Personal Bankruptcy: Beware the Next Chapter

Reforms will make it harder to file successfully

Bankruptcy is a dirty word to most Americans, even to those in dire financial straits. But beyond the posse of creditors on a debtor's tail, there's another reason to run--not walk--to a competent bankruptcy attorney. Congress is on the verge of giving final approval to an overhaul of federal bankruptcy rules that will make it tougher and more costly for most individuals to walk away from, or even restructure, their debts.

The bill seeks to curb the number of filings, which have been on the rise since the mid-1990s, by making the process more cumbersome and forcing those who file to repay more of their debts. It's also the product of years of lobbying by finance and credit-card companies. The legislation is especially harsh on lower-income debtors. But it's no picnic for middle- and upper-income consumers in financial trouble, either. "The point of [the bill] is to discourage people from filing for bankruptcy at all," says Henry Sommer, vice-president of the National Association of Consumer Bankruptcy Attorneys, which opposes the reforms.

For the first time, debtors would have to take a "means test" to determine if they can file for bankruptcy under Chapter 7. That part of the bankruptcy code lets people erase most of their debts and make a clean start. Last year, some 70% of the 1.5 million bankruptcy filings were Chapter 7 cases.

If your income is below your state's median income for your family size, you automatically qualify for Chapter 7. Above the median, you may still qualify if you have as little as $166 a month left after living expenses and secured and priority debts. What's different under the proposed law is that those expenses are determined by rigid Internal Revenue Service standards instead of a bankruptcy judge. For example, if your family owns a car, the IRS doesn't allow you to deduct the cost of your spouse taking the bus to work.

Those who don't qualify for Chapter 7 may be able to work out repayment plans under Chapter 13 (or, for those whose unsecured debt exceeds $290,525, Chapter 11). But the terms will be tougher. You'll be required to keep paying a portion of your debts for five years instead of just three. As with Chapter 7, IRS standards, not a judge, will determine what's allowed for living expenses. You likely will have to repay more credit-card debt. And it will be harder to write off auto loans. Current law requires a debtor to pay off the depreciated market value of the car, plus interest. Under the reform bill, if the loan is less than two-and-a-half years old, you must repay the full amount owed, plus interest.

The revisions in the law basically leave state law alone on homestead exemptions. That means if you live in one of a handful of states, such as Florida or Texas, that allow unlimited homestead exemptions, you can still keep a multimillion-dollar mansion. But the new law makes it harder for you to qualify if you move to Florida or Texas from a state with a lower home-equity cap prior to filing. And, with Enron executives in mind, lawmakers slapped a $125,000 ceiling on the exemption for individuals convicted of securities fraud and certain other crimes.

Regardless of where they live, though, all debtors will have to submit reams of paperwork. Courts will demand more pay stubs, prior tax returns, and proof of credit counseling. A higher standard of evidence will make bankruptcy cases harder for attorneys, too. "Lawyers who do a little bankruptcy work will probably stop, and those who do mostly bankruptcy work will raise their fees," says G. Ray Warner, a University of Missouri at Kansas City law professor. An uncomplicated Chapter 13 filing, which now runs $1,000 to $1,500, could cost 40% more, he says.

Altogether, such provisions will make bankruptcy unworkable for many, some experts predict. Already, more than 60% of people who file under Chapter 13 don't complete their plans, meaning they could lose their homes and cars. And the new rules may leave some bankrupt debtors without enough money for legitimate expenses.

Most provisions in the reform bill take effect six months after enactment. Anyone contemplating bankruptcy should file sooner rather than later.

By Amy Borrus

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