9 Nasty Pitfalls of Chapter 7 Bankruptcy That You Should Know - TheStreet

For millions of debt-ridden individuals and owners of small businesses, filing for personal bankruptcy protection is the only way out of their financial quagmires.

If you're an individual or small-business owner struggling with debt, seeking shelter under Chapter 7 of the U.S. bankruptcy code may help. Chapter 7 bankruptcy can eliminate most or all of your company's debts for which you're personally liable.

If you're a sole proprietor or your business is a general partnership, you're personally liable for your business's debts, which is why Chapter 7 could be your salvation. It's among several crucial tactics that can rescue your retirement years from poverty.

Chapter 7 bankruptcy, otherwise known as "liquidation bankruptcy," means that the company is beyond the stage of reorganization and must sell off any nonexempt assets to pay creditors.

Under Chapter 7, the creditors collect their debts according to how they loaned out the money to the firm. The court appoints a trustee, who ensures that any assets that are secured are sold and that the proceeds are doled out to specific creditors.

Chapter 11 bankruptcy, called "rehabilitation bankruptcy," is much more complicated than Chapter 7, because it gives the business the opportunity to reorganize its debt and to attempt to re-emerge as a healthy, viable entity.

Here, we take a look at Chapter 7, the most common recourse for small-business owners who run into trouble.

The Hard Facts

There are many advantages to declaring bankruptcy. In most cases, filing for Chapter 7 will automatically stop most collection actions, including lawsuits, wage garnishments and those never-ending phone calls.

However, before you take the drastic step of filing for Chapter 7, you need to be fully apprised of the potential pitfalls. An effective wealth-building roadmap should always include reconnaissance of potential landmines ahead.

If you choose Chapter 7, here's a look at a few nasty surprises that may await you:

1) Bankruptcy laws vary from state to state.

Every state has its own peculiarities and exemptions; some state laws are more generous than others. Some states allow exemptions to shelter your automobile, household goods, Individual Retirement Accounts, etc. Other states are more restrictive.

Before you file for bankruptcy, do some homework to find out the laws applicable to your home state.



2) Mortgages and any other secured
loansare not eliminated.

Bankruptcy is designed to get creditors off your back, so you can get some breathing room to right yourself. Certain types of unsecured debt (e.g., credit cards) can be wiped off the books. However, to the consternation of many who file for bankruptcy, the laws don't allow you to just walk away from your mortgage or any other secured loan (any loan in which you've pledged some kind of "collateral" -- like your car or your home for the loan). Bankruptcy only keeps those payments at bay until you have dealt with other creditors.

3) Any co-signers of any collateral are in the same boat as you.

Likewise, if any of your collateral involves co-signors, your co-signers won't be able to emerge out of debt with you. They will be liable for part or all of the debt you discharge through bankruptcy.

4) Bankruptcy is reported on your credit reportfor 10 years.

Bankruptcy is like a Scarlet Letter that follows you around for a decade. The good news is that within this time frame, you can still re-establish a good credit rating, through frugality and paying off your debts in a timely fashion.

5) Bankruptcy does not wipe out withholding or sales taxes.

It's possible to get rid of old income taxes that are more than three years old, but this benefit has given rise to a myth that you also can eliminate withholding or sales taxes. This is not possible, no matter how old the taxes.

6) You can't cherry-pick the debts and property to list in your bankruptcy.

Many people seem to think that they can go through their portfolio of possessions and pick and choose what they want to list in the bankruptcy. They're shocked when they discover that it's all fair game. When you file for bankruptcy protection, the law mandates that you list all your property and debts.

7)Declaring bankruptcy does not get your "ex" off your back.

Bankruptcy doesn't allow you to cease payment on child support or alimony. Sorry, but you still need to write those checks. Although divorce is one of the most common causes of bankruptcy, your agreement isn't affected by a Chapter 7 filing. So, if you're thinking that you can wiggle out of those responsibilities, think again.

8) Declaring bankruptcy does not get you off the hook on student loans.

Your student loan payments still need to be made. They can't be wiped out as a credit card balance can be.

9) You must still fear the repo man.

A bankruptcy discharge doesn't eliminate liens. A secured debt is a debt where the creditor has a lien on your property and can repossess it if you don't pay the debt. Bankruptcy can wipe out the debt, but it still doesn't prevent the secured creditor from repossessing your property.

For further advice on surviving tough financial times, you can consult the trained brokers and financial advisers at Charles Schwab, T. Rowe Price or TD Ameritrade.

As I've explained, Chapter 7 can protect your financial future. Have you saved enough for your retirement? To avoid common money mistakes that can ruin your nest egg, download our free report: The Ultimate Retirement Guide.

John Persinos is editorial manager at Investing Daily. At the time of publication, the author held no positions in the stocks mentioned.