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What Is Bankruptcy and How Does It Work?

Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. The debtor usually files a bankruptcy petition. The debtor's assets are then valued, and those assets may be used to pay off some or all of their outstanding debt and liabilities.

In bankruptcy, debts that an individual or business cannot repay are forgiven. Creditors may seek repayment using a sale of the debtor's assets. Bankruptcy relieves debtors from previous obligations.

The bankruptcy proceedings are handled by a federal court in the United States. The district and federal courts decide whether a debtor can file for bankruptcy and whether their debts should be discharged. In bankruptcy cases, the United States Trustee Program of the Department of Justice is often appointed to represent the debtor's estate. As a result, the bankruptcy judge and debtors often don't deal with each other directly until the creditor raises some objections.

Types of Bankruptcy Filings

The three most common types of bankruptcy filings are Chapter 7, 11, and 13. Chapter 7 and 13 bankruptcies are the most common bankruptcy types for individuals, while Chapter 11 is mainly filed for corporate bankruptcy. With Chapter 7 bankruptcy, a liquidation, or Chapter 13 bankruptcy, a structured repayment plan, debtors and creditors can reach arrangements to pay off balances and discharge debt.

Chapter 7 Bankruptcy: Chapter 7 is the most common type of bankruptcy for individuals. Chapter 7 involves liquidating assets under the United States bankruptcy code. Individuals or businesses can receive bankruptcy relief in liquidation by surrendering non-exempt property and walking away from most of their debts and liabilities. Means testing is required - that is, debtors must earn less than their state's median income to qualify. Chapter 7 is the most common type of bankruptcy for individuals. A Chapter 7 discharge can only be obtained every eight years. Usually, only student loans and child support survive a Chapter 7 bankruptcy. A bankruptcy judge will also evaluate a debtor's disposable income to determine if the debtor should be placed in Chapter 7 or 13 bankruptcy.

Chapter 11 Bankruptcy: Chapter 11 is a form of bankruptcy that involves the process of reorganization for businesses. Also known as business bankruptcy, in Chapter 11, shareholders' assets are not at risk as the company is treated as a separate legal entity. The owner and debtor in a sole proprietorship business, on the other hand, are the same person, so both personal and business assets are considered in the Chapter 11 bankruptcy filing. A small business owner can benefit from Chapter 11 filing by minimizing their personal liability following the closure of their company or by restoring profitability to their business.

Chapter 13 Bankruptcy: Bankruptcy under Chapter 13 reorganizes or restructures a person's debt so debt collectors can receive full repayment with interest, and other creditors will receive a percentage of the debt. Most repayment plan periods are between three and five years. A debtor must have a regular income, and certain debt thresholds apply. Under this filing, the unsecured debt must not exceed $394,725, and the secured debt must not exceed $1,184,200. Chapter 13 also offers bankruptcy protection from the threat of foreclosure of the debtor's home during these proceedings. 

Who Declares Bankruptcy

People and businesses often declare bankruptcy when they are over-leveraged. Many debtors' assets are usually held in real estate. The value of real estate is always subjective. Property valuations fluctuate on different factors such as supply and demand, market conditions, interest rates, and location.

When you can repay your debts but need to restructure the terms, Chapter 13 bankruptcy can serve as a financial planning tool. For example, a structured repayment plan is frequently used when someone owes back taxes or mortgage payments. Bankruptcy can give a borrower the opportunity for a fresh start, but it hurts your credit score. A bankruptcy can remain on your credit report for seven years. The bankruptcy process can prevent or delay foreclosure on a home, car repossession and wage garnishment, and other legal action creditors may take, which is why individuals make up the majority of bankruptcy filings in the United States.

Typically, people wait 22 months after their first 90-day past-due notice before filing for bankruptcy.

Why Declare Bankruptcy?

People declare bankruptcy for a myriad of reasons. Usually, people declare bankruptcy seeking relief from overwhelming debt. Others file for bankruptcy to avoid foreclosure and discharge student loans, medical bills, tax liabilities, and credit card debt.

In 2021, most people owed an average of $240,000 by filing for bankruptcy. The purpose of bankruptcy is to give people a chance to get back on their feet financially. The safest, simplest, and most legal way to discharge your debts is through bankruptcy if you cannot pay them on your income.

How to File for Bankruptcy

Bankruptcy is a legal process that reduces, restructures, or eliminates debt. Whether you get that opportunity depends on the bankruptcy court. There are two ways to file for bankruptcy: either independently or with a bankruptcy lawyer, which most experts recommend.

You will have to pay legal fees and filing fees when filing for bankruptcy. You will still be responsible for filing fees if you file independently. You may be able to get free legal services if you cannot afford to hire an attorney. If you need assistance finding a bankruptcy lawyer or free legal services, the American Bar Association can provide you with resources and information.

Make sure you understand what bankruptcy is and how it works before filing. Bankruptcy is a highly complex process. A debtor considering bankruptcy should seek advice from a bankruptcy attorney to properly plan for the best course of action. 

Here is a list of tasks involved in a bankruptcy:

Make a list of all of your debt, monthly payments, credit card payments, assets, income, and expenses. Having a clear understanding of your situation helps you, anyone who helps you, and the court at the end of it.

Before filing for bankruptcy, you must undergo bankruptcy counseling within 180 days. Before filing for bankruptcy, you must prove to the court that all other options have been exhausted. The counselor must be an approved agency provider listed on the US Courts website. This service is offered by most credit counseling agencies online or by phone, and you get a certificate of completion once it's completed that you must include with your paperwork. You will not be accepted if you skip this step.

You may wish to hire a bankruptcy lawyer if you have not already done so. It is not required that individuals who file for bankruptcy have legal counsel, but representing yourself could be very risky. Knowing the bankruptcy laws of your state and federal jurisdiction and which ones apply to your case is vital. Judges and court employees are not permitted to offer advice. You should also be aware of some significant differences between Chapter 7 and Chapter 13 before making any decisions. To succeed in court, you must know and follow the proper procedures and rules. Furthermore, you run the risk of your property being seized and sold without legal counsel.

Meeting with creditors: When your petition is accepted, you will be assigned a bankruptcy trustee, who will schedule a meeting with your creditors. Debtors are responsible for attending, but the creditors do not have to show up. However, the debtor must disclose all of their assets in the bankruptcy schedules.

What Is a Bankruptcy Discharge?

There are two outcomes to bankruptcy. One outcome is a discharge, and the other is a dismissal. In a bankruptcy discharge, you are no longer responsible for paying back debts. However, you still owe money to the IRS and other tax collectors. In a bankruptcy dismissal, you are allowed to start over again, debt-free. The discharge applies only to debts incurred before the filing date. You can protect your possessions by receiving a bankruptcy discharge. If you receive an automatic stay, your possessions will be protected. Until your creditor gets relief from the automatic stay, they cannot repossess your property. You may not be able to discharge a debt if a judge finds that you received money or property through fraud.

Bankruptcy exemptions are another option for protecting your valuable assets. During a bankruptcy proceeding, there will be nonexempt property. A variety of exemptions are available. Among them are homestead exemptions, vehicle exemptions, social security, etc.

Bankruptcy Dismissal

There are many requirements before you can obtain a bankruptcy discharge. Your case might be dismissed before you receive a discharge if you don't follow instructions from the bankruptcy trustee. A dismissal means that the court halted all proceedings in the main bankruptcy case and all adversary proceedings, but no discharge order was entered. The debtor may request voluntary dismissal when they qualify for it. If a trustee or creditor files a motion for dismissal and the court grants it, a debtor may be dismissed without their consent.