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Better Understand the Law

How Does Bankruptcy Work?

About 2 million Americans file bankruptcy each year. Annually, there are 1,400,000 personal bankruptcy petitions (Many of those filers are married and are filing jointly.) Fortunately, we no longer live in the world described by Charles Dickens.

There are no more debtor prisons or poor houses, where debtors are locked up for the failure to pay their bills. You cannot be jailed for failing to pay your bills. Fortunately, when the United States was established, the foundation for today’s bankruptcy laws was also established.

This article provides a general overview of bankruptcy law, but if you are considering filing bankruptcy or wonder if bankruptcy is a good fit, consult with a qualified bankruptcy attorney in your state of residence.

Where Bankruptcy Laws Come From

The Congress shall have Power [t]o establish… uniform Laws on the subject of Bankruptcies throughout the United States” (Article I, Section 8, Clause 4, United States Constitution.) The U.S. Constitution holds the authority for Congress to make bankruptcy laws.

  • Congress did so. Federal law dictates bankruptcy procedure and applies to all Americans.
  • State law determines property rights bankruptcy exemptions and only applies to residents of that state. This is why bankruptcy laws differ state to state.

Homestead Exemptions in Bankruptcy

Your homestead is your real property (or personal property, in some states) that is used as a home. Each state has its own bankruptcy exemption law. Here’s how four states protect residents’ homes in bankruptcy:

  • If you live in Florida and file for bankruptcy, you can keep your home no matter how much it’s worth or how much equity you have it in. You could keep a $25 million home and still receive a bankruptcy discharge.
  • However, if you live in Ohio, you can only protect $21,625, if filing as a single person and double that to $43,250, if married and filing jointly.
  • Arizona affords a $150,000 homestead exemption, no matter if you’re filing individually or jointly; and,
  • California’s homestead exemption is more complicated with many categories; the least amount protected in California is $75,000 of equity in a home.

Bankruptcy Chapters

You’ve likely heard of Chapter 7 and Chapter 13, and, maybe, Chapter 11 bankruptcies. These “chapters” refer to the chapters (sections) of the Bankruptcy Code (which is federal law.)

Chapter 7

Chapter 7 bankruptcy is called “liquidation” bankruptcy because assets are sold to pay off creditors in exchange for the debtor being relieved of debt. However, in actuality, very few Chapter 7 filers lose any assets because of the exemptions.

Individuals and married persons are eligible to file Chapter 7 bankruptcy if they qualify by meeting the “means” test. Get good advice and don’t count yourself out if you don’t think you qualify at first glance. There is more than one way to qualify.

Chapter 13

Chapter 13 bankruptcy proceedings are the “wage earners bankruptcy” or “reorganization bankruptcy” because debts are renegotiated into a 3 to 5 year payment plan. Most debts are not discharged.

Individuals and married persons are eligible to file Chapter 13 bankruptcy. You can keep assets on which you:

  • Reaffirm your debt, and
  • Can pay for as part of your repayment plan.

Renegotiation, through bankruptcy, may make these assets easier to keep.

Chapter 11 and Chapter 12

Businesses file for bankruptcy protection under Chapter 11; however, fisherman and farmers file under Chapter 12.

Bankruptcy allows your business to continue functioning. Like Chapter 13 for personal bankruptcy, business contracts are renegotiated under Chapters 11 and 12. Some debts may be discharged, but the focus is on renegotiation and reorganization.

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