What is Chapter 7 Bankruptcy?

Chapter 7 is the most common type of bankruptcy, comprising almost 70 percent of the 413,616 bankruptcy filings in calendar year 2021. It is also the quickest type of bankruptcy to get through and the simplest to file.

Termed “liquidation bankruptcy,” a Chapter 7 bankruptcy does not include reorganization of debt. Rather, some types of unsecured debts are wiped out in Chapter 7, others are unchanged, and a third category could go either way on a case-by-case basis.

Considering filing for bankruptcy? It's important to understand the basics before jumping in. There is much to be gained by a successful bankruptcy case, but there are definitely negative consequences as well.

Most people have heard of bankruptcy, but few understand the basics of this legal proceeding. Filing for bankruptcy is a legal proceeding that is intended to give individuals and businesses relief from overwhelming debt while still offering creditors a chance for, at least, partial repayment.

Don't head for your state court to explore bankruptcy options; bankruptcy is handled exclusively in federal bankruptcy courts. The rules that are followed in these proceedings are set out in the United States Bankruptcy Code. They can be quite complicated, so in most bankruptcy cases, it pays to bring in an experienced attorney.

There is not just one form of bankruptcy, but several, commonly referred to by the chapter number in the U.S. Bankruptcy Code where they are discussed. The most common forms of bankruptcy are Chapter 7 and Chapter 13.

The rules and procedures for Chapter 7 bankruptcy are outlined in Chapter 7 of the Bankruptcy Code, while Chapter 13 rules are found in Chapter 13 of the code. All types of bankruptcy negatively affect an individual's credit and make it challenging to get new credit.

‌Chapter 7 bankruptcy is a legal procedure that offers relief to debtors who have more debt than they can reasonably expect to pay off given their current income and assets.‌

Many individual filers have lost their jobs or racked up medical debt. Some have overextended credit cards.

While there is a considerable list of debts that cannot be discharged in bankruptcy court, many unsecured debts, including credit card debts and medical debts, disappear after a successful petition.

A Chapter 7 case starts when the debtor files a petition in the appropriate bankruptcy court. Generally, this is the court that serves the region where the individual lives or where the business debtor is organized.

The debtor fills out court forms that report their assets and debts, income and expenditures, and other documents related to their financial affairs, like tax returns.

The debtor is entitled to keep certain "exempt" property – types of assets specified in the Bankruptcy Code or made exempt by the laws of the debtor's home state. States have the right to use the federal exemptions or replace them with their own list of exempt property available to their residents.

Filing a petition under Chapter 7 puts a brake on most collection actions against the debtor. This is automatic and requires no court action. It is called a bankruptcy stay. As long as the stay is in effect, creditors cannot sue the debtor or take actions in ongoing lawsuits, they cannot garnish debtors' wages, or contact the debtor to demand money.

After the petition is filed, the case trustee is appointed by the court and holds a meeting of the debtor's creditors. During this meeting, the debtor answers questions under oath about their debts and about their finances and property; both the trustee and the creditors can ask questions.

If the case trustee determines that the case is presumed abusive under the means test, they advise the court.

All of the debtor's nonexempt property is moved into an "estate." The Chapter 7 trustee's job is to sell this property in a way that gets the most money, then distribute the proceeds equitably to the creditors under section 726 of the Bankruptcy Code. The statute sets up six levels of claims. The creditors of each level must be paid in full before the next lower level of creditors gets paid.

An individual debtor rarely gets any money from this sale. They are largely concerned with being assigned the exempt property, then getting discharged as many remaining debts as possible.

Note that these debts cannot generally be discharged in bankruptcy:

• Child support.
• Alimony.
• Student loans.
• HOA fees.
  
• Personal injury debts that result from a DUI.
  
• Unsecured debts intentionally unaccounted in the petition.
  
• Most tax liens.
• Secured debts.

Both individual debtors or business entity debtors may qualify for relief under Chapter 7 of the Bankruptcy Code. Business debtors can be partnerships, corporations or other business entities, but most filers for Chapter 7 bankruptcy are individuals.

To be eligible to file for Chapter 7 bankruptcy, debtors whose current monthly income exceeds their state's median income must pass a means test. The Bankruptcy Code requires the court to apply this test to determine whether the Chapter 7 filing is abusive.

Basically, this inquiry reviews the debtor's monthly income over five years, subtracting allowed expenses and secured debt payments.

Abuse of the bankruptcy filing process is presumed if this amount is not less than either 25 percent of the debtor's non-priority unsecured debt, or $9,075, whichever is greater, or $15,150.

