New Law Tougher on Debtors


Erasing debts by filing for bankruptcy is about to get much tougher. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was signed by the President this week. This new law will sharply reduce the number of people eligible to relinquish their debts through bankruptcy.


Currently, individuals file for bankruptcy under Chapter 7 or Chapter 13. In a Chapter 7 bankruptcy, a debtor must liquidate all nonexempt assets and the proceeds are used to pay the creditors. Some of the debtor’s assets qualify as ‘exempt’ under their state laws, meaning that according to the law this asset is necessary for the debtor’s support and the support of their dependents, will not be liquidated. After all proceeds are paid, any remaining debts are cancelled and the individual is debt free. The key point about Chapter 7 bankruptcy is that many of the debtors do not have assets that can be liquidated and therefore most of their debts are erased and the creditors receive little or nothing.


In a Chapter 13 bankruptcy, instead of liquidating assets, the debtor is put on a repayment plan for up to five years. The payments are in regular installments until the debts are paid in full or until the end of a three to five year period.


The new law establishes provisions that will force more debtors to file under Chapter 13 and establish a repayment plan for their debts. The now law requires an income-based test. This test measures the debtor’s ability to repay his debts. Basically, if the debtor’s income is above his state’s median income and he can pay $6,000 over 5 years then he will be forced into Chapter 13 and the judge will set up a repayment plan. Other changes made in the law will enhance the restrictions and make it harder for debtors to abuse the bankruptcy laws.


One notable change involves limiting the state’s homestead exemption. A few states, Florida and Texas, for example, have unlimited homestead exemptions, meaning that if you file for bankruptcy, your home—regardless of its value—will be sheltered from creditors. The new law restricts a state’s homestead to $125,000 if the individual in bankruptcy bought his or her residence three years and four months before filing. The goal is to prevent the transfer of substantial assets into your home in anticipation of filing a Chapter 7 bankruptcy. Alabama has a low homestead exemption of only $5,000, therefore this particular change in the law does not have a major impact on residents of Alabama.


A second change in the law gives child support payments top priority among creditor’s claims, which will help single parent hardships. The bill also allows for special accommodations for the military that are in active duty, those that are seriously injured and low-income veterans.


Lawmakers did not make any changes to the loophole in the existing laws of debtor friendly states such as Delaware and Alaska. These states allow individuals to shelter assets into special Asset Protection Trusts that have special anti-creditor provisions barring invasion of the trust assets. Because of the costs to set up and maintain the trusts, they are typically reserved for the wealthy.


Let’s not forget that earlier this month debtors won a battle with the Supreme Court. On April 4, 2005, The Supreme Court ruled in the Rousey vs. Jacoway case that Individual Retirement Accounts Plans are similar to company pension plans and 401K therefore are protected under the same provisions because an individual can only receive payment from the IRA without a penalty at a certain age. Creditor protection for IRAs is further reinforced under this new law.


This law is poorly written and there is currently a 100-plus page technical corrections memorandum that will help clarify many of the provisions. “This law will tend to paint debtors into a corner for which there is now exit,” says Jim Henderson, an attorney who specializes in bankruptcy law and a partner with Pritchard, McCall & Jones of Birmingham. He expressed concern over what people will do when they feel they have no way out of their financial problems. We can only hope that the results will be positive and people will be much more careful in handling their personal finances.


My thanks to my associate Kimberly Reynolds, for her substantial work on this article.