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Monday, May 1, 2017

Who is Eligible to File Bankruptcy?

I'm often asked about whether a particular person is eligible to file bankruptcy.  A lot of people think their income is too high.  There are a lot of misconceptions about the 2005 Bankruptcy Code revisions and their impact on an individual debtor's ability to file for bankruptcy reliefin particular, the so-called "means test."

In a nutshell, what Congress did was create an income/expense calculation that was supposed to coerce consumer debtors (it does not apply to debtors whose debts are primarily business-related) who are over a certain income threshold into filing a repayment plan under Chapter 13 of the Bankruptcy Code, instead of allowing them to discharge debts through a Chapter 7.

The resulting means test is a somewhat complicated mathematical exercise; but luckily, Congress also put in a few "safe harbors." The most common safe harbor provides that if you make less than the median income for your household size in your state of residence, then you don't have to go through the full means test calculation.  The United States Trustee's Office (the part of the U.S. Department of Justice responsible for oversight of  bankruptcy cases) has recently published revised median income figures, which are applicable for any bankruptcy case filed on or after May 1, 2017.  For Massachusetts, those figures are:
  • Household size of 1: $61,102
  • Household size of 2: $76,414
  • Household size of 3: $93,755
  • Household size of 4: $113,651
  • Add $8,400 for every household member over 4
If you are a Massachusetts resident considering a Chapter 7 bankruptcy and your total household income in the last 6 months is less than half the above figures (which are 12-month figures), you qualify for the median income safe harbor, and you will not have to worry about your Chapter 7 case being dismissed because you are over-income.

Even if you're over the safe harbor amount, you still may be able to satisfy the means test if you have enough qualifying expenses, or can otherwise demonstrate special circumstances justifying a departure from the standard test (like a recent drop in income).  Short of that, you could still file for bankruptcy under a different chapter of the Bankruptcy Code.  In short, bankruptcy remains an option for just about everyone.

Sunday, January 31, 2016

Congress extends tax relief for homeowners who experience a foreclosure or short sale

In an earlier post I wrote about the potential tax consequences for people with cancellation of debt (COD) income stemming from a foreclosure, short sale or mortgage principal write-down.  In that post I briefly described the insolvency exclusion that may be available to allow some people to treat the COD as a non-taxable event.

There is also another way homeowners may be able to "exclude" certain types of cancellation of debt from taxable income, and Congress recently extended this exclusion as part of the it's latest tax and spending bill.

While that's good news for many homeowners, the exclusion covers only a very specific type of cancelled debt called "qualified principal residence indebtedness" (QPRI).  First enacted in 2007 as the real estate bubble burst and foreclosures were becoming more common, the QPRI exclusion allows borrowers to avoid taxes on COD income, but only if the debt cancellation was for a mortgage that secured their main home, and only as long as it was originally taken out to buy, build, or substantially improve that home.  The QPRI exclusion also applies to any debt secured by a main home that was used to refinance a mortgage taken out to buy, build, or substantially improve the main home, but only up to the amount of the old mortgage principal just before the refinancing.


Because of the limitations on the QPRI exclusion, a lot of people who had tapped their home equity for purposes other than refinancing a purchase money mortgage or home improvements are not able to take advantage of it.

The QPRI exclusion had expired at the end of 2014, but Congress recently extended the law through the end of 2016, so anyone with qualifying COD income in 2015 or 2016 will be able to take advantage of the exclusion.  The new law also includes language that covers "an arrangement that is entered into and evidenced in writing before" the end of 2016.  Presumably, this would cover a situation where an agreement for the cancellation of debt in connection with a deed-in-lieu of foreclosure or short sale is signed in 2016, but doesn't close until after the end of the year.  This is a potentially helpful planning device that was missing from the original law.

As I described in more detail in my last post, debts discharged as part of a bankruptcy never result in taxable COD income.   However, once the bank cancels a borrower's debt outside of a bankruptcy, assuming it's a taxable event, those taxes cannot be discharged in a bankruptcy commenced in the next three-plus years.  As a result, timing is critical, and a bankruptcy filed prior to receiving a 1099-C from the bank can be an effective strategy for avoiding taxes on COD income.

