Divorce and Bankruptcy

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Divorce and bankruptcy affect each other, so plan carefully.Financial stress may be a factor in the decision to get divorced. Divorce itself may also cause financial stress. Many couples who were able to handle the household debt while living together may find it difficult or even impossible to pay that debt once they have separated. As a result, you may find yourselves considering both divorce and bankruptcy.

How Bankruptcy and Divorce Affect Each Other

When someone files bankruptcy, the Bankruptcy Code imposes an “automatic stay,” meaning certain actions against the person who has filed bankruptcy cannot continue. Examples of actions that are stopped include collections actions, wage garnishments, collection calls and letters, and foreclosure actions.

Bankruptcy and Marital Assets

If the person who has filed bankruptcy is going through a divorce, the matrimonial court may not order a division of the marital assets until the bankruptcy case is over or the bankruptcy court gives permission to continue the division of assets, including the home and retirement accounts.

Other aspects of a divorce action, however, may continue even if one of the parties has filed bankruptcy. A matrimonial judge may still decide on issues such as child support, custody and visitation even if the husband or the wife has filed bankruptcy.

Bankruptcy and Marital Debt

Bankruptcy courts and divorce courts look at debt differently. Bankruptcy courts only look at whose name the debt is in. Matrimonial courts view debt incurred during the marriage as “marital debt” regardless of whose name it is in.

Let’s say a husband has $30,000 in credit cards in his name, the wife has $10,000 in debt, and the parties have similar income. A matrimonial court might even out the debt level by ordering the wife to be responsible for $10,000 worth of debt that is in the husband’s name.

However, if the husband were to file bankruptcy, he could likely discharge all $30,000 of the credit cards in his name, leaving only $10,000 in marital debt for the matrimonial court to divide up.

Bankruptcy, Child Support, and Spousal Maintenance

The bankruptcy system ensures that the person who files bankruptcy is paying their domestic support obligations. If the spouse has an obligation to pay child support, alimony or maintenance, the spouse will have to fill out a domestic support obligation form giving the contact information for the person they pay the support to. The bankruptcy Trustee must inform the domestic support recipient that the person who pays their support has filed bankruptcy and inform the recipient where the payor works.

In addition, if you file a Chapter 13 bankruptcy (explained below), you cannot get your Chapter 13 plan confirmed or obtain a Chapter 13 discharge unless you can testify under oath that you have kept current on your support obligations since your bankruptcy case was filed.

Which Comes First?

People often ask whether it is better to file bankruptcy first and then proceed with divorce, or whether they should get divorced first and then file bankruptcy.

Option 1: Bankruptcy Before Divorce

In some cases, it is better to do the bankruptcy first. Division of marital debt can be a contentious issue. If either or both parties file bankruptcy, it can eliminate the vast majority of the marital debt, leaving one less issue to resolve in the matrimonial action.

Also, since a bankruptcy Trustee can sometimes undo the division of marital assets (such as the transfer of a house without consideration), it may be better to keep the house titled in both names and file bankruptcy. Then when the bankruptcy is done, resume division of martial assets.

Option 2: Divorce Before Bankruptcy

However, sometimes it is better to have aspects of the divorce action decided first, such as child support or spousal maintenance. Someone whose income is too high to qualify for Chapter 7 (explained below) might be able to file Chapter 7 after the amount of support they pay is deducted from their gross income.

Be Careful with the Transfer of Assets During Divorce

If the decision is made to finalize the divorce before the bankruptcy, it is important to make sure that any transfer of assets is supported by adequate consideration in return.

For example, assume the husband and wife jointly own the marital home, it is worth $150,000, and it has a $100,000 mortgage on it. That leaves $50,000 equity in the house. The bankruptcy court assumes that each parties’ equity in the house is $25,000.

Also assume the husband transfers his interest in the house to the wife via a “quit claim deed,” without getting approximately $25,000 in return.

If he files bankruptcy within the next 6 years after the divorce, his bankruptcy Trustee may be able to undo the transfer of the house into the wife’s name and put the house back into joint ownership.

To prevent this, during the divorce, the wife first needs to pay the husband $25,000 in some way in order to buy out the husband’s interest in the property. This can be accomplished by a refinance of the mortgage so that the husband is paid $25,000 out of the mortgage proceeds. Or the wife could give up $25,000 of other assets that she would have otherwise gotten in the divorce.

Types of Bankruptcy

Certain debts, including the obligation to pay child support and maintenance, are never able to be discharged in bankruptcy. Most income taxes also do not go away in bankruptcy. Nearly all student loans survive bankruptcy. Whichever Chapter of bankruptcy you choose, it is imperative that you disclose all of your assets in your paperwork.

There are 2 chapters of personal bankruptcy that you can file, Chapter 7 and Chapter 13.

Chapter 7 Bankruptcy

Chapter 7 is called a liquidation bankruptcy. You can obtain a discharge of most of your unsecured debts (such as credit cards, medical bills, car loan deficiencies, and unsecured personal loans), but may have to turn over non-exempt property in return. The Bankruptcy Code offers exemptions for many of assets that most people have, including retirement accounts and home equity, so in reality, most people can obtain a discharge in Chapter 7 without losing any assets.

Chapter 13 Bankruptcy

This involves repayment of debt over a 3-to-5-year period. Someone may opt for Chapter 13 when they have a debt they want to repay but need extra time to do so, such as mortgage arrears or certain tax debts.

Chapter 13 may also be the only bankruptcy option for someone who is over the median income for their family size for their state. In NY, the gross median income for a single person is currently $49,028, for a family of 2 is $62,377, for a family of 3 is $71,989 and for a family of 4 is $88,642. Sometimes a couple that would be over the income limits for Chapter 7 while still living together may individually quality for a Chapter 7 once they have physically separated.

Long-Term Impact of Bankruptcy

Filing bankruptcy is a big decision. A chapter 7 filing will stay on your credit report for 10 years and may adversely affect your ability to get future credit. For people who have until now kept current on all of their debt payments, a bankruptcy filing will cause a bigger drop to their credit scores than for people who have already fallen behind on debt payments. If you are already delinquent on debt payments (credit cards, mortgage, car payments, student loans, etc.), then a bankruptcy filing will have a much smaller impact on your credit score.

Bankruptcy is designed to give you a fresh start, free of wage garnishments, bank restraints, collections calls, and many debt payments. It is important to get good legal advice from an attorney knowledgeable in the interplay of bankruptcy and matrimonial law before deciding on the best course of action in your divorce if you think one or both of you may file bankruptcy.

About the Author: Deborah Schaal, Esq. is a partner at Gordon and Schaal LLP. She concentrates her practice on bankruptcy law. She is a past chair of the Monroe County Bar Association’s bankruptcy committee, and she lectures frequently at continuing legal education seminars on various bankruptcy topics. She received her B.S. from Cornell University in 1988 and her J.D. from Cornell Law School in 1991. She can be reached at (585) 244-1070. For more information, please visit www.gordonandschaal.com.

Photo Credit: (c) Can Stock Photo

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