Occasionally a debtor experiences a substantial and continuing change of circumstances during a Chapter 13 bankruptcy case and need to convert it to a Chapter 7. This can occur because circumstances have made it impossible to continue to make monthly payments and a conversion to a Chapter 7 is in order.
Debtors with secured possessions such as a home, car or professional tools will probably want to save their secured assets if at all possible. For many people in debt, the only viable way to do that is to file a Chapter 13 bankruptcy.
- The Reasons Debtors Try to Convert to a Chapter 7 Voluntarily
- Forced Conversions by the Bankruptcy Court
- What Restrictions are There on Conversion?
- The means test problem
- How does the conversion take place
In Chapter 13, the debtor can protect his/her secured property by agreeing to pay the monthly payments and also submitting a plan in bankruptcy.
The chapter 13 plan will confirm the debtor’s intent to pay the arrears on any secured loans over a three to five year period. The plan will also provide for some amount of payment to unsecured creditors.
Debtors who fail the means test will also be forced to file a Chapter 13 bankruptcy. The means test compares the debtor’s income to the income of others who are similarly situated by family size and by geographical location. Debtors who fail the standard means test (which uses a simple comparison of incomes to a standard median income) may be able to pass the means test if they can show and prove unusual circumstances.
After filing the Chapter 13 bankruptcy, it may become clear that the Chapter 13 plan will not work. The debtor simply may not be able to keep up the monthly payments, the arrearage payments and continue paying something to the unsecured creditors.
When the debtor cannot make the Chapter 13 payments, the debtor may ask the Bankruptcy Court to convert the case to a Chapter 7 case. The Bankruptcy Court may also force the conversion from a Chapter 13 to a Chapter 7 if the debtor falls behind on the payments to the bankruptcy trustee. The conversion to a Chapter 7 is not automatic. The Bankruptcy Court decides each conversion case on a case by case basis.
The reasons debtors try to convert to a chapter 7 voluntarily
A debtor’s finances may change. Normally this means that a debtor loses his or her job or the debtor’s income is significantly reduced. The reduction may be work related and it can also be for medical or other extraneous reasons.
If you’re in troubled debt, you may decide there is no reason to keep the house, car, tools or other secured assets. The reasons to sacrifice the secured assets, other than financial, can include an opportunity to stay with relatives, loss of value of the asset(s), an accident to the property or other reasons.
Forced conversions by the bankruptcy court
The Bankruptcy Court, usually on the request of the Trustee in Bankruptcy, may force a conversion. Typical reasons for forcing the debtor to switch include the failure of the debtor to file the Chapter 13 plan when it is due, and the failure to make timely payments under the Chapter 13 plan.
What restrictions are there on conversion?
Many applicants can convert to a Chapter 7. There are some restrictions. The first restriction is that the debtor cannot convert to a Chapter 7 if the debtor received a Chapter 7 discharge within the prior eight years.
The means test problem
The new bankruptcy law, enacted in 2005, wanted to make sure debtors who had a reasonable ability to pay off their debts did make a viable effort to pay their creditors. As mentioned, there is now a means test which looks to see if the debtor’s income and expenses are too high. There is some question as to whether a Chapter 13 debtor who has failed to meet the Chapter 13 plan requirements needs to pass the means test again. Different bankruptcy jurisdictions seem to have different answers. This means it may depend on which state or federal bankruptcy district the debtor resided.
Even if a jurisdiction says the debtor has to pass the means test, the test that will be used is the one that applies at the time of the conversion, not the original test. For example, a debtor may have filed a Chapter 13 bankruptcy on January 1, 2014 because his or her income was over $60,000 and $60,000 was above the medium average for the debtor’s family size and location.
If, the debtor’s income is then cut in half, so that on August 1, 2015 his or her income is only $30,000, then the Bankruptcy Court will use the means test for the August 1, 2015 date. If $30,000 is below the medium for the debtor’s family size and location, then the debtor will pass the means test. In turn, the debtor will be able to convert to a Chapter 7.
Alternatively, if the debtor’s income stayed at $60,000, then the debtor would not be able to convert to a Chapter 7 with one exception. The figures the Bankruptcy Court uses for means testing do change on occasion to account for inflation and other factors. If the mean for Chapter 7 was move up to $61,000 before August 1, 2015, then the debtor would pass the means test and could convert to a Chapter 7.
How does the conversion take place
In most cases, the paperwork is the same unless the debtor’s financial situation changed. If the debtor’s income changes or the debtor incurred new debts, then amended bankruptcy schedules may be required. The debtor will also have to file a new Statement of Intention to explain what will happen to the secured debts. Unless the debtor can reaffirm the debts, with the permission of the creditor and the Bankruptcy court, the debtor will have to give his or her secured possessions to the Bankruptcy trustee.
There will normally be another meeting of creditors even if the debtor had a Chapter 13 meeting. The issues of the debtor’s exemptions will have to be reviewed. Often a Chapter 13 debtor will not claim exemptions because the Plan saves the key items.
