Were you aware that FICO offers lenders a proprietary score called the FICO Bankruptcy Score? According to FICO, the Bankruptcy Score will help lenders: “Identify more future bankruptcy, including likely surprise bankruptcies; Take action based on advanced warning of bankruptcy likelihood; and protect profits by reducing loss exposure while maintaining revenue streams.” In essence, the score is designed to identify high risk borrowers based on changes that occur in the consumer’s behavior. In 2006, Brigitte Yuille at Bankrate.com discussed these secret scores in this article.
Most consumers are familiar with the standard FICO credit score, but many are not aware that FICO (and other agencies) offer numerous types of scores for various circumstances such as mortgage lending, car buying, etc. According to Ms. Yuille’s article, a bankruptcy predictor has been around since the early 1990’s; and the scoring models have become quite sophisticated with the ability to send alerts to subscribers if the consumer’s behavior changes suddenly indicating an increased loss risk.
Regardless of how long you have been a customer, from the banks perspective, you are a number or SCORE. Why do you think it is so difficult to negotiate with the banks; they have billions (probably trillions) of data points gathered over 30+ years that predict how consumers will react in a given situation. The bank then creates systems and scripts for front-line customer service to use. Those scripts mostly contain the word “no” for anything you ask. Also, this data is why the threat of bankruptcy has little leverage.
The irony is that often your credit card companies know you will file bankruptcy before you do. When you see your available balance on a credit card reduced to the current balance owed, a significant increase in your interest rate, or a significant increase in your minimum payment; that is the bank telling you that you have become a risky borrower. That is the bank “taking action to protect profits and reduce loss exposure.” Unfortunately, the banks accept that you will file bankruptcy; banks are not generally interested in helping you avoid it because the accumulated data seem to show, on average, that any steps the bank could take to help will not help you avoid bankruptcy. That is some weird irony; although you may feel like the bank is “pushing you” to bankruptcy (I hear that comment a lot at consultations), the reality is the bank is telling you that you are already bankrupt, the bank has accepted it, so why don’t you?
By: Matt Berkus
I am often asked to explain attorney’s fees and the costs associated with bankruptcy; one way to view bankruptcy is as an investment and look at the Return on Investment (ROI). For example, for an investment of $2,700 in attorney fees in bankruptcy to discharge $50,000 in debt, the ROI is 1,852% in as little as four months time. No kidding, even I was amazed by the numbers when you really think about bankruptcy in an ROI context (note, for this blog piece, I am only looking at ROI, the model can get fairly sophisticated, and hence more difficult to explain when factoring extrinsic risk that some debts simply won’t settle).
Bankruptcy sets you up for success. It is the first step on the path to financial recovery; thus, bankruptcy is the critical step and must succeed. As the first step, it also has the largest Return on Investment. Assuming $2,700 in attorney fees, your return on investment in different scenarios is this:
Discharging $30,000 of debt: ROI = 1,011%
Discharging $70,000 of debt: ROI = 2,493%
Discharging $120,000 of debt: ROI = 4,344%
Short of being an Angel Investor or Venture Capitalist, there exist no investments you can make and expect such a return on investment. Assuming bankruptcy is an option for you in the first place, it is always the best option.
By contrast, let’s look at a comparable debt settlement program. To settle all debts and prevent hold outs (creditors who won’t settle for a really low amount), you should budget about 40% of the balance owed (most T.V. ads promise only 50%). Also, let’s assume an upfront fee of $1,200 and a 15% contingency on the amount saved (the industry average for private debt settlement companies). We won’t even factor in the potential income tax consequences of settling.
Settling $30,000 of debt: ROI = 89%
Settling $70,000 of debt: ROI = 97%
Settling $120,000 of debt: ROI = 100%
Thus, when viewed objectively, in a business-like manner using the same tools as corporations, bankruptcy makes the most financial sense and paying an attorney to do so (assuming you hire the right attorney) yields a huge Return on Investment. Don’t lose sleep over the decision to file bankruptcy, it is nearly always the must prudent option to solve debt.
By: Matt Berkus
Chapter 13 bankruptcy is a payment plan that allows client’s to force their creditors to accept payments that the client can actually afford to make, not what the creditors want. Thus, a chapter 13 bankruptcy client can pay all living expenses and only pay creditors the amount actually left over at the end of the month (as opposed to robbing Peter to pay Paul). Normally, a chapter 13 monthly payment is based on a family’s income, minus deductions, minus all living expenses; the amount left over, disposable monthly income, is paid to the chapter 13 trustee each month for 36 to 60 months.
