Bankruptcy & Divorce (Part Two)

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In our previous post, Bankruptcy & Divorce: Part One, we examined the basics of Chapter 7 and Chapter 13 bankruptcy and how they handle debt (discharge versus reorganization).

In this post, we consider how to file for bankruptcy to make divorce less costly, fairer to both spouses, and less complicated.

When the timing of divorce is important, and the parties would prefer to get divorced sooner rather than later, Chapter 7 is the quicker and cleaner option. It will discharge all debt legally allowed and leave both spouses on a cleaner slate, albeit with a troubled credit rating. Chapter 13 will take much longer, perhaps as long as five years, and that may simply be too much for a couple to handle.

On the other hand, if the couple can agree to a legal separation after the issuance of the reorganization, and wait until discharge to complete the divorce, it will allow the couple to save more assets and their credit rating.

Why does the timing really matter?

Bankruptcy filings trigger an automatic stay on current finances – no other court can begin to allocate assets and no party can access assets once the freeze of the stay takes place. So, a bankruptcy ties the hands of a divorce court and complicates jurisdictional issues. In short, avoid doing both at the same time.

Which should come first?

If the couple has predominantly marital debt, it makes sense to discharge all of that marital debt collectively at once in advance of divorce so the parties have a clear picture of their actual assets and liabilities before they seek a divorce. In essence, bankruptcy assures that each spouse gets an equal benefit of the discharge of marital assets.

By contrast, a divorce provides no such assurance. A court could decide to give one spouse more of the marital debt, offset by perhaps more of the marital assets. But after the divorce, if that spouse gets a Chapter 7 discharge, that spouse comes out way ahead in net gain (other than a credit rating hit).

If the couple has a mixture of individual and marital debt, with one spouse carrying a large share of individual debt, bankruptcy first could have strange impacts.

Suppose one spouse had come into the marriage with heavy credit card debt and a mortgage, and the other spouse had little debt and a retirement fund. Depending on the length of the marriage, the parties may not have much marital debt. In that case, the spouse with little debt will likely not care about helping the other spouse, only about getting out of the marriage.

However, if the couple has children together, the debt-free spouse may want the other spouse to go through a bankruptcy first so that spouse can be in a position to pay child support. While the child support amount is never dischargeable in bankruptcy, if bankruptcy happens first, the court will seem more willing to award more child support to the debt-free spouse.

Also, if the parties had a prenuptial agreement regarding separate property, the timing of the bankruptcy might not matter because they already agreed to how to handle that debt coming into the marriage.

As you can see, multiple factors are at play in these situations and each spouse will have to think short term and long term to assess the full financial impact.

One final point: If a couple decides to do Chapter 7 first, each spouse must be aware that non-compliance with the court orders could create a non-dischargeable debt. If one spouse has reason to think the other spouse will duck out of responsibility, that spouse will want either a written agreement in advance of the bankruptcy or should consider divorce first.

If you have questions about bankruptcy and divorce, contact us – we can help.

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