Friday, December 18, 2015

Housing Crash Persists for Many

As remarkable as it sounds, even though it's been almost a decade since the peak of the housing bubble, RealtyTrac recently reported that there are still almost 7 million residential properties that are "seriously underwater," which it defines as any property where the outstanding mortgage balances exceed the property's estimated value by at least 25%.  The housing data provider estimates that approximately 13% of all residential properties with a mortgage are still seriously underwater.

So, what does this mean for people who are this far underwater and can no longer make their mortgage payments?

Tax Implications of Walking Away
People are frequently surprised when they find out that they could end up owing taxes on "cancellation of debt income" after going through a short sale or foreclosure.  This happens when property is underwater and the bank recovers less through the short sale or foreclosure than was owed under the mortgage.

Depending on the circumstances, the bank may decide to sue the homeowner for the deficiency after a short sale or foreclosure.  If and when the bank comes up empty, it will cancel the debt.  When the bank cancels the debt, it will issue a 1099-C, which reports to the IRS the amount of the debt it cancelled on its books.  This amount is reported as income to the borrower.  The bank does this because the money that was given to the borrower in connection with the mortgage loan is no longer expected to be repaid, so it counts as income.

Depending on the borrower's financial situation, this cancellation of debt income may constitute a taxable event.  One way the borrower can avoid tax liability on the cancelled debt is if the borrower is insolvent (i.e., total liabilities exceed total assets), but only to the extent the borrower is insolvent as of the date of the debt cancellation.  This can be a complicated exercise, and may require the assistance of an accountant to determine the extent of any tax liability.

Bankruptcy as a Solution to Tax Problem
It's important to note that the IRS's insolvency definition requires borrowers to include their retirement accounts as assets in the calculation.  If a person has more than a few thousand dollars in his or her retirement accounts, this can make it much more difficult for borrowers to establish that their insolvency was greater than the amount of the debt cancelled.  By contrast, funds held in a tax sheltered retirement account like a 401k or IRA can be protected in a bankruptcy.  This means you can avoid a potential tax hit on cancellation of debt income if you file bankruptcy.

But Delay Could be Costly
If a borrower files bankruptcy before the bank cancels the debt, any money owed to the bank will be eliminated (the legal term is discharged) as part of the bankruptcy.  Debts discharged in bankruptcy are never taxable. 

However, if the borrower does not act until after he or she receives a 1099-C, any income taxes owed on that cancelled debt cannot be discharged in a bankruptcy filed in the next 3-plus years.  This means that if you wait until you receive a 1099-C, you can't get the benefit of a bankruptcy discharge with respect to any income taxes arising out of the debt cancellation for at least another three years.

If you've recently gone through a foreclosure, short sale or principal reduction (or are considering one), and you're being pursued by the bank for a deficiency, or if you're concerned that you may have cancellation of debt income, please give me a call to discuss if a Chapter 7 bankruptcy could put these matters to rest.

Friday, October 3, 2014

Bankruptcy and its Impact on Credit Scores and Access to Credit (Part II--Credit Scores)

In my last post, I covered the derogatory payment history information that can find its way into a credit report, and how long it can stay there.  As I described in more detail in that post, bankruptcies will stay on a credit report for 10 years after you file and missed payments will stay on the report for 7-7½ years.  This is important to know because, as long as these negative items are on a credit report, they are fodder for negatively impacting a credit score.  In this post, we'll try to get a handle on just how big an impact a negative payment history has on the credit score.

I.  Which score matters most?

In the earlier post I said there's no such thing as one, omnipresent credit score that is used by all creditors in all situations.  That was accurate as far as it goes, but in reality the FICO scoring formula is, by far, the most commonly used.*  Given the overwhelming importance of FICO scores, I've limited my discussion below to FICO scores, though other, less widely-used scoring products no doubt follow similar patterns.  

