Understanding Secured, Unsecured & Priority Claims in Bankruptcy

When you file bankruptcy, each "creditor"—a person or company you owe money to—wants to be paid out of the bankruptcy proceeds. But most people file for bankruptcy because there isn't enough money to pay everyone, a fact that usually doesn't change after the filing. To deal with this problem, bankruptcy laws contain a payment priority system to ensure the most important or neediest creditors are paid before less important creditors.

This article explains when the trustee will pay three debt categories—priority unsecured debt, general unsecured debt, and secured debt—and how creditor claims are handled in a bankruptcy case. Learning about these categories will help you understand which creditors will get paid in your case and what happens to your debt in bankruptcy.

Once you've learned about secured, priority unsecured, and general unsecured creditor claims, check out the resources provided at the end of the article. You'll find links to applicable bankruptcy forms and additional articles we think you'll enjoy.

What are Priority Unsecured Debts in Bankruptcy?

Unsecured debts are not secured by collateral. You, the borrower, have not agreed to put up any property as security for payment, and in general, the creditor doesn't have the right to take any of your property to pay the debt.

But some unsecured claims in a bankruptcy case are treated differently because the law considers them to have a higher priority over other debts. These debts have priority typically for public policy reasons—that is, the public's well-being depends upon these debts being paid. Priority unsecured debts in a personal bankruptcy case might include

• child support
• spousal support
• other domestic support obligations
• recent income taxes
• wages that you owe your employees, and
• amounts for death or serious injury that you caused while driving intoxicated.

Priority unsecured claims have priority over almost all the other debts in a bankruptcy case. They are first in line to be paid out of the bankruptcy estate in a Chapter 7 case or through your repayment plan in a Chapter 13 case. Any amounts not paid in a Chapter 7 case will remain nondischargeable, which means that any amounts you owe will not be eliminated in the bankruptcy. In a Chapter 13 case, all priority unsecured claims will be paid in full over three to five years as part of your Chapter 13 repayment plan.

Example. Kyle was sued by the family of a man he killed in a drunk driving accident. The court awarded the family $500,000 in wrongful death damages, a priority unsecured debt. Kyle is responsible for the full amount. He also owes $25,000 in credit card debt. Kyle is unemployed, so he files for Chapter 7 bankruptcy. His estate has no assets, so none of Kyle's creditors will receive payment. The credit card debt will be discharged. However, Kyle will still be responsible for the $500,000 wrongful death judgment.

What are General Unsecured Claims in Bankruptcy?

General unsecured claims have no priority and are not backed by a security interest in property. General unsecured debts include

• credit card debts
• student loans
• personal loans
• some utilities, and
• medical bills

General unsecured claims have the lowest priority of all claims. After the bankruptcy estate pays administrative expenses, priority unsecured claims, and secured claims, general unsecured creditors will receive a pro rata (equal percentage) distribution of the remaining funds.

Most general unsecured debts are dischargeable, which means any amount that is not paid through bankruptcy is wiped out and no longer your responsibility. There are exceptions to this rule.

• Student loan debt is dischargeable only if you can demonstrate extreme hardship.
• If you obtained a good or service through fraud, the court can declare the debt you incurred to be nondischargeable.
• Debts you incur for luxury goods or services within 90 days before filing bankruptcy are presumed to be nondischargeable.
• Cash advances taken within 70 days before filing bankruptcy are presumed to be nondischargeable.

For more information about nondischargeable debts, see Bankruptcy Discharge: Which Debts Are Wiped Out?

Often, if the bankruptcy estate has any money to pay general unsecured debts, it won't be enough to cover all of them 100%. The bankruptcy trustee will pay some claims a percentage (pro rata). Here are some examples to illustrate what happens when all the claims won't be paid in full.

