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A debtor-friendly decision on 401(k) contributions in bankruptcy came out of Washington state last week, but it requires some background to explain:

The Chapter 13 Means Test

One of the factors determining the size of your Chapter 13 Plan payments is your income; the more money you make, the more money your unsecured creditors need to be paid. The process of arriving at that number is called the Chapter 13 Means Test.

In the Chapter 13 Means Test, you start by taking your average income for the past 6 complete months. Then you subtract amounts that the government thinks people nationally and in your area spend on necessities, as well as amounts that you specifically spend on necessities (e.g. income tax, health insurance, mortgage, etc.). The result is your Disposable Monthly Income (“DMI”), the minimum amount that, based on this analysis, your unsecured creditors must receive per month through your plan.

In re Parks: Harsh Treatment for 401(k) Contributions in Bankruptcy

In August 2012, the Bankruptcy Appellate Panel (“BAP”) for the Ninth Circuit published an opinion in In re Parks. In Parks, the question was: Can a person’s ongoing 401(k) contributions be subtracted from income when calculating DMI? The BAP answered no, holding that post-petition 401(k) contributions are NOT excluded from the bankruptcy estate. Amounts that would otherwise have gone into a 401(k) must be paid to creditors, and cannot be deducted from income on the Means Test.

In re Bruce: Taking the Sting Out of Parks

In December 2012, the Bankruptcy Court for the Western District of Washington revisited the subject of 401(k) contributions and the Chapter 13 Means Test in the case of In re Bruce, and found favorably for the Debtor in two ways.

The Bruce Court’s first holding has to do with the different treatment of above and below-median debtors. You only have to go through the full Means Test process described above if your average income is above the median income for a household of your size in your state. If your income is below the median, then you are assumed not to have any disposable monthly income.

The Court held that the Parks prohibition on deducting post-petition 401(k) applies only to above-median debtors. For below-median debtors, whether those contributions are reasonable and necessary is still a question of fact for the court. And this Court, noting that modernly people primarily save for retirement not through pensions but through 401(k)s, held that these contributions were in fact reasonable and necessary.

Secondly, the Court held that when calculating income for the past 6 months, a debtor may subtract 401(k) contributions made during those 6 months. Thus, even though you can’t take future 401(k) contributions into account when calculating the Means Test, you can take past contributions in account. (Indeed, calculating it in this way may be much better for debtors as it may enable more of them to qualify for 3-year plans. But that’s a subject for a different post.)

This is a debtor-friendly decision that takes some of the sting out of Parks while still being consistent with it. As a Western District of Washington case, it’s not binding on the Northern District of California, where I practice, but the reasoning could very well be applied to cases here.  The opinion can be found here.

The appropriateness of a type of case to your particular situation is the single most important determination in filing a bankruptcy case.  From the moment you begin your conversation, your bankruptcy lawyer will be thinking about whether your situation is Chapter 7 or Chapter 13.

By numbers alone, Chapter 7 cases are more common.  They’re what you typically think of when you think about bankruptcy cases.  You file your case, and (usually) three months later, the Court issues an Order “discharging” your unsecured, non-priority debts (e.g. credit cards, personal loans, medical bills, payday loans, deficiencies on repossessed cars, second mortgages on foreclosed homes).  “Priority” debt (e.g. recent income tax) is not discharged; you still owe it at the conclusion of your case.  With secured debt (usually car loans or mortgages), you have two basic choices: keep the car or house, and keep the debt, or get rid of the car or house and get rid of the debt.  (“Redemption” is a third option, but it’s not practical in most consumer cases.)

However, in Chapter 7, if you have certain types of assets over certain amounts (which varies from state to state), the Trustee is empowered to liquidate those assets and distribute them among your creditors.

Additionally, in Chapter 7, you have to pass something called the “Means Test.”  What the Means Test basically comes down to is, if you make too much money, you can’t file Chapter 7 and have to go to Chapter 13 instead.

Chapter 13 is quite different from Chapter 7.  You propose a Plan to the Court (which the Court either rejects or “confirms”) saying you will pay a certain amount every month to a Trustee for the next five (or sometimes three) years.  The Trustee takes that money and pays off certain debts in full, such as mortgage arrears, car loan balances, and recent taxes.

As to the aforementioned unsecured, non-priority debt such as credit cards, the Trustee pays something to those creditors too, but the amount is usually less than 100%.  Whether your unsecured creditors get 1%, 100%, or somewhere in between is determined by several factors, the most significant of which is income (as determined by the Chapter 13 Means Test, a cousin to the Chapter 7 version).  Upon successful completion of your Plan, any remaining unpaid unsecured debt is discharged.