II.  What is the purpose of a credit score?

As mentioned in the previous post, the credit score is supposed to provide a numeric value that will enable a potential lender to assess a borrower's risk of default.  More specifically, most scoring models are supposed to provide an assessment of the risk of default in the next 18-24 months.  The "classic" FICO scoring scale goes from 300 (highest risk of default) to 850 (lowest risk of default).  

III.  How does the FICO Score treat derogatory events like defaults and bankruptcies?

According to FICO, the largest factor in the scoring model (35% of the total) is, unsurprisingly, a person's "payment history."  This is where payment delinquencies, settled debts, foreclosures and bankruptcies come into play.  

The good people at FICO have been nice enough to provide a hypothetical comparison of two people (one with a very good score and one with a more mediocre score), and how each of their scores fared after various negative credit events.  

According to these hypothetical scenarios, a person with a credit score of 780 could expect a drop to:  (i) 670-690 with one 30-day delinquency on one credit account, (ii) 655-675 after settling one credit card debt, (iii) 620-640 after a foreclosure, and (iv) 540-560 after a bankruptcy.

By contrast, a person with a credit score of 680 could expect a drop to: (i) 600-620 with one 30-day delinquency on one credit account, (ii) 615-635 after settling one credit card debt, (iii) 575-595 after a foreclosure, and (iv) 530-550 after a bankruptcy.

IV.  What does this mean for people considering bankruptcy?

For people who are contemplating a bankruptcy (namely, people who have probably already defaulted on multiple credit accounts, or are expecting that they will soon have to do so because of difficult financial straits), I think FICO's hypothetical scenarios make a few things clear:
  1. Simply one 30-day delinquency on one account results in a 60 to 110 point drop for debtors with these credit profiles.  By contrast, a bankruptcy will result in a 130 to 240 point drop for these same debtors.  This means merely being 30 days late on one account has almost half the effect of a bankruptcy filing (at least in the short term).
  2. This hypothetical also shows that, if you've missed multiple payments lately, your credit score has probably already taken a substantial hit (undoubtedly much more than the 60 to 110 points projected for being 30 days late on just one account).  For a person desperate enough to be contemplating bankruptcy, the alternative (default on multiple debts) doesn't promise much of a credit score improvement over a bankruptcy.  
  3. On a related note, the hypothetical shows that people with higher credit scores suffer a bigger "hit" to their score with a bankruptcy--about 90 points worse for the person with the stronger score.  In fact, on a different page, the FICO website makes this point explicitly: "[S]omeone with many negative items already listed on their credit report might only see a modest drop in their score [as a result of a bankruptcy]." 
People under acute financial distress and contemplating bankruptcy rarely have high credit scores, so their credit score hit from a bankruptcy will not be anywhere near as large as it would be for someone with pristine credit.
The FICO site also alludes to another aspect of a bankruptcy's impact on a credit score when it says that "the more accounts included in the bankruptcy filing, the more of an impact on your score."  Since default on more than one account is much worse for a credit score than default on just one account (and defaults on larger accounts are worse than defaults on smaller accounts), it's unsurprising that a bankruptcy involving the discharge of many debts would be worse than a bankruptcy discharge of just a few debts.

V.  Is a Chapter 7 more or less detrimental to a credit score than a Chapter 13?

In the last post I wrote that the FCRA requires the CRAs to report which chapter of bankruptcy relief a person files under, so it must matter for purposes of calculating a person's credit score, right?  Apparently not.  The FICO website says that their scoring system treats Chapter 7s and Chapter 13s as "having the same level of severity" because their "research has found both types [of bankruptcy] to be similarly predictive in assessing future creditworthiness."  (I find this statement surprising, but we have no choice but to take them at their word.)

Therefore, to the extent a person contemplating bankruptcy is trying to decide whether a Chapter 7 or a Chapter 13 is right for them, the impact on their credit score need not be a consideration.