Example. Anne files Chapter 13 bankruptcy. She owes the IRS $10,000, which is a priority unsecured claim. She also owes $100,000 in general unsecured claims. Over the course of Anne's Chapter 13, she will make $55,000 in Chapter 13 plan payments. Of those payments, $8,000 will go toward administrative expenses, such as trustee fees and attorney fees. The IRS will receive $15,000 for the tax debt plus interest. The remaining $32,000 will be distributed pro rata to the general unsecured creditors. $32,000 is 32% of the total $100,000 debt, so each general unsecured creditor will receive 32% of the amount owed, and the rest will be discharged.

Example. Ben files Chapter 7 bankruptcy. He owes back child support of $12,000, which is a priority unsecured claim. He also owes $25,000 in credit card debt. He owns an RV that he cannot exempt, so the trustee sells the RV for $10,000. The trustee's expenses, including fees, for the sale of the RV total $1,500. The remaining $8,500 of the proceeds will be paid to the state for the child support arrears. The credit card companies will receive nothing, and the credit card debt will be discharged. Ben will still be responsible for the remaining $3,500 in back child support.

How are Secured Claims Treated in Bankruptcy?

Secured claims are backed up by an interest in property. A secured creditor has a lien on your property, which gives the creditor the right to take that property (the collateral) if you default on the debt. The most common secured loans are car loans and mortgage loans, but you can also have secured loans for furniture, jewelry, watercraft, and other types of property.

Converting a Secured Debt to General Unsecured in Chapter 7

In a bankruptcy case, your liability for the debt can be discharged, but your obligations that arise from the lien or security agreement are not discharged. You can choose to surrender the property to the creditor or keep the property and pay for it.

If you choose to keep the property, you'll pay back all or a portion of the claim by reaffirming the debt, redeeming the collateral, or through a Chapter 13 repayment plan.

If you surrender the property, the creditor will sell it, apply the proceeds to your loan, and any remainder will be treated as a general unsecured debt and discharged in the bankruptcy.

Example. Dave owes $10,000 on his car; the car is worth $8,000. Dave files Chapter 7 bankruptcy; his estate has no assets. He cannot afford the car, so he chooses to surrender it. The dealership repossesses the vehicle and sells it for $4,000. The remaining $6,000 of the loan is a general unsecured claim and will be discharged in Dave's bankruptcy.

Example. Joanne is underwater on her house; she owes $150,000 to the mortgage company, but her latest tax appraisal gives a value of $100,000. She has fallen behind on her mortgage payments. She files Chapter 7 bankruptcy and decides to surrender the house. She does have an investment account that she cannot fully exempt, and the trustee seizes $8,000 from the account. The mortgage company forecloses and sells the home for $60,000, leaving a deficiency of $90,000. This deficiency becomes a general unsecured claim in her Chapter 7 bankruptcy. The mortgage was Joanne's only debt. The trustee's fees for the seizure of the investment account total $1,500, leaving $6,500 for creditors. The mortgage company receives the $6,500 and the remaining $83,500 deficiency balance is discharged.

Learn more about secured debt and collateral in Chapter 7 bankruptcy.

Converting a Secured Debt to General Unsecured in Chapter 13

In a Chapter 13 case, you also have to decide whether you'll keep and pay for the collateral or surrender it. If you keep and pay for it through your Chapter 13 plan, you might have some opportunities to reduce the interest rate or reconsider the car's value. Read more about Debts That Must Be Paid in Chapter 13 Bankruptcy.

Some bankruptcy courts limit a Chapter 13 debtor's ability to surrender collateral after the court confirms (approves) the repayment plan. However, most courts allow a debtor to surrender collateral well into the case and to reclassify the secured debt to a general unsecured claim. Here's an example.

Example. Sue files for Chapter 13 bankruptcy to save her car. Her Chapter 13 plan proposes to pay the full loan balance, which is $8,000, plus interest. Two years into her Chapter 13 case, Sue suffers a pay cut at work and can no longer afford the car. She modifies her Chapter 13 plan to surrender the car. The current balance due is $5,000. The creditor repossesses the car and sells it for $2,000. The creditor must then amend its proof of claim with the bankruptcy court to reflect a general unsecured claim in the amount of $3,000, which will be paid pro rata along with all other general unsecured creditors.

