Bankruptcy offers people who are overwhelmed by debt an opportunity for a fresh start through either liquidation (Chapter 7) or reorganization (Chapter 13). In both cases, the bankruptcy court can discharge certain debts. Once a debt has been discharged, the creditor can no longer take action against the debtor, such as attempting to collect the debt or seize any collateral. Not all debts can be discharged, however, and some are very difficult to get discharged.
- If you file for Chapter 7 or Chapter 13 bankruptcy, the court may discharge some of your debts.
- Discharge means you are no longer responsible for repaying the debt, and the creditor can no longer attempt to collect from you.
- Certain debts, however, are not eligible for discharge, and some can be discharged only in rare cases.
Chapter 7 vs. Chapter 13
Chapter 7 and Chapter 13 are the two most common types of personal bankruptcy.
In a Chapter 7 bankruptcy, a trustee appointed by the bankruptcy court will liquidate (sell off) many of your assets and use the proceeds to pay your creditors some portion of what you owe them. Certain assets are exempt from liquidation. Those typically include part of the equity in your home and automobile, clothing, any tools you need for your work, pensions, and Social Security benefits.
Your nonexempt assets that can be sold off by the trustee include property (other than your primary home), a second car or truck, recreational vehicles, boats, collections or other valuable items, and bank and investment accounts.
In Chapter 7, your debts are typically discharged about four months after you file your bankruptcy petition, according to the Administrative Office of the U.S. Courts. (Bankruptcy is governed by federal law and overseen by federal bankruptcy courts, although some rules differ from state to state.)
In a Chapter 13 bankruptcy, by contrast, you commit to repaying an agreed-upon portion of your debts over a period of three to five years. As long as you meet the terms of the agreement, you are allowed to keep your otherwise nonexempt assets. At the end of the period, your remaining debts are discharged.
In general, people with fewer financial resources choose Chapter 7. In fact, to be eligible for Chapter 7, you must submit to a means test, proving that you would be unable to repay your debts. Otherwise, the court may determine that Chapter 13 is your only option.
Debts Never Discharged in Bankruptcy
While the goal of both Chapter 7 and Chapter 13 bankruptcy is to put your debts behind you so you can move on with your life, not all debts are eligible for discharge.
The U.S. Bankruptcy Code lists 19 different categories of debts that cannot be discharged in Chapter 7, Chapter 13, or Chapter 12 (a more specialized form of bankruptcy for family farms and fisheries). While the specifics vary somewhat among the different chapters, the most common examples of nondischargeable debts are:
- Alimony and child support.
- Certain unpaid taxes, such as tax liens. However, some federal, state, and local taxes may be eligible for discharge if they date back several years.
- Debts for willful and malicious injury to another person or property. "Willful and malicious" here means deliberate and without just cause. In Chapter 13 bankruptcy, this applies only to injury to persons; debts for property damage may be discharged.
- Debts for death or personal injury caused by the debtor's operation of a motor vehicle while intoxicated from alcohol or other substances.
- Debts you failed to list in your bankruptcy filing.
If you file for a Chapter 7 bankruptcy, you will also continue to owe any condominium or cooperative association fees, along with any other debts that were not discharged in a prior bankruptcy. You can usually keep your car by reaffirming your car loan and continuing to make payments. Similarly, you can usually keep your home if you declare bankruptcy, even if you owe money on it, as long as you continue making the payments and don’t have more equity than you are permitted under state and federal bankruptcy laws.
If you have income tax or student loan debt, you may be able to negotiate a workable repayment plan without filing for bankruptcy.
Debts Difficult to Discharge in Bankruptcy
Student loans are notoriously difficult to discharge through bankruptcy; it is only possible if you can demonstrate undue hardship to yourself or your dependents, such as being unable to maintain a minimal standard of living. In some cases, a court may discharge part, but not all, of your student loan debt. If student loan debt is a major reason for your considering bankruptcy, first contact your loan servicer and see if it's possible to negotiate a repayment plan that would work for you. In the case of federal student loans, for example, there are several repayment plans available.
You cannot have income tax debts discharged without a special exemption, which can only be obtained by petitioning the bankruptcy court and explaining why you deserve relief. So if you have income tax debts you cannot repay, you may be better off consulting with a tax attorney, before filing for bankruptcy, to discuss your options.
In the case of federal taxes, for example, the Internal Revenue Service can offer several alternatives to people who are unable to pay what they owe. One is an offer in compromise, in which the IRS agrees to accept a lesser amount. The IRS may also arrange for a payment plan, or an installment agreement, that will allow you to pay your taxes over an extended period of time.
It's worth noting that your creditors have some ability to stop certain debts from being discharged. They may also ask the court for relief from the automatic stay that prevents them from pursuing collection activity. So the discharge process doesn't always go as quickly or smoothly as debtors might hope.
Debt Relief Alternatives to Bankruptcy
Bankruptcy has serious consequences. A Chapter 7 bankruptcy will remain on your credit reports for 10 years, and a Chapter 13 will remain for seven years. That can make it more expensive or even impossible to borrow money in the future, such as for a mortgage or car loan, or to obtain a credit card. It can also affect your insurance rates.
So before filing for bankruptcy it's worth exploring other types of debt relief. Debt relief typically involves negotiating with your creditors to make your debts more manageable, such as reducing the interest rates, canceling some portion of the debt, or giving you longer to repay. Debt relief often works to the creditor's advantage, too, as they are likely to get more money out of the arrangement than if you were to declare bankruptcy.
You can negotiate on your own or hire a reputable debt relief company to help you. As with credit repair, there are scam artists who pose as debt relief experts, so be sure to check out any company you're considering. Investopedia publishes a regularly updated list of the best debt relief companies.