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The complex interplay between divorce and bankruptcy

Financial difficulties are often part of divorce, even to the extent that one or both parties are considering filing for bankruptcy. The timing of both legal proceedings – the divorce in Virginia state court and the federal bankruptcy – can impact the financial circumstances of both parties when the dust has finally settled.

The unique financial situation and personal goals of a Virginian facing divorce and potentially bankruptcy will drive which proceeding to file first. Overlap of the two proceedings is complex because each judge is dealing with the couple’s property and debts.

Joint or single bankruptcy filing

Two overarching issues drive the filing order. First, is there a reason to file a joint bankruptcy as a married couple instead of filing as single debtors after divorce? For example, discharging marital debt as joint filers may be preferable to dividing marital debt in divorce. Even if a joint credit card or other debt is assigned to one party to pay off after the divorce, the credit company may not hesitate to go after the other spouse whose name is on the account despite the state court’s divorce order that the other party pay it off.

Liquidation or reorganization

Second, what kind of bankruptcy is better – Chapter 7 liquidation or Chapter 13 reorganization? With Chapter 7, the debtor can keep certain exempt property, the rest may be sold to pay down debt, and the court discharges (extinguishes) the remaining debt. However, child support, spousal support and some other obligations are not dischargeable.

In Chapter 13, the debtor – or married debtors in a joint filing – enters a three-to-five-year repayment plan to pay down debts at more manageable levels. Filing jointly before divorce may be too difficult if the couple does not want to remain married through the repayment plan or if it would be hard to cooperate. Should one of them file for divorce during the plan, the bankruptcy court might dismiss the Chapter 13 filing or convert it to two separate proceedings. This could end up being expensive in the long run.

Considerations leaning toward bankruptcy first

Other issues suggest that filing for bankruptcy before divorce is favorable:

  • Some equity in the marital residence is likely to be protected in a joint bankruptcy as exempt property. This may allow the home to be kept going into the divorce if the couple wants it to remain as the children’s residence or to sell it and split the proceeds in divorce.
  • Filing bankruptcy jointly would likely preserve more property overall as exempt, potentially leaving more to be divided in divorce or allowing them to save certain desired assets.
  • A joint Chapter 7 may be resolved relatively quickly, which would not significantly delay the divorce.

Factors favoring divorce first

  • Debt incurred by an individual after separation and during divorce may be eligible for discharge in a later bankruptcy filing.
  • A married couple may make too much money together to qualify for Chapter 7, but after divorce they may individually pass the means test to qualify (although receiving alimony could put an individual over the means test threshold).
  • Student loans are rarely dischargeable and only when they cause undue hardship, which is a very high bar. If a divorcing individual wants to try to discharge student loan debt but would not qualify if their spouse’s income is considered, if the person anticipates very serious financial problems after divorce, the bankruptcy judge is more likely to discharge student loans then in an individual filing.

Careful crafting of divorce settlement if bankruptcy likely to follow divorce

If the other party could file individually for bankruptcy after divorce, it can be smart not to negotiate as part of a divorce settlement (or argue against this in court if the issue goes before the judge) that the other spouse pay a sum of money in a lump sum or in payments as part of the equitable division of property. While alimony and child support are not dischargeable in bankruptcy, the bankruptcy court may classify money owed as part of the property division dischargeable, so the recipient could lose that part of the divorce settlement.

There are likely creative ways within the agreement to divide or classify the payments to avoid this potential problem.

This introduces a complex question the answer to which depends on the individual circumstances. You should consult an attorney experienced and knowledgeable on these issues as early in the process as possible.