What Is a Proof of Claim?

Sometimes money is available to pay creditors in Chapter 7, but not always. It happens only when the Chapter 7 bankruptcy trustee sells the debtor's property. By contrast, Chapter 13 creditors receive monthly payments through a Chapter 13 repayment plan.

Before a trustee will pay a creditor in bankruptcy, the creditor must file a form with the court called a proof of claim. The proof of claim provides information to the court regarding the debt and must include documentation to support the creditor's claim.

In most cases, creditors will file a proof of claim. But if one of your creditors fails to file a proof of claim, you can file one on its behalf if you want that creditor to get paid in your bankruptcy.

Why Would a Creditor Not File a Proof of Claim?

Creditors file proofs of claim in bankruptcy because they want to receive a portion of any potential distributions the bankruptcy trustee might make in your case. If a creditor doesn't file a proof of claim with the court, it will not get paid even if it otherwise has a valid claim. But, it is common for creditors to not file proofs of claim in bankruptcy.

A creditor might not file a proof of claim in your bankruptcy if:

• you have a no-asset Chapter 7 bankruptcy (meaning you don't have any property the bankruptcy trustee can distribute to your creditors, so they won't get paid)
• you owe the creditor a very small sum, or
• the creditor fails to follow the court's instructions or otherwise makes a mistake.

Reasons You Might File a Proof of Claim for a Creditor

While it may sound strange to file claims on behalf of creditors in your own bankruptcy case, sometimes it can be in your best interest to do so. Below we discuss when it might make sense to file a proof of claim for a creditor.

You Want to Pay Off Your Nondischargeable Debts

Certain debts don't go away simply because you receive a bankruptcy discharge. These are called nondischargeable debts and include obligations such as alimony, child support, certain taxes, and student loans. Because you remain on the hook for paying back your nondischargeable debts after your case is closed, you want these creditors to get paid before your other general unsecured creditors (such as credit card companies) in your bankruptcy.

This means that whether you have nonexempt assets that will be distributed to creditors in Chapter 7 bankruptcy or you are paying off a portion of your debts in Chapter 13 bankruptcy, you want to make sure that any creditors who have nondischargeable debts file their proofs of claim with the court. If they fail to do so, it will be in your best interest to file a claim on their behalf so that they can receive a portion of the proceeds in your case.

To learn more about which debts can't be discharged in bankruptcy, see Debts That Survive Chapter 7 Bankruptcy and Debts You Must Pay in Chapter 13 Bankruptcy.

You Want to Catch Up on Missed Secured Debt Payments

If you are behind on your mortgage, car loan, or other secured debts, you can file for Chapter 13 bankruptcy to catch up on your arrears and save your property. If the purpose of your bankruptcy is to pay off your missed loan payments, you must make sure that the creditors you want to pay (such as your mortgage or car lender) file their proofs of claim with the court.

If they don't file their proofs of claim, the trustee may request court permission to pay off your unsecured creditors instead. This means that if a secured creditor you intend to pay doesn't file its claim, you may need to file it on its behalf.

For more information on how Chapter 13 bankruptcy can help you save your home or car, see our topic area on The Chapter 13 Repayment Plan.

When Can You File Proofs of Claim for Your Creditors?

Most creditors must file their proofs of claim with the court within 90 days of your meeting of creditors (government entities have 180 days from when you filed your case). Before filing a claim on behalf of a creditor, you must wait until the deadline expires for the creditor to file its own claim. After the deadline passes, you have 30 days to file the claim on behalf of the creditor.

Navigating Your Bankruptcy Case

Bankruptcy is essentially a qualification process. The laws provide instructions for completing a 50- to 60-page bankruptcy petition, and because the rules apply to every case, you can't skip a step. We want to help.

Below is the bankruptcy form for this topic and other resources we think you'll enjoy. For more easy-to-understand articles, go to TheBankruptcySite.

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.