What Is Chapter 7 Bankruptcy: Understanding the Basics
While the idea of bankruptcy often carries a negative connotation, bankruptcy laws were designed to give people in dire financial situations a chance to start over.
Bankruptcy can help you resolve your debt and get back on stable financial ground, but because of the long-term negative impact on your creditworthiness, it’s important to understand the implications before you begin. This guide will explain what Chapter 7 bankruptcy entails, who is eligible to file and how bankruptcy will affect you now and in the future.
What is Chapter 7 bankruptcy?
Chapter 7 bankruptcy, named for Chapter 7 of the Bankruptcy Code, is sometimes called liquidation bankruptcy because debtors may have to sell some of their assets to repay their debts. When the process is complete, the vast majority of debts are discharged and the consumer’s slate is wiped clean. Some debts, like tax liens or child support, will not be forgiven.
In 2021, there were 399,269 non-business bankruptcies, according to the Administrative Office of the U.S. Courts. Of those, Chapter 7 is by far the most common, making up 70% of all non-business bankruptcy filings that year.
There are two types of Chapter 7 bankruptcies:
- Asset case: Where the debtor owns assets that can be sold and the proceeds distributed to creditors
- No-asset case: Where the debtor doesn’t own any nonexempt property, cash or valuables
Other forms of bankruptcy, such as Chapter 13, typically allow the debtor to keep their property and work out a plan to repay creditors.
Pros and cons of Chapter 7 bankruptcy
Filing for bankruptcy is serious business, so it’s important that you understand the benefits and risks before beginning the process.
Can offer a fresh financial start and your credit score may start to go up after your debt is discharged
You may be able to keep certain exempt assets
Collection efforts by your creditors must stop as soon as you file
May impact your ability to get credit, buy a home or car and rent an apartment for some time
Can remain on your credit report for up to 10 years
You may lose some of your assets, such as vehicles, jewelry and real estate
In order to file Chapter 7, you must be able to pass a means test, which is designed to determine whether you have the means to repay a portion of your debts. The process requires you to provide information about your income, expenses and debt, and if you don’t pass, your case may be converted to Chapter 13 or be dismissed altogether. Additional information on means testing is available through the U.S. Department of Justice.
But just because you’re eligible doesn’t mean filing for bankruptcy is the right choice for your financial situation. Chapter 7 bankruptcy may make sense for people who:
- Are overwhelmed by debt that they have no way to repay
- Already have a low credit score
- Don’t have many assets
- Earned less than the median income level in their state during the last six months
- Are current on their mortgage and don’t have a lot of equity
- Have little or no disposable income
- Have not successfully filed Chapter 7 during the previous eight years (or Chapter 13 during the previous six years)
- Have waited more than 181 days after unsuccessfully filing for Chapter 7 previously
Debts that can be forgiven in Chapter 7 bankruptcy
After Chapter 7 bankruptcy, many of your debts will be discharged, or wiped out, at the end of your case.
However, this isn’t true of all debts. Some debts cannot be discharged in bankruptcy, so you will still owe them even after your other debts have been discharged.
Debts that may be discharged
- Credit card debt
- Medical bills
- Unsecured personal loans
- Lawsuit judgments (unless they’re based on fraud)
- Most debts arising from car accidents (unless they involve intoxicated driving)
- Past due utility bills
- Obligations under leases and contracts
Debts that cannot be discharged
- Child support and alimony
- Secured debts
- Fines, penalties and restitution you owe for breaking the law
- Most tax debts
- Student loans (in most cases)
- Debts arising out of someone’s death or injury as a result of your intoxicated driving
Some debts can be discharged in a Chapter 7 bankruptcy unless a creditor objects and convinces the court that they should not be discharged. These can include any debts arising from fraud or misconduct.
James Shenwick, a bankruptcy attorney with Shenwick & Associates in New York, says that fewer than one in 10 debts are objected to by creditors in court, in his experience.
“It’s rare for the creditor or the trustee to object,” Shenwick says. “The presumption in bankruptcy is that the person is entitled to a discharge. The goal is a fresh start, so as many debts as can be wiped out should be discharged.”
Assets you can lose during bankruptcy
Chapter 7 bankruptcy requires the debtor to sell certain assets and use the proceeds to pay their debts. But some assets are exempt under federal and state bankruptcy laws, meaning the individual is allowed to keep the assets.
Federal bankruptcy law permits each state to adopt its own exemption laws in place of the federal exemption. In some states, the debtor may choose between the federal and state exemption lists.To understand which exemptions apply to you, be sure to look up the laws for your state.
Exemptions may enable you to keep your home, car, clothing, household items and even some proceeds from the sale of your property. Keep in mind that exemptions are not automatic. For an asset to qualify for an exemption, you must list the item on the exemption form and specify the amount of the exemption you’re claiming.
The amount of exemption you are entitled to claim for different assets may vary by state.
The following are examples of assets you could lose during bankruptcy and how exemption laws might impact them.
