When you file bankruptcy, each creditor (the person or company to which you owe money) has a claim against your bankruptcy estate, which consists of all your property. To get paid, each creditor must file a proof of claim form, indicating how much you owe and the type of debt.
Knowing the type of debt is important, because not all debts are treated alike in bankruptcy cases. Most bankruptcies don't produce enough cash to pay all the claims filed in the case. Therefore, the bankruptcy code prioritizes some claims over others to ensure that the neediest claimants have the best chance of sharing in the assets that the bankruptcy trustee is able to gather.
Although debts are defined in different ways for different purposes, a personal bankruptcy case will deal with three main categories of debt: priority unsecured debt, general unsecured debt, and secured debt. In this article, we'll consider each type of debt and how the claims are handled in a bankruptcy case.
For more information about payment of bankruptcy claims, see What Happens to Your Debt 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 well-being of the public depends upon these debts being paid. Priority unsecured debts in a personal bankruptcy case might include
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, which is 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 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.
General unsecured claims have no priority and are not backed by a security interest in property. General unsecured debts include
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 the bankruptcy is wiped out and no longer your responsibility. There are exceptions to this rule.
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.
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.
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 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.
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 value of the car. 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 Chapter 13 bankruptcy to save her car. Her Chapter 13 plan proposes to pay the full balance of the loan, 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.
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.
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