So if Chapter 13 lasts so long, and only provides a partial discharge, why would anyone chose it over Chapter 7?

For starters, people who stand to lose property in a Chapter 7 case might opt for Chapter 13 instead because you never lose property in Chapter 13.  Another reason might by that you don’t pass the means test.  However, for most Chapter 13 filers, Chapter 13 is simply better for them.  For example, if you’re behind on your mortgage payments, a Chapter 13 case enables to you to get caught up those arrears over 5 years, at 0% interest, during which time you’re protected by the Court from foreclosure.

Here’s another benefit: If you have two mortgages, and your house is worth less than the first mortgage (i.e. you are “under water” on the first), in Chapter 13 you can “strip” that second mortgage.  The second mortgage then gets treated just like other unsecured debt.

If you’re behind on your car payments, Chapter 13 gives you five years to pay off the loan in full, during which time you’re protected by the Court from repossession.  And if you’ve had the car for more than two and a half years, you can do a “cram down.”  That means you don’t pay what you owe under the contract; instead you pay what the car is worth.

If you have recent, non-dischargeable tax debt, Chapter 13 gives you five years to pay that off, too.

Thus, generally speaking, lower income, few assets, and mostly dischargeable debts are factors pointing toward a Chapter 7 case.  Higher income, mortgage arrears, and the possibility of a lien strip or a cram down are factors pointing toward a Chapter 13 case.  People trying to stop foreclosures are almost always Chapter 13 cases.

Of course, no one’s actual situation is this simple.  People’s lives are complex, and there are many more factors than the ones I’ve briefly outlined here.  It is your lawyer’s job to consider and balance those factors and to determine which Chapter (if any) stands to provide you the greater benefit.  Regardless of the complexity of your situation, at the end of an initial consultation your lawyer should be able to recommend one Chapter or the other to you.

See our other blog post for more information on the difference between Chapter 7 and Chapter 13 bankruptcy.

“Chapter 20” is the term commonly applied to situations where a debtor files a Chapter 7 bankruptcy case and then some time shortly after receiving a discharge, files a Chapter 13 case.

Why might someone do this? Here’s a common hypothetical: A debtor cannot file Chapter 13 because her unsecured debts exceed the $360,475 Chapter 13 limit. Instead, she files a Chapter 7 case and receives a discharge, reducing her unsecured debts to $0. However, she still has a second mortgage on her house, and the first mortgage is “under water.” That second mortgage was not stripped because lien stripping is not available in Chapter 7. Can she then file a subsequent Chapter 13 case (for which she now qualifies) in order to strip the second mortgage?

Some courts have responded with a no, agreeing with trustees that § 1325(a)(5)(B)(i)(I), read in conjunction with § 506(d), makes lien stripping dependent on the debtor receiving a discharge. However, this debtor has already received a discharge in her Chapter 7 case and is not entitled to a second one. Ipso facto, no discharge, no lien strip.

In an opinion issued on October 15, 2012 the case of In re North, Judge Efremsky of the United Bankruptcy Court for the Northern District of California came down on the other side of the argument, finding that permanent lien stripping is dependent not on receipt of a discharge, but on completion of the Chapter 13 Plan’s payments.

Thus, since the Chapter 7 case extinguishes the debtor’s personal liability for the second mortgage but not the creditor’s in rem rights (i.e. the lien), since and those in rem rights can be restructured in Chapter 13 (i.e. the lien stripping, which is permissible under the rationale above), at the completion of the debtor’s Plan the creditor is question has no recourse against either the person or the property. The is, for all effective purposes, gone.

Thus Chapter 20 cases, and the ability to strip liens within them, remain a powerful tool in the hands of debtors, especially in Northern California where the regularity of million-plus mortgages puts many ordinary homeowners in danger of running afoul of the debt limits. However, Chapter 20 cases are rife with other potential pitfalls, not least of which are bad faith issues, and so you should make sure you find a lawyer who knows what he or she is doing. Additionally, the Chapter 13 Trustee in the North case has indicated that she intends to appeal the decision.

“Exemption Laws” are those laws that allow people who file bankruptcy cases to keep certain amounts of certain categories of assets.  Like most states, California (where I practice) has its own set of exemption laws.

If you’re over 65 or disabled, California allows you to keep $175,000 worth of equity in your house.  That’s called the “Homestead Exemption.”