VI.  Summing Up

Near-term credit score considerations are rarely a factor for people contemplating bankruptcy, since people generally don't even consider a bankruptcy unless they're already in a position where they feel that they are unable satisfy their debts.  People who have been able to maintain a higher credit score despite struggling with debt have more at stake than those who have already defaulted on multiple accounts, but even these people need to make a sober assessment of whether they have any reasonable likelihood of retiring their debt in the future without being delinquent (or deferring critical home and car maintenance, retirement savings, etc., which are, after all, much more essential to long-term financial security than a solid credit score).

As described above, a bankruptcy filing pretty much guarantees a credit score in the 500s in the immediate aftermath of the filing.  But how long does that last?  In the next post, I'll address the somewhat more nebulous issue of how long it takes to resurrect a credit score after a bankruptcy.

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* For example, the Consumer Financial Protection Bureau, citing industry sources, estimated that 90% of the credit scores sold to lenders in connection with credit-related decisions in 2010 were sold by FICO.  In addition, Fannie Mae and Freddie Mac require mortgage originators (banks and other lenders) to use the "classic FICO score" in making credit evaluations if they wish to sell mortgages on the secondary market through Fannie or Freddie.  Moreover, the Federal Housing Authority uses FICO scores in connection with loans that are going to be insured through the FHA.

Monday, September 22, 2014

Bankruptcy and its Impact on Credit Scores and Access to Credit (Part I--Credit Reports)

I get a lot of questions from clients about how a bankruptcy will affect their credit score.  It is at this point when I am typically forced to give a frustratingly vague answer: "It depends," or its even more aggravating cousin: "It's complicated."

Since I recognize that these are wholly unsatisfying responses, I've decided to dedicate the next few blog posts to the issue of credit reports, credit scores, the effect of a bankruptcy on credit scores, and its potential impact on access to credit and the interest rates at which people can borrow.  As I said, this is a complicated subject.  It's complicated for two reasons: (1) because the credit scoring algorithms are considered proprietary trade secrets not available to the general public, and (2) because every lender has its own set of lending criteria based (in part) on whatever score the lender happens to use.  Because of this opaque system, any specific prediction about a person's credit score and (more importantly) his or her future access to credit is necessarily speculative.

That said, there are certain aspects of the credit reporting and credit scoring system that are known, which we can use to make some educated guesses about how a person's access to credit will be impacted by a bankruptcy filing.

First, some basics:

Though we often refer to a person's credit score as if it's some magic number that single-handedly determines whether a person gets credit and at what rate in all circumstances, that is not really the case. There is no such thing as a universal credit score for any given person.  The term "credit score" is a generic term referring to some company's calculation of what they perceive to be a consumer's risk of default in the future.  This calculation is then sold to a lender so that the lender can make a decision about whether or not to extend credit, and at what rate.  Some lenders use their own scoring models, rather than buying a scoring algorithm "off the rack" from a third-party company.

The calculation of a credit score is based on raw data which are supposed to be predictive of a person's potential for default.  The raw data that are used are generally drawn from the information in a person's credit report from one of the three major consumer credit reporting agencies (Equifax, Experian, or TransUnion).  These companies are commonly referred to as CRAs.  Some scoring systems use additional information beyond that drawn from the CRAs, but for the purposes of this post, it is sufficient to focus on what is reported in the CRAs and for how long.

Since the raw data that are fed into the credit scoring models come from the credit reports maintained by the CRAs, it's first important to understand what derogatory payment history information makes it into the credit reports and how long it stays.

Under the federal Fair Credit Reporting Act, the CRAs are permitted to report a bankruptcy on a credit report for 10 years from the date the bankruptcy is filed.  The Fair Credit Reporting Act makes no distinction between a bankruptcy case filed under Chapter 7, 11, 12 or 13, so cases filed under those chapters are all reported for the same 10 year period.  However, the law does require the CRAs to specify which chapter of bankruptcy relief a person filed under.

