As the credit card bills pile up near the holidays, I often hear questions about personal bankruptcy as a way out. In a recent question posted on Investopedia, someone asked what will happen if you have secured debt in bankruptcy.
What happens to secured debt in bankruptcy depends in large part on your income and asset situation before the bankruptcy and which type of bankruptcy you file.
Here’s the question: Lets say Alex owes Bob $250,000 on a mortgage on Alex’s residence. Alex also has $100,000 in stocks and securities. Alex has no other debt. Alex’s house has gone down in value to $200,000. Alex has credit card debt of $3,000,000 and has no other assets or debts. Alex declares bankruptcy. How much will Bob be able to collect? How much will the credit card companies be able to collect?
Individuals have two options when it comes to bankruptcy: Chapter 7 and Chapter 13. In a Chapter 7 bankruptcy filing, you can have all or part of your debts erased assuming you meet certain income level tests. You’ll need to prove that your income is less than the median for families of your size in your state. You’ll also need to complete court-approved credit counseling. (You can find resources here at the US Trustee’s Program website).
In a Chapter 13 filing, you’ll be petitioning the court to approve a three- to 5-year repayment plan. If your plan is approved, you’ll be making payments to the court which will manage repayments to your creditors. If you have any remaining debt after you’ve completed your repayment plan, the remainder will be discharged.
The situation described here may be more suited for a ‘strategic default‘ where a borrower decides that because the value of the property that secures the mortgage is below the loan amount you want to ‘walk away’ from the loan even though the borrower has the income and means to pay. This happened frequently during the height of the Great Recession.
You can just as strategically default on your mortgage with Bob and not file bankruptcy. In this case, Bob will foreclose, regain title to the property and possibly sell it. If he sells the property for $200,000, he could file a claim with the mortgage insurance company (if you had been required to get such insurance because you were borrowing more than 80% of the purchase price). The mortgage insurer will make the lender (Bob) whole and there would be no further impact on you to consider.
It’s more likely that you don’t have mortgage insurance. In this case, Bob may end up short by $50,000 which would trigger him sending you a Form 1099-C for cancelled debt. This cancelled debt could be ‘phantom income’ that you’ll need to include when you file your tax return. In some cases, this amount may not be income. If you can prove you were insolvent at the time of the debt cancellation, you’ll file a form with your tax return and avoid income tax on this debt forgiveness.
While your credit would be hurt by a foreclosure, it would potentially have less of an effect on your credit and job prospects than a bankruptcy. And you’d still have your $100,000 in stocks and securities.
Given the outline of assets versus liabilities noted in this question, you may be better off filing for bankruptcy. State law will detail what assets are exempt from repaying your creditors. But if you have no exempt assets, then you’ll likely see most if not all of the $100,000 in stocks and securities used to repay your creditors. The court will determine how much would go to each but there is preference for secured creditors over unsecured credit card debt.
For the finer details of which option is best for you, I recommend you contact a qualified bankruptcy attorney.
Whether you choose Chapter 7 or Chapter 13, you’ll have to consider the tax consequences of your bankruptcy filing. In my tax planning and preparation practice, I’ve come across situations like the one described here. This is why it’s best to consult a team that includes a bankruptcy attorney, tax planner and financial planner so that you’ll be in a position to better understand your options and the impact long-term.
Read more: What will happen to secured debt in the case of bankruptcy? | Investopedia http://www.investopedia.com/advisor-network/questions/what-will-happen-secured-debt-case-bankruptcy/#ixzz4TIcgbHgB