The law is full of loopholes, and nowhere is this more true than in the area of bankruptcy statutes. The U.S. Bankruptcy Code is crystal clear about inheritances in some respects, and vague in others. If you inherit while you're involved in a Chapter 7 proceeding or shortly thereafter, your trustee will probably use the asset to pay down your debts -- with some exceptions.
Your Bankruptcy Estate
When you file for Chapter 7 bankruptcy protection, all your assets and property become your bankruptcy estate. Your bankruptcy trustee pays your debts from this estate by liquidating the assets and converting them into cash. If you have no assets, your creditors don't receive payment. If you have a few assets but are able to protect them by using exemptions – certain values in various items of property which you're permitted to retain – your creditors may not receive payment. After determination of your exemptions and liquidation of your bankruptcy estate, your case is closed and the court discharges your unpaid debts. You no longer owe them.
Read More: Stages of Bankruptcy
Your Inheritance as an Asset
Your bankruptcy estate includes not only the property you own, but any property in which you have an interest as well, even if that property isn't actually in your possession at the time you file. If you're named as a beneficiary in a loved one's will, you have an interest in his property. Therefore, the potential inheritance is part of your bankruptcy estate – but only for a certain period of time.
Your inheritance only becomes part of your bankruptcy estate if your loved one dies within 180 days or six months of the date you file your Chapter 7 petition. If you file on June 1, and your loved one dies on November 28, 180 days later, your bankruptcy trustee can take the inherited cash or liquidate the inherited asset to pay your creditors. If your loved one dies on November 29, 181 days later, you can keep the inheritance. It doesn't matter when you actually receive the money or the property. If it doesn't come into your possession for another two years, the court will reopen your bankruptcy to distribute the proceeds to your creditors if your loved one died within this six-month window of time.
The issue of inheritances is complicated by the fact that the U.S. Bankruptcy Code doesn't say exactly what an inheritance is. It's open to the interpretation of judges on a case-by-case basis. Some bankruptcy courts have ruled that only inheritances you receive by way of a last will and testament are part of your bankruptcy estate. If you're the beneficiary of a trust instead, your inheritance may be exempt. This is particularly true if the trust has a spendthrift clause intentionally designed to prevent creditors from reaching the assets. Likewise, if you receive money because your loved one named you on a payable-on-death account, some judges may not consider this part of your bankruptcy estate.
Duty to Report
Given how long the probate of a will can take, you might be tempted to simply not mention your inheritance to your bankruptcy trustee. You might figure that by the time you receive the bequest, your bankruptcy will be over and no one will be the wiser. However, you have a legal duty to report the death and the fact you're inheriting. Not doing so is bankruptcy fraud, which is a federal crime.