When considering the exemptions, the Bankruptcy Court will have to decide which date, the original filing date or the conversion date, is used to value the exemptions.
Lastly, non-dischargeable debts will also have to be addressed.
The bankruptcy laws permit a Chapter 13 debtor to convert the case to Chapter 7 without any special permission.
Converting the case is a very simple process. The debtor pays a small conversion fee and files a notice of conversion with the bankruptcy court. The debtor must amend his bankruptcy schedules and account for any changes to his finances.
This includes any new debts that arose after the original bankruptcy filing, but before the case was converted. Those debts may be eligible for discharge in the new Chapter 7 case.
The converted case keeps the original case number and is considered a continuation of the bankruptcy case. However, a Chapter 7 trustee is assigned to the converted case and the debtor must attend a second 341 meeting with that trustee.
Money the Chapter 13 trustee is holding
Generally, after conversion the trustee makes an accounting, and pays trustee’s fees, attorney fees and/or adequate protection payments to creditors. Any remaining money is returned to the debtor.
Only the debtor’s property as of the filing date becomes property of the Chapter 7 bankruptcy estate.
Any property acquired after the filing of the Chapter 13 case, but before the conversion to Chapter 7 is excluded (not property of the bankruptcy estate) as long as the debtor converted in good faith.
In most situations the debtor will receive a refund of the balance of the payments. The amount of the refund largely depends on whether the Chapter 13 Plan was confirmed prior to conversion:
- If the debtor’s Chapter 13 Plan was not confirmed prior to dismissal, money held by the trustee is returned to the debtor;
- If the debtor’s Chapter 13 Plan was confirmed prior to the dismissal of the case, any money received by the trustee prior to the entry of the Order of Dismissal is disbursed to creditors pursuant to the Order Confirming Plan;
- any money received by the trustee following the entry of the Order of Dismissal is returned to the debtor.
Property of the Chapter 7 bankruptcy estate
The debtor must account for all of his property, but some property is not property of the Chapter 7 bankruptcy estate.
The Bankruptcy Code states that the Chapter 7 estate consists of the property belonging to the Chapter 13 estate at the time of the initial bankruptcy filing that remains in the possession or control of the Debtor. 11 U.S.C. §348(f)(1)(A).
However, if the court finds that the debtor converted the case in bad faith, the Chapter 7 estate property is determined upon the date of conversion. 11 U.S.C. §348(f)(2).
A recent Bankruptcy Appellate Panel case out of the 9th Circuit highlights a situation where property of the Chapter 13 bankruptcy estate is spent by the debtor, and thereafter the debtor converts the case to Chapter 7.
In the case of In re Salazar, 465 B.R. 875 (9th Cir BAP 2012), the debtors were owed an income tax refund when they filed their Chapter 13 bankruptcy (and admitted it was part of the Chapter 13 estate); received the refund and spent the money on ordinary and necessary expenses; and then converted the case to a Chapter 7. The BAP agreed with the lower bankruptcy court that the debtors spent the tax refund money in good faith to pay ordinary and necessary living expenses during the period from the petition date to the conversion date.
Consequently, the spent tax refund was not property of the bankruptcy estate on the conversion date, and the request by the trustee to turnover the tax refund was denied.
While most court orders issued during the Chapter 13 case remain valid, there are a few potential landmines to consider in a conversion case.
For instance, an order to cram-down the value of an automobile, or to lien strip a second mortgage have no effect in a Chapter 7 case. This can cause a problem when the debtor has not made payments to the creditor, but wants to retain the property.
Upon conversion, a secured debt that was modified in Chapter 13 reverts to pre-petition terms. In plain English, the old contract interest rate and contract monthly payments are now in effect and the debtor is likely in default on the loan.
A Chapter 7 debtor has three bankruptcy options for a defaulted secured loan: (1) surrender the property and discharge the entire debt; (2) reaffirm the debt with the lender; or (3) redeem the property for its fair market value. A fourth option is to pay the arrearage current which may be available in some jurisdictions.
Surrender obviously means giving the property back to the lender. Surrendering property can take weeks or months and can range from simply dropping off property at the bank, or waiting months for a foreclosure sale.
While in possession of the property, whether it is a vehicle, personal property, or real estate, the debtor is responsible for care, maintenance, and insurance until the lender takes possession.
Reaffirmation is simply continuing the debt after bankruptcy. Reaffirmation is difficult when seriously behind on the loan payments. Some courts may refuse reaffirmation if the debtor is not current on the payments.
Because the terms of the original contract may be changes by agreement in a reaffirmation, a common tactic is for the debtor and creditor to declare that the loan payments are current within the proposed reaffirmation agreement.
The debtor may redeem personal property that is intended primarily for personal, family or household use including a family vehicle, but not real estate.
The debtor must pay the fair market value of the property in one lump sum, and any remaining deficiency balance is discharged at the end of the Chapter 7 case. This often requires a new, non-bankruptcy loan to obtain the money to fund the redemption.