So, for example, if you’re a Californian over 65 and owe $500,000 on your house, and it’s worth $675, 000 or less, then that $175, 000 in equity is fully protected.  If a Trustee in a Chapter 7 case took your house and sold it, she’d have to pay the mortgage holder (the bank) first, and then give you a check for $175, 000 before she had any assets with which to pay your creditors.  That being the case, she’s not going to bother trying.

However, if the house was worth $700, 000, she would be much more likely to go after your house: She would sell it for $700,000, give $500,000 to the bank, give $175,000 to you, and then distribute the remaining $25,000 to your creditors.

A recent Ninth Circuit Court of Appeals decision (Wolfe v. Jacobson, U.S. Court of Appeals, Ninth Circuit, No. 10-60040) stands to have an enormous impact on the bankruptcy cases of people who make use of the Homestead Exemption.

In this case, the Jacobsons, both over 65, had more than $150,000 equity in their home. ($150,000 was the Homestead Exemption amount at the time they filed their case.) A creditor asked for, and the Court granted, permission to proceed with a foreclosure of the home.  The house was sold, the Jacobsons got $150,000, and everything else went to pay off the creditors.

However, the Jacobsons didn’t use that money to buy another house; they put it in the bank to use for ordinary expenses.  The Trustee in their Chapter 7 case then pursued the $150,000, claiming that because the Jacobsons didn’t use it for a new home within six months, it had lost its exempt status.  The Bankruptcy Court and the Bankruptcy Appellate Panel decided against the Trustee, but the Ninth Circuit Court of Appeals reversed those decisions.

An appeal is pending, and a question remains as to whether this applies to sales by the Trustee as well as to sales by creditors, but under this precedent, a debtor who receives proceeds from the sale of his or her house pursuant to the Homestead Exemption, must reinvest those proceeds in to a new home within 6 months or lose those proceeds.

If your bankruptcy case is dismissed for any reason and you file a second case within a year, the “Automatic Stay” in the second case is different from the first. (The Automatic Stay is a protection created the moment you file.  It “stays” your creditors from trying to collect on your debts.  It stops lawsuits, foreclosures, garnishments, repossessions, and creditor phone calls and letters.) While the Automatic Stay usually last s indefinitely, in your second bankruptcy case filed within a year, it lasts only 30 days unless you ask the Court to “extend” it.

Generally, this rule exists to stop people from repeatedly filing and dismissing bad bankruptcy cases in order to thwart foreclosure indefinitely.

There’s an extra wrinkle to this rule:  The statute (11 U.S.C. § 362(c)(3)) is ambiguous as to whether the Automatic Stay’s protection terminates only as to you and your property, or if it also terminates as to the property of the “estate” that was created when you filed.  (The “property of the estate” includes all of your assets at the time of filing.  In a Chapter 13 case, it also includes your earnings during the course of your payment plan.)  As a result, a disagreement has arisen among the Circuit Courts, with a majority taking the former approach and a minority taking the latter approach.

The reasoning behind the majority approach is that it preserves the equal treatment of creditors: Let’s say you’re filing your second case within a year, following a dismissal, but fail to extend the Automatic Stay.  You have a house with equity that you want to surrender.  The house becomes property of the estate, and the Trustee takes possession, planning to sell it and distribute any proceeds to your creditors. Under the majority approach, your bank/mortgage holder can’t step in and take the house all for itself; it has to get its share from the Trustee, just like all the other creditors.  But under the minority approach, because there is no Automatic Stay as to the property of the estate, the bank can just step in and take the house all f or itself, leaving the other creditors out in the cold.

In its February 2011 decision In re Reswick (2011 WL 612728), the Bankruptcy Appellate Panel (BAP) for the Ninth Circuit (which includes California) came down on the side of the minority approach.  The facts of Reswick are atypical:  The debtor filed his second case within the year (the first having been dismissed for failure to make Chapter 13 Plan payments), but he did not obtain an extension of the Automatic Stay.  After 30 days elapsed, a creditor, based on a pre-pet it ion lawsuit, started garnishing the debtor’s wages (which, in Chapter 13 cases, are property of the estate). When the debtor sought damages f or violation of the Automatic Stay, the Court found that there was no Automatic St ay and therefore no violation. The BAP agreed.

Thus, the decision in Reswick gives preference to creditors who happen to have obtained pre-pet it ion judgments.  An appeal to the Ninth Circuit Court of Appeals is expected.  For Californians who’ve had one bankruptcy case dismissed and are contemplating a second filing within a year, the lesson of here is clear: Make sure your lawyer knows about your previous case, and make sure he or she seeks an extension of the Automatic Stay.