- Homes: Federal homestead exemption of $27,900
- Vehicles: Federal exemption of $4,450
- Tools of the trade: Federal exemption of $2,800
- Jewelry: Federal exemption of $1,875
- Individual household items: Federal exemption of $700
Let’s say you own a home and are current on your mortgage payments. The home is worth $250,000, and you still owe $225,000. This means that you have $25,000 in equity. Since your equity is less than the federal exemption, you would likely be allowed to keep your home, since selling it wouldn’t generate any money to repay other debts. (It’s worth noting that if you are facing foreclosure, filing for Chapter 7 bankruptcy likely won’t prevent that process.)
Because the process is so complex, it’s wise to consult an attorney to fully understand what you stand to lose.
How Chapter 7 bankruptcy can affect your credit
Bankruptcy will no doubt hurt your credit score, but the extent of its impact depends on your overall credit profile.
In reality, if your debts are so overwhelming that you need to file for bankruptcy, chances are your score is already pretty low to begin with. If that’s the case, your score may not see a huge drop at all. However, if you have good credit, you can definitely expect to see a significant dip.
A Chapter 7 bankruptcy can remain on your credit report for up to 10 years from the date filed. The negative impact of the bankruptcy on your credit score will lessen over time, meaning a bankruptcy that is only one year old will have a more significant impact than one that happened eight years ago.
Differences between Chapter 7 and Chapter 13 bankruptcy
There are several types of bankruptcy, and the one you choose will depend upon your financial needs and situation. The two most common types, Chapter 7 and Chapter 13, both offer debt relief; Chapter 7 liquidates certain assets to repay creditors, while Chapter 13 involves creating a repayment plan.
Chapter 7 Bankruptcy vs. Chapter 13 Bankruptcy
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How to prepare for Chapter 7 bankruptcy
If you think bankruptcy may be in your future, there are steps you can take to prepare for the endeavor.
Stop paying your creditors: While this may feel counterintuitive, you’ll want to stop paying your creditors — such as credit card companies and personal loan lenders — at the same time. This way, you can avoid being seen as giving certain creditors preferential treatment during your bankruptcy process.
Contact a bankruptcy attorney: Do your research and find a bankruptcy attorney who can guide you through the process. An initial meeting with an attorney can also help you learn how to prepare to file for bankruptcy.
Don’t accrue more debt: If, for instance, you apply for a new credit card and charge it right before filing for bankruptcy, that creditor could make the case that you never intended to repay that amount. This could be viewed as fraud and may not be discharged in bankruptcy.
Don’t try to hide assets: While some people may find it tempting to hide or move around assets so they can keep their belongings, this can get you into hot water. Concealing assets can lead to your bankruptcy filing being denied or even criminal charges being filed against you.
How to file for Chapter 7 bankruptcy
Filing for Chapter 7 bankruptcy can be a long and complex process. Here’s an overview of the steps involved in filing for Chapter 7 bankruptcy.
Find an attorney
Your best course of action is to speak to an experienced personal bankruptcy attorney who is familiar with the laws of your state.
Shenwick says that once a person realizes they have a problem that may lead to bankruptcy, they often speak to their accountant rather than an attorney.
“So many people say they wished they’d come to see me a year ago,” Shenwick says. “It’s the avoidance reaction — they put off what is unpleasant or uncomfortable.”
Despite those fears, Shenwick says delaying the inevitable is a mistake.
“Some people make their problems worse by attempting to transfer assets to friends and family — that’s a big no-no. Or they might pay the wrong creditors. If you sense you’re in trouble, speak to an attorney as soon as possible to prevent mistakes that can make matters worse.”
Shenwick recommends getting a referral from your accountant, family attorney or friend. If you can’t find someone through word of mouth, call your local bar association. They maintain a list of bankruptcy attorneys in your area.
Attend credit counseling
The federal Bankruptcy Code requires individuals filing for bankruptcy to get credit counseling within a 180-day period before filing a bankruptcy petition. If you are married, both spouses must attend credit counseling.
The credit counseling agency must be approved by the U.S. Trustee Program. You can find a list of approved agencies from the U.S. Department of Justice.
Petition and prepare paperwork
Next, you’ll file a petition with the bankruptcy court in your area. In addition to the petition, you will also have to submit:
- A schedule of assets and liabilities
- A schedule of current income and expenses
- A statement of financial affairs
- A schedule of contracts and unexpired leases
- Certificate of credit counseling
- A copy of any debt repayment plan developed through credit counseling
- Pay stubs (if any) for the last two months
The court is required to charge a $338 case filing fee, a $78 miscellaneous administrative fee and a $15 trustee surcharge. In most cases, you have to pay these fees before filing, but in some cases, the court will permit you to pay in installments over the course of 120 days.
A trustee is appointed to your case
After your petition is filed, an impartial trustee is assigned to your case. It’s the trustee’s job to administer your case and liquidate any nonexempt assets.
The trustee is also required to ensure that you understand the potential consequences of bankruptcy, including its effect on your credit rating, your ability to file for bankruptcy in the future and the financial impact of receiving a discharge of your debts.
It’s crucial to cooperate with the trustee and promptly deliver any financial records or documents the trustee requests.
