The New Bankruptcy Law

Here are some of the major changes you should know about.

Now that the new bankruptcy law is in effect, the landscape has changed for those who are considering bankruptcy. All debtors will have to get credit counseling before they can file a bankruptcy case -- and additional counseling on budgeting and debt management before their debts can be wiped out. Some filers with higher incomes won't be allowed to use Chapter 7, but will instead have to repay at least some of their debt under Chapter 13.

Here are some of the most important changes.

Before you can file for bankruptcy under either Chapter 7 or Chapter 13, you must complete credit counseling with an agency approved by the United States Trustee's office. (To find an approved agency in your area, go to the Trustee's website, www.usdoj.gov/ust, and click "Credit Counseling and Debtor Education.") The purpose of this counseling is to give you an idea of whether you really need to file for bankruptcy or whether an informal repayment plan would get you back on your economic feet.

Counseling is required even if it's obvious that a repayment plan isn't feasible or you are facing debts that you find unfair and don't want to pay. You are required only to participate, not to go along with any repayment plan the agency proposes. However, if the agency does come up with a repayment plan, you will have to submit it to the court, along with a certificate showing that you completed the counseling, before you can file for bankruptcy.

Once your bankruptcy case is over, you'll have to attend another counseling session, this time to learn personal financial management. Only after you submit proof to the court that you fulfilled this requirement can you get a bankruptcy discharge wiping out your debts. (The website above also lists approved debt counselors.)

Under the old rules, most filers could choose the type of bankruptcy that seemed best for them -- and most chose Chapter 7 over Chapter 13. The new law will prohibit some filers with higher incomes from using Chapter 7.

Under the new rules, the first step in figuring out whether you can file for Chapter 7 is to measure your "current monthly income" against the median income for a family of your size in your state. Your "current monthly income" is not your income at the time you file, however: It is your average income over the last six months before you file. For many people, particularly those who are filing for bankruptcy because they recently lost a job, their "current monthly income" according to these rules will be much more than they take in each month by the time they file for bankruptcy.

Once you've calculated your income, compare it to the median income for your state. (You can find median income tables, by state and family size, at the website of the United States Trustee, www.usdoj.gov/ust; click "Means Testing Information.")

If your income is less than or equal to the median, you can file for Chapter 7. If it is more than the median, however, you must pass "the means test" -- another requirement of the new law -- in order to file for Chapter 7.

The purpose of the means test is to figure out whether you have enough disposable income, after subtracting certain allowed expenses and required debt payments, to make payments on a Chapter 13 plan.

To find out whether you pass the means test, you start with your "current monthly income," calculated as described above. From that amount, you subtract both of the following:

• Certain allowed expenses, in amounts set by the IRS. Generally, you cannot subtract what you actually spend for things like transportation, food, clothing, and so on; instead, you have to use the limits the IRS imposes, which may be lower than the cost of living in your area.
• Monthly payments you will have to make on secured and priority debts. Secured debts are those for which the creditor is entitled to seize property if you don't pay (such as a mortgage or car loan); priority debts are obligations that the law deems to be so important that they are entitled to jump to the head of the repayment line. Typical priority debts include child support, alimony, tax debts, and wages owed to employees.

If your total monthly disposable income after subtracting these amounts is less than $100, you pass the means test, and will be allowed to file for Chapter 7. If your total remaining monthly disposable income is more than $166.66, you have flunked the means test, and will be prohibited from using Chapter 7.

So what about those in the middle? They have to do some more math. If your remaining monthly disposable income is between $100 and $166.66, you must figure out whether what you have left over is enough to pay more than 25% of your unsecured, nonpriority debts (such as credit card bills, student loans, medical bills, and so on) over a five-year period. If so, you flunk the means test, and Chapter 7 won't be available to you. If not, you pass the means test, and Chapter 7 remains an option.

The new law imposes some additional requirements on lawyers, chief among them that the lawyer must personally vouch for the accuracy of all of the information their clients provide them. This means attorneys will have to spend even more time on bankruptcy cases.

Under the old rules, people who filed under Chapter 13 had to devote all of their disposable income -- what they had left after paying their actual living expenses -- to their repayment plan. The new law adds a wrinkle to this equation: Although Chapter 13 filers still have tohand over all of their disposable income, they have to calculate their disposable income using allowed expense amounts dictated by the IRS -- not their actual expenses -- if their income is higher than the median in their state (see "Restricted Eligibility for Chapter 7," above). These expenses are often lower than actual costs.

What's worse, these allowed expense amounts must be subtracted not from the filer's actual earnings each month, but from the filer's average income during the six months before filing. This means that debtors may be required to pay a much larger amount of "disposable income" into their plan than they actually have to spare every month -- which, in turn, means that many more Chapter 13 plans will fail.

Under the old law, Chapter 7 filers could value their property at what they could sell it for in a "fire sale" or auction. This meant that used furniture, hobby items, cars, heirlooms, and other property a debtor might want to keep were typically assumed to have little value -- and, therefore, that it often fell well within the "exempt property" categories offered by most states. (Exempt property is property that cannot be taken by creditors or the trustee -- you are entitled to keep it.)

Under the new law, you must value your property at what it would cost to replace it from a retail vendor, taking into account the property's age and condition. This requirement is sure to jack up the value of property, which means more debtors stand to have their property taken and sold by the trustee.

Under the old bankruptcy law, the personal property debtors were allowed to keep in Chapter 7 bankruptcy was determined by the laws of the state where they lived (as long as they lived there for at least three months). Under the new law, you must live in a state for at least two years prior to filing in order to use that state's exemption laws. Otherwise, you must use the exemptions available in the state where you used to live. Similar rules apply to homestead exemptions, which determine how much equity in a home you can keep when filing for Chapter 7 bankruptcy. However, to use your new state's homestead exemption, you must live there for at least 40 months.

Because exemption amounts vary widely from state to state, these new residency requirements could make a big difference in the amount of property you get to hold on to. For example, if you recently moved from California to Nevada and you have a fairly valuable car, you might want to wait to file for Chapter 7: Once you've been in Nevada for two years, you can claim its $15,000 exemption for motor vehicles. If you have to use California's exemptions, you can keep only $2,300 worth of equity.