However, there is another rule that must be satisfied for the court to approve a chapter 13 plan, liquidation value. Liquidation value is the amount of money a client’s creditors would receive if the client filed chapter 7 bankruptcy. Thus, if a client’s liquidation value is $30,000, then the total of chapter 13 plan payments must be at least $30,000 over the life of the plan. When does liquidation value come into play?
The asset rich, cash-flow poor, families are the ones that run into liquidation value problems. Some families have assets with too much equity; we call this scenario having non-exempt assets. For example, a Colorado family with 200,000 equity in its home but owes $300,000 in credit card debt would have a liquidation value of $140,000 (the homestead exemption in Colorado is $60,000). Meaning, that over the chapter 13 plans’s 60 months, the couple would need to pay $140,000; ouch!. Most of the time, if the family is contemplating bankruptcy, that payment is not be feasible.
If the family cannot afford to pay the liquidation value with monthly income, the available debt solutions are limited. The couple may either file chapter 7 bankruptcy and lose the home (actually liquidate it), or try to settle with creditors. However, settling requires immediate cash on hand to the tune of 30-50% of the balance owed. So, in this scenario, the couple would probably need to sell the house to raise money to settle. I typically recommend an attorney managed debt settlement program in these circumstances since we can usually maximize the amount of money the client can retain as the result of selling assets and manage collection activity.
Bankruptcy attorneys often advise small businesses not to file chapter 7 bankruptcy; and for the most part, that advice is sound. However, so far, year to date, Colorado has seen 675 business bankruptcies only 93 were chapter 11 bankruptcies. So, reasons exist to file a business chapter 7 bankruptcy.
If a business files chapter 7 bankruptcy, it is liquidated and closed. For very small businesses that process can be handled by the business owner with the advice of an attorney. However, often times it is preferable and advisable to put the business into chapter 7 bankruptcy and make closing the business the headache of the chapter 7 bankruptcy trustee.
- Oft times, the business owner doesn’t want the hassle and headache of closing the business; doesn’t want to deal with the incessant phone calls from creditors, vendors, and taxing authorities; the debtor simply wants peace and someone else to deal with it. A bankruptcy makes closing the business the problem of the chapter 7 trustee.
- The business has some assets; so the bankruptcy liquidation will pay certain important debts e.g. payroll tax for which the owner would be personally liable; and therefore, bankruptcy creates a streamlined forum to resolve certain debts.
- The business operation may have created high litigation risk; as such, a bankruptcy forces claimants out of the woodwork to deal with their claims or lose their rights. In essence, the bankruptcy packages all the claims and deals with it.
- Frequently a business will try chapter 11, but for various reasons the chapter 11 fails, so case is converted to chapter 7 bankruptcy.
I must note that a business bankruptcy is almost always followed by the owner’s personal bankruptcy. Lenders and vendors nearly always require small business owners to personally guarantee debt. The benefit of the business bankruptcy plus personal bankruptcy is the certainty it brings to the status of the debts and claims. The business is closed properly and the business owner receives a bankruptcy discharge leaving creditors now where to go. The owner wont need to put up with phone calls from various junk debt buyers that can occur many years after the business closes.
By: Matt Berkus
A business can file bankruptcy, but the result of a business bankruptcy is not the same as an individual bankruptcy. Businesses either file chapter 11 or chapter 7 bankruptcy. In Colorado, as of the end of September, 2012, 675 businesses filed bankruptcy, of those cases, only 93 were chapter 11.
A chapter 11 bankruptcy is a debt reorganization. A business in chapter 11 bankruptcy continues to operate and the chapter 11 allows the business to make more affordable payments to creditors. Although small businesses and individuals can file chapter 11 that type of bankruptcy is more suited to established, larger corporations (e.g. airlines). However, a business chapter 7 bankruptcy simply shuts down and liquidates the business. If a business files chapter 7 bankruptcy, the business is done. Unlike individuals who receive a bankruptcy discharge and fresh start, business do not. A business that files chapter 7 bankruptcy is closed.
So, a business can file a business bankruptcy, but there are other strategies for dealing with business debt. At this point, it is helpful to distinguish the business entity from the business operation. The business entity is the legal form of the business, e.g. Corporation. Limited Liability Company, Limited Partnership, etc.. The business operation is what the business does; e.g. manufacture and sell machine parts to diesel engine builders, sell real estate, manage properties, etc. The business entity incurred the debt (and often the owner(s) will have guaranteed the debt).
The business owner is usually interested in keeping the business operation. In bankruptcy, the only option for that goal is chapter 11. However, we can often perform a private reorganization of the business entity which keeps the business out of chapter 7 bankruptcy, may eliminate most business debt, and allows the business operation to continue. Keep in mind, a private reorganization cannot save a business that cannot pay its basic bills; the business operation must be viable. A business with good cash flow but too much debt can usually benefit from a private reorganization of chapter 11 bankruptcy if the goal is to keep the business operation intact.
