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January 28, 2022

How Does Bankruptcy Work?

Bankruptcy. It’s a term you’ve probably heard before. Either from playing a not-so-friendly game of monopoly or from watching the news. Chances are, some of the people watching this will also go through bankruptcy in their life. That said, bankruptcy is a little more complicated than Michael Scott makes it seem in the Office – you can’t just declare bankruptcy, rather it’s a legal process that is overseen by bankruptcy courts. 

The process is designed to help people and businesses eliminate part or all of their debt and repay what they owe where needed. Bankruptcy can get you relief from your debt, but it’s a pretty serious process and can have impacts on your ability to make and spend money for up to 10 years. 

Let’s go through the basics of bankruptcy in the United States to understand just what it means. 

The Basics of bankruptcy

Bankruptcy is a fairly complex process and it requires the average person or company to work with bankruptcy attorneys to make sure it goes smoothly. There are rules and regulations surrounding bankruptcy in the US.

Companies and individuals have to meet these requirements in order to file for bankruptcy, and they’re essentially just conditions that make it certain a person or a company can’t repay their debts and are in need of some kind of mitigation to get out of those debts.

There are two types of Bankruptcy though, chapter 7 and chapter 13, which drastically change what bankruptcy means for a financial entity. 

Both types help individuals or companies eliminate debt, halt foreclosures, and stop wage garnishments among other things, but the actual mechanisms that they relieve this debt by vary. Let’s take a look at the types of bankruptcies.

Types of Bankruptcies

Chapter 7 bankruptcy is known as a straight bankruptcy and is what most people probably think of when they hear the term. 

In this type, you or a company have to allow a federal court trustee to supervise the sale of any assets your company holds outside of a list of exempt assets. Money from the sale of these assets goes towards paying creditors, or the people who lent you or a company money. 

The balance of what you owe to those creditors is then eliminated after the bankruptcy is finalized. 

It’s important to note though that this doesn’t work for all kinds of debts. Individuals will still have to pay alimony, taxes, and student loans. 

Companies and individuals who go through chapter 7 will lose property, and the bankruptcy itself will remain on credit reports, making it harder for those entities to get money through debt down the line. It’s also not possible to file for bankruptcy again for another 8 years after chapter 7.

Moving on to Chapter 13 bankruptcy, this is slightly different. Chapter 13 allows a person or company to keep their property in exchange for partially or completely repaying debt. The bankruptcy court will typically negotiate a  three to five-year repayment plan in under chapter 13. Depending upon what’s agreed, all or part of the debt is repaid after that time, after which any remaining debt is discharged. Think of chapter 13 as restructuring debt and chapter 7 as eliminating debt through liquidation. While bankruptcy is all around a bad thing, Chapter 13 is the more favorable route as it shows that you are still repaying some debt. Chapter 13 also gets removed from a credit report after just 7 years, and one could refile for chapter 13 again in as little as 2 years. 

In terms of companies, if a company files for chapter 7 bankruptcy, they stop all business and everything is sold. Under chapter 13, the company will remain in business, but their future operations will likely be different as they have restructured debt agreements. 

Now that we’ve covered the basics of bankruptcies and how they wipe out debt, let’s take a look at the types of debt that bankruptcies can’t eliminate and what other consequences bankruptcies can have. 

Types of debt exempt from a bankruptcy filing

Bankruptcies can’t get you out of Student loan debt, alimony or child support, federal tax liens for back taxes, government fines or penalties, and court fines. Ultimately, while bankruptcy can solve a lot of debt problems, it can’t get rid of them all. 

In terms of other consequences of bankruptcy, the biggest effect is the loss of property. Both types of bankruptcy can require you to give up possessions for sale so that creditors are repaid. In many cases, this means losing real estate, vehicles, jewelry, furniture and other possessions of value outside of necessity.

To add to this, if anyone has co-signed a loan with an individual that goes bankrupt, that other person would become responsible for part of the bankrupt individual's debt. 

The last biggest effect of bankruptcy is that it damages your credit. Bankruptcies are negative hits to an individual's credit, meaning they’ll get higher interest rates in the future with unfavorable terms, if they’re even able to get loans.

So, hopefully, that taught you a little bit about how bankruptcies work and what they do. Now, when you watch the news and see a company declare bankruptcy, you’ll be able to understand exactly what that means for the future of the company. You also have a better understanding of what debt elimination options are available to you down the line. 

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