Untangling The Converted Case

Conversion of a chapter 13 case to Chapter 7 usually comes amid some sort of train wreck.

The debtor has defaulted on plan payments, decided to surrender the house, or even got a loan modification that allows him to keep the house.

Often, there is pressure to convert the case before it is dismissed.

In the bustle, don’t forget to counsel the debtor on the differences between 13 and 7.

Big picture differences

The discharge available in Chapter 7 is not as expansive as Chapter 13.  Non support debts to a former spouse are not dischargeable.  Neither are debts for willful and malicious acts.

Lien strips of voluntary mortgages don’t survive conversion to Chapter 7.

A separate taxable estate is created when an individual files Chapter 7.

A Chapter 7 trustee is not going to pay secured creditors unless he happens to sell the collateral.

Conversion gotcha’s

Two practical and tangled issues have come to the fore in our conversions recently,  ones for which I  didn’t adequately prepared the clients.

The first is the car that was being paid through the Chapter 13 plan.

Unless conversion comes after all contractual payments were made in the Chapter 13, the deal reverts to prepetition terms.  You are back to contract interest rate and contract monthly payments.

Chances are high that the debtor isn’t current to the contract.

If the debtor expects to reaffirm the car loan, a standard question of judges reviewing reaffirmation agreements is “Are the payments current?“.  A negative response doesn’t bode well for reaffirmation.

Forewarned is forearmed.

  • Alert your client to the issue.  Get them paying ASAP.
  • Be in contact with the lender.  Find out what the deficiency is, if any.
  • Negotiate the reaffirmation to declare the debtor current to the reaffirmed deal.

The second gotcha that has bitten a couple of converted clients recently is the penalties and interest on priority tax claims.  In the 13, the priority taxes were being paid, and even the penalties on those priority taxes were dischargeable in Chapter 13.

Penalties on taxes less than 3 years old are not dischargeable in Chapter 7.  Section 523(a)(7) excepts from discharge debts…

to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty—

(A) relating to a tax of a kind not specified in paragraph (1) of this subsection; or
(B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition;

Generally, the taxing authorities apply payments to the tax first, then to interest and then to penalties.  Chances are “good” that if the Chapter 13 plan included  priority taxes, the debtor will emerge from the Chapter 7 owing penalties as well as any unpaid tax.

Managing expectations

Good lawyering can’t change the law that creates these tangles in a converted case.

But alerting the client to the issue ahead of time saves you from the familiar whine:  you didn’t tell me….

Image courtesy of Zengarland.org.

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  1. http://johnrogersattorney says

    Cathy … thank you for this article … these issues are so overlooked by many attorneys that are in a rush to convert a case or the client is in a rush to convert a case … many times staying under the protection of the Chapter 13 for a month or two and evaluating the options is much, much better than rushing into a conversion. We have a checklist to go though to help avoid these issues. Again, thank you for sharing !