reason why Chapter 13 may be more appropriate than a Chapter 7 case. For example, a person may own a non-exempt car which has no lien and worth $4,000.00. In a Chapter 7 case, the trustee may administer this asset through a sale of the vehicle, with the net proceeds being distributed to unsecured creditors.
In a Chapter 13 case, the debtor could pay the equity value ($4,000.00) of the vehicle to a Chapter 13 trustee over a period of 3 to 5 years and keep the car. The Chapter 13 trustee would then disburse the net proceeds over time to the unsecured creditors. The same scenario is true for any asset with equity value that is not exempt.
4. CRAM DOWN
One of the most powerful tools in a Chapter 13 is the ability of the Debtor to modify the rights of secured creditors. In other words, a Debtor has the ability to change the amount to be repaid and the terms of repayment on secured debt. For example, if a debtor has a car worth $5,000.00 encumbered by a lien of $9,000.00 payable over the next 16 months, the debtor can modify the loan to provide for the repayment of the value of $5,000.00 over a period of 36 to 60 months. In other words, the secured creditor is only entitled to receive the lesser of the value of the collateral or the amount due. Note that in order to cram down of a vehicle in Chapter 13, it had to be purchased over 910 days before the case was filed.
Creditors who hold collateral consisting solely of real property which forms the debtor’s principal residence may not be crammed down. Secured creditors who hold a valid mortgage only on a debtor’s home which is real property cannot be modified. Of course, an exception to the exception exists. When the final payment on the original repayment schedule of a mortgage secured solely by real property consisting of the debtor’s home comes due during the term of the plan (ie: 36-60 months), the mortgage may be crammed down.
Also, a second mortgage on the debtor’s residence may be stripped off or avoided if no equity attaches to the second mortgage. For example, if a debtor has a home worth $75,000.00 with a first mortgage payoff of $80,000.00 and a second mortgage payoff of $18,000.00, the debtor can avoid the second mortgage. However, if even one penny of equity attaches to the second mortgage, the second mortgage cannot be modified or avoided.
5. TAX DEBT
Another popular reason for the filing of a Chapter 13 case over a Chapter 7 case is when non-dischargeable tax debt is owed. By filing a Chapter 13 case to pay tax debt, a debtor can repay his taxes over three to five years without the accrual of additional interest, late fees or other penalties, as long as the plan is successfully completed and a Chapter 13 discharge issued. Compare this to a Chapter 7 case where the tax debt will only be paid off if enough of the debtor’s assets are liquidated to pay the tax debt in full. Additionally, in a Chapter 7 case, if the tax debt is not paid out in full, once the Chapter 7 case is closed, the Internal Revenue Service can recapture the accrued interest, late fees and other penalties that were prevented from accruing during the pendency of the Chapter 7 case, all in addition to placement of tax liens and other collection efforts.
6. NONDISCHARGEABLE CHAPTER 7 DEBT
Certain debt that may be nondischargeable in a Chapter 7 case may be discharged in a Chapter 13 case. A Chapter 13 case provides a “super discharge.” A Chapter 13 discharge is a “super discharge” because it encompasses a broader range of debt than does a Chapter 7 discharge.