By Matt Berkus
Whether a bankruptcy debtor can keep rental property will depend on the specifics of the case, but in general, there are two issues created by rental properties in bankruptcy: (1) the value of the property as an asset, and (2) the income and expense related to the property.
If the rental property has equity; that is, the property’s value is more than what is owed against the property, then the rental property would likely be seized and sold in chapter 7 bankruptcy. In chapter 13 bankruptcy it is possible to keep rental property in bankruptcy so long as the monthly payment in the chapter 13 payment plan can reconcile the value of that equity. For example, if the rental property has $20,000 equity, the chapter 13 plan must minimally pay $20,000 to the debtor’s unsecured creditors over the life of the plan (that is what we call reconciling the value of non-exempt equity). If there is no equity in the rental property, then this issue is moot.
The main challenge with rental properties in bankruptcy is related to the income and expense the property creates. The court looks at the cash flow position of the rental property; is it positive cash flow (profitable), break-even, or negative cash flow. In chapter 7 bankruptcy the rental income is income for the Means Test, so that income counts toward qualifying (and disqualifying) the debtor for chapter 7 bankruptcy. In most cases, the rental property has a corresponding mortgage expense so the income is offset and usually moot. However, if the property is significantly cash flow positive, in theory, a chapter 7 trustee may still seize the property and attempt to sell it as a going concern. For example, if the property is consistently $1,000 per month cash flow positive, someone may be willing to buy that income stream at a future dollar discounted value. However, if there were any risk of that last eventuality, the debtor would be filing chapter 13 or chapter 11 bankruptcy.
The cash flow position is particularly important in chapter 13 bankruptcy. If the rental property is significantly cash flow negative, the chapter 13 trustee will always object to the debtor supporting that property. For example, if the property rents for $1,200, but the combined mortgage, HOA, and other expenses are $1,600, the trustee will argue that the debtor should pay that $400 to unsecured creditors. The reason being that the debtor’s unsecured creditors are being unfairly prejudiced if the debtor is allowed to maintain the rental property which is not necessary for the debt reorganization. That doesn’t mean the court forces the sale, but the court may not allow you the budget to make-up the monthly short fall.
In short, yes, it is possible to keep rental properties in bankruptcy, but whether it is practical to do so is a discussion for you and your attorney.
By: Matt Berkus
Many debtors and even many bankruptcy attorneys are surprised to find out that the IRS kept a tax refund to pay the debtor’s tax debt after the debtor filed chapter 13 bankruptcy. This situation typically arises for chapter 13 bankruptcies filed between February and May; reason being, most debtors have just filed, or are about to file, their prior year tax return; but if the debtor is going to receive a refund for that year and owes back-taxes, the filing of bankruptcy does not stop the IRS from keeping that particular refund.
There are 2 reasons why the IRS gets to keep the tax refund?
(a) Internal Revenue Code 6321 provides the IRS with an automatic, statutory lien when a taxpayer owes a tax debt, the IRS has demanded payment, and the taxpayer has not paid. This tax lien is known as the silent or shadow tax lien. The IRS, in essence, has a security interest in the tax refund by virtue of its shadow lien.
(b) Bankruptcy Code section 362(b)(26) expressly allows the IRS to keep the tax refund if the debtor’s bankruptcy case was filed after the end of the applicable tax period for which the refund (for individual income tax, the tax period ends December 31) and the refund is being used to pay prior year(s) taxes. This concept is known as the right of set off. The IRS’s claim to the refund matures on December 31, but the claim doesn’t get paid until the debtor files her tax return. This bankruptcy code section is saying that the Automatic Stay (which prevents most collection activities against the debtor) does not apply to the IRS’s ability to take a refund to pay taxes owed for prior years. The bankruptcy Automatic Stay does not quash the IRS’s right of set off.
For example, Don Debtor owes $35,000 in back income tax for 2006, 2007, and 2008. Don files chapter 13 bankruptcy in February, 2011. Because of changes in his circumstances, Don will receive a $5,000 tax refund for 2010. The chapter 13 bankruptcy was filed after the end of the 2010 tax year. The combination of IRC 6321 and Bankruptcy Code 362(b)(26) allows the IRS to keep that $5.000 refund and apply it toward Don’s back-taxes. That is the case even though the tax debt for 2006 and 2007 would be dischargeable in Don’s bankruptcy.
So, IRC 6321 creates the IRS’s right to set off, and Bankruptcy Code section 362(b)(26) allows the IRS to maintain that right notwithstanding that the taxpayer filed bankruptcy. But, you, as the taxpayer, are no worse off; if Don had not filed bankruptcy, the IRS would have kept the refund anyway.