Meet with your creditors
Between 21 and 40 days after your petition is filed, the trustee will hold a meeting of creditors. During this meeting, you will be placed under oath and must answer questions posed by the trustee and your creditors. You are required to attend the meeting and answer questions about your finances and assets.
Your lawyer will prepare you for the meeting of the creditors and attend the meeting with you. In most cases, the questions will be very similar to the ones already asked by your attorney. The purpose of this meeting is simply to get you to confirm, under oath, that the written disclosures you provided in your paperwork are true and complete.
Complete debtor education course
After the creditor meeting, you’ll have 60 days to complete a second counseling session on handling debt to help you avoid bankruptcy in the future. You’ll likely need to submit a certificate of completion to the court.
Confirm your eligibility
At this point, your trustee has gathered enough information for the court to make a decision on whether or not you are eligible for Chapter 7 protection. If you are eligible according to the means test, your case will proceed. If you’re not eligible, you have the option to file for Chapter 13 bankruptcy instead.
Nonexempt property is liquidated
If you have nonexempt assets, the trustee will determine whether they are worth seizing and selling. In some cases, you may be able to keep certain nonexempt assets if the trustee determines that selling them is not worth the effort. For instance, if you own a boat worth $3,000, but owe $2,800 on the loan you used to purchase the boat and the cost to transport and sell the boat would be $200, the trustee may determine it’s not in your creditor’s best interest to sell the boat.
The trustee also has the power to recover money or property under their “avoiding powers.” This includes the ability to reverse certain transfers made to creditors within 90 days of your petition for bankruptcy and undo certain transfers of property.
Once the trustee has sold nonexempt assets and paid out creditor claims, remaining eligible debts are discharged and the creditors are no longer allowed to take any collection actions. In most cases, the Court issues the discharge order within 60 to 75 days of the meeting of the creditors.
Alternatives to Chapter 7 bankruptcy
Bankruptcy can give people in dire circumstances a fresh start, but it’s not a decision to be taken lightly. Before you file, consider some alternatives.
With debt consolidation, you can roll all unsecured debts — such as credit cards, personal loans and medical bills — into one new loan with one monthly payment. In some cases, you can negotiate lower interest rates or a reduced balance with your creditors so your payments are manageable.
Debt consolidation can still have a negative effect on your credit score because you aren’t paying your debts as agreed, but its impact is typically not as severe as declaring bankruptcy.
Debt settlement involves negotiating with creditors to settle your debt for less than is owed. This is most often used when you have one large debt with a single creditor, but it can sometimes be used to deal with multiple creditors.
Debt settlement still has a negative impact on your credit score because you aren’t paying the full amount owed. It can stay on your credit profile for up to seven years.
Keep in mind that any forgiven debt will be reported to the IRS and may increase your taxable income.
Liquidate your assets
If you have cash in the bank or own other assets that can be sold to pay off your debt, this may be a viable alternative to declaring bankruptcy. Take into account any potential consequences. If you tap your retirement account to pay down debt, for example, you may owe a 10% income tax for early withdrawals. You could pay off one debt, only to find yourself owing additional money to the IRS.
Life after bankruptcy
After filing a Chapter 7 bankruptcy, your credit score will be lowered, possibly by hundreds of points, and the bankruptcy will remain on your credit report for the next 10 years.
But this doesn’t mean you won’t be able to access credit for the next decade. Within the first couple of years after you’ve filed for bankruptcy, you may even start to receive personal loan and credit card offers from lenders.
It will take time to rebuild your credit score, and there’s no legal way to remove the bankruptcy from your credit report before the 10-year time frame has elapsed. But bankruptcy does give you a second chance, so don’t waste it. If you take this opportunity to learn a lesson about handling debt responsibly, over time, your credit score will begin to reflect that.
Chapter 7 bankruptcy: FAQ
How long does it take to file for Chapter 7 bankruptcy?
The process of filing for Chapter 7 bankruptcy can take several months from start to finish. Typically, from the time you file until your debt is discharged, it can take anywhere from four to six months.
When should you file for Chapter 7 bankruptcy?
Bankruptcy is a last resort for those who are struggling financially and can’t afford to repay their debts. Bankruptcy may be a good option for you if:
- Your debt-to-income (DTI) ratio is 50% or higher
- You’re struggling to pay your bills
- You’re dipping into accounts like your 401(k) in order to keep up with your bills
What is a Chapter 7 bankruptcy discharge?
A Chapter 7 bankruptcy discharge absolves you from the legal obligation to repay most unsecured debts such as credit cards and personal loans. Discharge also prevents creditors from trying to collect those debts from the borrower.
Is it better to file a Chapter 7 or 13?
Whether you should file a Chapter 7 or Chapter 13 depends on your individual financial situation. If you’re unable to pass the means test and your income is too high to qualify for Chapter 7, you may be eligible for Chapter 13 bankruptcy instead. With Chapter 7, your eligible debts will be discharged once you’ve finished filing; however, you may lose some of your assets in the process. With a Chapter 13 filing, you’ll have to follow a three- to five-year payment plan before your debts are discharged, but it may be a way for you to avoid losing assets.