This sounds like bad news for people considering a bankruptcy, but it's important to keep in mind that most other negative credit information (like delinquent payments) can and will stay on a report for 7 years.*  The 7 year period starts to run the month the first payment is missed.  The CRAs are allowed to report a delinquent debt for an extra 180 days if the account is "placed for collections" or "charged-off" more than 180 days after the delinquency.  This means that the 7-year clock can start all over again once the delinquent account goes to collections or is charged-off, but only for up to 180 days more. The upshot is that debtors have to assume that delinquencies can stay on their credit reports for 7½ years from the date they first miss a payment.

In addition, CRAs are permitted to report delinquent debts even if the statute of limitations for enforcing the debt has run and the creditor could no longer file a lawsuit to recover on the debt.  It's also worth remembering that a creditor's "charge-off" of the account does not shorten the length of time the payment delinquency is reported on a credit report.  A charge-off is merely an accounting term for when the creditor recognizes for its own bookkeeping purposes that the loan has become non-performing.

In short, the only relevant date for the purposes of calculating the reporting period is 7 years from the date of the first delinquent payment, plus up to 180 days more if and when the account goes to collections or is charged off.

All this means that, just because creditors have stopped trying to collect on a given debt (and you may have forgotten about it), it does not mean that the debt is no longer adversely impacting your credit. This is one of the many reasons why it's important to check your credit reports regularly (the other big reasons being mistakes on the credit report, which are all too common, and identity theft).

That's the background on how, and for how long, delinquent debts and bankruptcies get reported on a credit report.  Again, this is important because your credit reports provide the raw material that is used to generate a credit score, which is in turn relied upon by lenders in making credit decisions.  In my next post, I'll cover the credit score in more detail: how it is comprised in general, how much of the score is derived from payment/non-payment history, and a discussion of how bad payment history can impact the score.

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*There are a couple of wrinkles which are of no interest to anyone but me, which I include simply in the interest of completeness.  Feel free to skip.

Technically, the Fair Credit Reporting Act permits CRAs to report payment delinquencies for longer than 7 years and bankruptcies for more than 10 years if the report is to be used in in connection with certain high-dollar transactions--for example, in a credit decision expected to involve $150,000 or more.  15 U.S.C. § 1681c(b).  However, the Consumer Financial Protection Bureau reports that, as a practical matter, the CRAs "do not utilize these exemptions, and cease reporting negative information after the standard time limits have elapsed."  Consumer Financial Protection Bureau White Paper, December 2012, "Key Dimensions and Processes in the U.S. Credit Reporting System: A review of how the nation’s largest credit bureaus manage consumer data"  (Footnote 23).  Presumably this is because the burden of establishing administrative safeguards against accidentally disclosing older information in connection with non-qualifying transactions is too much for the CRAs to handle (they have enough trouble complying with the law as it is).  And in any event, it's hard to see how credit history relating to events so far into the past would be of much relevance in rendering credit decisions anyway.

Also, the Federal Trade Commission (which was the agency responsible for enforcing the FCRA until the Dodd-Frank bill shifted that responsibility to the CFPB) has issued some non-binding guidance that suggests that withdrawn or dismissed voluntary bankruptcies can be reported for ten years from the date of dismissal, rather than 10 years from the date the case is filed.  40 Years of Experience with the Fair Credit Reporting Act: An FTC Staff Report with Summary of Interpretations, Federal Trade Commission, July 2011, § 605(a)(1)(3).  This could have major ramifications for Chapter 13 debtors, where a case may get dismissed years after it is filed.  However, this FTC guidance should be ignored because it directly contravenes the FCRA (and in any event is non-binding).  The FTC guidance stems from an informal opinion letter issued in connection with an involuntary bankruptcy that misconstrues the meaning of "adjudicated" in 15 U.S.C. § 1681c(a)(1).  For a whole variety of complex statutory interpretation reasons having to do with the the terminology of the old, pre-1978 Bankruptcy Act (which was in effect when the FCRA was originally enacted in the 1970s) and the difference between voluntary and involuntary bankruptcy cases (which I will spare everyone), I believe this guidance is wrong with respect to voluntary bankruptcies and should be ignored.