The debtor is able to offer evidence rebutting the presumption of abuse if they can show special circumstances that justify other expenses or reductions to current monthly income.

If the individual debtor meets the means test, they can apply for Chapter 7 bankruptcy.

It doesn't matter if they are solvent or not, and the amount of their debts is not relevant. However, an individual cannot file under Chapter 7 – or any other chapter of the Bankruptcy Code – if they have filed a petition within the prior six months, and:

• That petition was dismissed because of the debtor's willful failure to appear before the court or comply with orders of the court, or
  

• Debtor voluntarily dismissed the prior bankruptcy filing because their creditors sought relief from the Bankruptcy Court to recover property upon which they hold liens.
  

A debtor must also get credit counseling from an approved credit counseling agency within six months prior to filing the petition.

An honest debtor who is overwhelmed by debt can get a second chance – a new start – by discharging their debts in bankruptcy. For example, a debtor who was keeping up with their medical bills and credit cards might lose their job and be unable to continuing paying.

In a successful Chapter 7 case, the debtor walks out of the courtroom with no liability for discharged debts. Note that most Chapter 7 filings are successful.

In 2020, 94.9 percent of Chapter 7 filings were successful, and most resulted in discharge of debts.

In a Chapter 7 case, discharge of debts is available only to individual debtors. Partnerships, corporations and other business entities do not get to discharge their unpaid debts. And some types cannot be, or usually aren't, discharged in Bankruptcy Court. And a bankruptcy discharge does not extinguish a lien on a property.

Chapter 7 and Chapter 13 are the two most common types of bankruptcy, but they are otherwise very different proceedings. Each serves a particular type of financial situation.

Chapter 7 bankruptcy is usually filed by an individual who has more debts than they can stay on top of. An individual or a business overwhelmed by debt can file for Chapter 7 bankruptcy. Some property is termed "exempt" and will not be sold in bankruptcy, but most will, with the proceeds distributed to creditors. That is why it is called "liquidation" bankruptcy.

The debtor is relieved of many of their debts, but not all types of debts can be discharged in bankruptcy. Notably, tax debts, child support debts, and student loan debts are rarely discharged.

On the other hand, Chapter 13 bankruptcy is appropriate for those companies and individuals that are not able to pay their current debts, but may be able to become solvent if allowed to reorganize. Those filing for Chapter 13 bankruptcy present the court with a repayment plan. The court presides over the reorganization and allows them to reemerge as viable enterprises.

The bankruptcy court usually grants a discharge from Chapter 7 bankruptcy about 16 to 36 weeks after the bankruptcy petition is filed. One of the reasons that Chapter 7 bankruptcy is so popular is the speed with which it proceeds.

However, a case can sometimes take longer. For example, a matter like trying to get student loans discharged in bankruptcy may necessitate a lengthy trial.

Part of understanding the bankruptcy process is knowing that while a Chapter 7 petition gives a debtor the chance to start over, the debtor's credit will be affected negatively for 10 years after filing the petition. This makes it difficult to get credit at a reasonable rate of interest.

Borrowers with low credit scores who are offered credit may pay double the national average for borrowers without a bankruptcy on their credit report.

A bankruptcy proceeding of any kind negatively impacts the debtor's credit score. It usually stays on a debtor's credit record for 10 years from the date the petition is filed. However, the accounts paid off or discharged in the bankruptcy are removed from the credit report earlier than that.

When an individual files for Chapter 7 bankruptcy, all debt collection efforts against them by creditors are immediately and automatically stopped.

The debtor presents the court with information about their assets and debts, as well as other financial matters, including a list of property they own that is exempt under the Bankruptcy Code. They are usually allowed to keep all exempt property while all other property is sold to pay off creditors. Most remaining unsecured debts are dissolved.

Chapter 7 bankruptcy offers a debtor the chance for a fresh start. But anyone considering this must understand that they will end up with less property and fewer assets than they had going into Bankruptcy Court. Discharging debts can be a great relief, but a bankruptcy proceeding also results in bad credit and difficulty getting credit in the future. Whether this will work well for a particular individual depends on their exact circumstances.

When an individual files a petition for Chapter 7 bankruptcy, this stays on their credit report for between seven and 10 years.

Chapter 7 and Chapter 13 are the two most common types of bankruptcy proceedings.

• ‌Chapter 7 bankruptcy‌ — an individual or a business with excess debts can get some relief. They get to keep exempt property, but most of their assets are sold, and the proceeds go to pay off creditors.
• ‌Chapter 13 bankruptcy —‌ the debtor reorganizes their debts and provides a new payment plan that gives them additional time to pay. They emerge from bankruptcy as viable enterprises.