Couple Contemplating Filing for Bankruptcy Have More Choices Than They Think

Q My wife and I were considering filing for Chapter 7 bankruptcy until we discovered that

we stood to lose some family heirlooms of significant value. Our principal problem is a house that is worth about $40,000 less than we owe on it.

We understand that we are liable for income taxes on any amount of the debt that is not repaid when the house is either lost through foreclosure, through deed in lieu of foreclosure or sold in a short sale.

What real choices do we have open to us? Clearly, we are not able to pay taxes on $40,000 of income we never received. Also, is our mortgage--a first trust deed--a recourse loan? Finally, what are the consequences of filing for bankruptcy? Some people tell us it’s horrible; others say it’s no big deal.

--M.B.

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A You may have more alternatives than you think, says Robin Leonard, author of several books on credit and bankruptcy issues for Nolo Press. First, a Chapter 7 bankruptcy does expose you to a forced sale of any valuable possessions, such as heirlooms, to offset your debts. And it’s also true that unless you file for Chapter 7 bankruptcy, any forgiven mortgage debt will be considered taxable income for the year in which the debt is waived.

What now? If getting rid of your house is your primary objective, Leonard recommends that you do it and accept the tax consequences. Then you could file for Chapter 13 bankruptcy protection, a process that allows you to pay your debts over three to five years. Although this type of bankruptcy--unlike Chapter 7--doesn’t discharge your tax obligation entirely, it will allow you to repay the levy over time and without any accrual of interest or penalties on the outstanding balance, Leonard says.

Another possibility, Leonard says, is to skip the bankruptcy filing and go straight to the Internal Revenue Service and attempt to negotiate a tax repayment plan that meets your financial situation. But the IRS is under no obligation to accept your pleas for leniency, and you do not have the protection of bankruptcy laws against the accrual of interest and penalties. By the way, if the mortgage on your house was made when you purchased your home, then it is a purchase money mortgage, which in California is a no-recourse loan. This means that the lender cannot attach your other assets for repayment of the note.

Now for the consequences of a bankruptcy filing. According to Leonard, there are three major ramifications: It will be a blotch on your credit record, it could prevent you from getting a residential or business rental, and it might hurt your efforts to get a new job.

Let’s look at each of these. A Chapter 7 bankruptcy filing, which essentially wipes out your unsecured debts, will stay on your credit record for 10 years. A Chapter 13 filing can also be listed for 10 years, but in practice most credit bureaus erase it after seven years. Practically speaking, Leonard says, most employed, motivated and disciplined people find they can overcome the stigma of a bankruptcy in their credit histories by taking immediate steps to restore their credit-worthiness after emerging from the legal process. These steps include getting a secured credit card, which is provided by lenders only if you pledge savings as collateral to your credit limit.

“Studies show that as many as 7 million Americans have filed for bankruptcy within the past decade, and the rate is currently running at more than 1 million filings per year,” Leonard says. “The credit industry cannot afford to exclude such a wide group of people from its reach, so it works with them.” Of course, people who have filed for bankruptcy pay more for this credit than those who haven’t.

Leonard says landlords, especially in tight rental markets, are increasingly asking prospective tenants to submit credit reports before renting residential or commercial real estate. If competition is particularly tough for a home or office, someone with a past bankruptcy could lose out to more credit-worthy applicants. At the very least, a landlord may require you to have a co-signer on any rental agreement.

The same principle applies to job hunting. Although it is illegal for you to be fired or demoted from your job because of a bankruptcy filing, a prospective employer cannot be prohibited from hiring someone else. Leonard says that an increasing number of employers, particularly in the financial services industry, are asking job applicants to disclose their financial histories. Leonard adds that a law that will take effect later this year will give them the right to ask applicants for permission to obtain their credit reports.

For more information on bankruptcy, visit your local library or bookstore. Nolo Press in Berkeley has three books on the issue: “Money Troubles: Legal Strategies for Coping With Your Debts,” “Chapter 13: Repay Your Debts” and “How to File for Bankruptcy.” Also, check out Nolo’s home page at https://www.nolo.com

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. Or send e-mail to [email protected]