By: Matt Berkus
For all things bankruptcy, the value given to debtors’ assets is the current market value of the item. The real art in bankruptcy is in how you determine that “current market value” and present it to the bankruptcy trustee and the court. You cannot learn this art from a book or a seminar; you only learn it through trial and error and pressing the issue to get the best result for your client.
For real estate, the starting point is a Current/Comparable Market Analysis (“CMA”). These analyses can be done by real estate agents and in most cases is all you need; a CMA gives you a good estimate for what price the home would likely sell. But even a CMA can be massaged to meet a debtor’s needs. If the CMA does not get a number needed or is close, then an appraisal may be needed.
As for how this works, assuming we are talking about a primary residence for which the homestead exemption applies, the exemption attaches to the house (or property). Presently in Colorado the homestead exemption is $60,000 (and for elderly or disabled, $90,000). Joint ownership is usually a non issue, the “home” receives the homestead exemption; the home could have 5 owners, but the homestead exemption is still $60,000. So if the home is worth $250,000, and the mortgages total $200,000, the equity would be exempt because it is less than $60,000. However, if the home is worth $300,000 and the mortgages are only $210,000, the home would have $30,000 of non-exempt equity.
Home valuation is especially important for chapter 13 bankruptcy lien strips. Again, you start with a CMA; if the home is horribly upside down, a CMA will usually suffice since no one is going to challenge the value. If the property’s value is borderline, most judges will want to see a full-blown appraisal. But, real estate agents have testified as experts against the bank’s appraiser and won, so which value you need really depends on the specifics of the case.
Author: Matt Berkus
I am often asked to describe the bankruptcy worst case scenario. I must admit, I am extremely hesitant to even write this post as it may provide a reason for someone to needlessly prolong his financial suffering by not filing bankruptcy. So, I must stress, the bankruptcy worst case scenario is rare, rare, rare, and entirely in the debtor’s control. The worst case scenario only occurs when the client is not forthcoming or intentionally withholds information. If all information is on the table, there is always a way to plan for, address, and deal with whatever challenges a client’s circumstances create and put them in a better situation.
Aside from criminal prosecution for bankruptcy fraud (again, super rare), the worst case scenario in bankruptcy is denial of discharge.
Denial of discharge is different than having your case dismissed. The result of a denial of discharge is that whatever you were trying to hide is going to be taken and sold, and none of the debts that were listed in your bankruptcy will be discharged. You will be stuck with all that debt, forever. A dismissal at least gives you the option to reevaluate your options and re-file your case if necessary.
For example, if you fail to mention that you own free and clear a vacation home in Canada, the bankruptcy trustee will seize and sell that home, and you will have your discharge denied. In bankruptcy, you must disclose all assets, no matter where located.
See the case of poor Sidney Peters in Ft. Worth, Texas.
Personally, I think denial of discharge was a bit harsh for that debtor’s transgression, but it illustrates the point that you should not try to “hide” things in bankruptcy. Instead, hire a qualified bankruptcy attorney who is willing to help you with pre-bankruptcy asset planning and is willing to set proper expectations (i.e., tell you what you need to hear, not what you want to hear).
Author: Matt Berkus
(1) Bankruptcy is NOT a 10 year death sentence to your credit. MOST PEOPLES CREDIT SCORE WILL BE IN THE LOW 700’S WITHIN 18-36 MONTHS AFTER BANKRUPTCY.
(2) Most people lose nothing in a chapter 7 bankruptcy (except the debt, of course).
Credit rebuilding after bankruptcy occurs fairly quickly and you will have access to credit (if you want it) immediately after filing bankruptcy. You will be shocked by how quickly you receive credit card offers and offers to finance a car immediately after your chapter 7 discharges. During that rebuilding phase, if you use credit, you will pay a higher interest rate, but once you reach the 18-24 month mark, you should be able to receive market, prime credit interest rates for most loan/credit types.
Every state, in some manner or another, allows you to protect your assets from being taken in bankruptcy. Bankruptcy is not about leaving you destitute for the benefit of your creditors. If you were left destitute, you would become a burden on society and taxpayers. Instead, bankruptcy is about rebuilding your financial life so you thrive and can become successful. In over 90% of chapter 7 bankruptcies, the debtor loses nothing (source).
Stop agonizing over your decision to file bankruptcy; if your total unsecured debt is 40% or more of your gross annual income, it is time to consider bankruptcy. Your debt is the obstacle to you paying your necessary living expenses, living a happier life, and planning for your financial future.
Author: Matt Berkus