Preferences: Some Payments Don't Pay Off

Bankruptcy gives you a fresh start by wiping out most of your debts or by letting you repay some of them over time. As a result, obviously, some of your unsecured creditors are left empty-handed at the end of the case. The bankruptcy laws, however, work to make sure all your creditors are treated fairly.

For instance, the trustee in your bankruptcy has the power to set aside or cancel certain payments or property transfers you made to one or more creditors before you filed for bankruptcy. These are called preferences or preferential payments or transfers. The idea being that one or more of your creditors shouldn't get more than other creditors who are in the same boat.

It's important to know how a trustee can set something aside as a preferential payment or transfer if you're thinking about filing for bankruptcy.

Preferences: The Basics

The bankruptcy law details what and when the trustee may cancel as a preference, but in general, a preferential payment or transfer is one made:

  • To a creditor as payment on a debt you owed
  • While you were insolvent
  • Within 90 days before you filed for bankruptcy, or within one year if the payment or transfer was to an insider creditor, such as a family member
  • That enables the creditor to receive more than it would have received if your property and assets were distributed to all creditors in a Chapter 7 bankruptcy

For example, there's probably a preferential payment or transfer if:

  • You pay back a $2,000 loan from a parent or sibling within one year of the date you filed bankruptcy
  • You pay off a large credit card balance 90 days before filing for bankruptcy
  • A friend or family member pays one of your creditors in exchange for work you do for the friend or family member
  • You give a creditor a lien or mortgage on some land you own to secure payment of an old debt you owe 90 days before your bankruptcy case is filed

If the court agrees with the trustee and a payment or transfer is in fact a preference, the receiving creditor has to give back the money or property and it will be used to pay all of your creditors.

Payments you make on your home mortgage or car loan, however, usually aren't preferences. That's because, as secured creditors, the bank or lender holding the loans aren't getting anything more than they would get in a Chapter 7 bankruptcy. Generally, they have the option of foreclosing on the home or repossessing the car, or getting paid the value of the property through the bankruptcy.

Dollar Limits for Trustees

The trustee in a consumer bankruptcy like yours - where at least half of your debts are for personal, family or household needs and expenses - can use the preference power only if more than $600 is involved. (It's $5,850 if it's a non-consumer or commercial bankruptcy).

So, for example, if your only pre-bankruptcy payment is repayment of a $500 loan from your parents, the payment can't be set aside as a preference. Likewise, if you pay off two credit cards by making $550 in total payments, there's no preference.

Exceptions and Defenses to Preferences

There are several exceptions or defenses a creditor may use to stop the trustee from canceling a payment or transfer as a preference. It's up to the creditor to prove to the bankruptcy court that one the exceptions applies. Some of the exceptions or defenses include:

  • Exchanges that are substantially contemporaneous exchanges for new value. For example, cash purchases or certain security interests. For example, 90 days before you file for bankruptcy you buy some new furniture and give the creditor a security agreement making the furniture collateral for the loan
  • Payments on debts incurred in the ordinary course of business between you and the creditor, such as payments for current utility services
  • Bona fide payments of debts for a domestic support obligations, such as child support
  • Payments or transfers made as part of an alternative repayment schedule between you and a creditor created by an approved nonprofit budget and credit counseling agency

Preferential payments and transfers can get complicated. Talk to your bankruptcy attorney before you make any payments to creditors to make sure you get the full benefit of the payment. You don't want a payment to backfire when the person or company you pay has to turn it over to the trustee.

If you've already made payments, be sure to tell your attorney about them. You may be advised to wait until the 90-day or one-year preference period lapses before you file for bankruptcy.

Questions for Your Attorney

  • Can I repay my 401(k) loan before I file for bankruptcy?
  • Is it a preferential transfer if I take my name off of a joint savings account I have with my spouse?
  • Is it a preferential transfer if I change the beneficiary of my life insurance policy from me to my child?
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