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Why You Should Be Careful About Repaying Debts Before Filing Bankruptcy

When financial problems hit, it is normal for many persons to turn to friends and family for a loan to tide them over. However, if the financial difficulties do not improve, many consider filing bankruptcy as a way out. If you are in this situation, you may decide to use the last bit of cash that you have to repay those that helped you out during your financially difficult period (or even a favored creditor). Although this normally would be the right thing, if you later file bankruptcy, you may be putting those that helped you out in a difficult situation later.

The reason for this is because bankruptcy requires you to treat all of your creditors equally from the time just before you file bankruptcy until it has been completed. As a result of this rule, you are prohibited from favoring one creditor over another, even if the creditor is not a friend or family member. Any violation of this rule is known as a preferential transfer. Under the law, this type of illegal transfer is defined as:

  • A payment or a series of payments to a creditor because of a debt owed;
  • Made within 90 days of filing bankruptcy (with an exception discussed below);
  • During a period in which you were insolvent (this is presumed 90 days before you file); and
  • That allowed your creditors to receive more money than they would have if you had filed Chapter 7 bankruptcy

Since most unsecured creditors (i.e. holders of personal loans, credit card debt or medical bills) generally receive little or no payment during Chapter 7, almost any significant repayment of an unsecured debt before or during bankruptcy would likely be regarded as a preferential transfer.

As mentioned earlier, the 90-day period that prohibits the repayment of creditors before filing bankruptcy does not always apply. If you repay a debt to someone who is an “insider” under the law, the period is lengthened to one year before bankruptcy. An “insider” under the law includes friends, family and business associates. Because of this rule, most significant repayments of personal debts to family and friends within one year before filing bankruptcy would be considered preferential transfers.

The rule against preferential transfers does have some limitations. For example, alimony and child support payments made during the prohibited period do not count as preferential transfers. Likewise, most aggregate payments of $600 or less do not qualify.

What Happens If A Transfer Is Preferential?

As soon as you file bankruptcy, the transfers you made before bankruptcy are scrutinized by the bankruptcy trustee assigned to your case. If the trustee finds any prohibited transactions, he or she may sue the creditors that received the illegal payments and essentially force them to repay the amounts received back to the bankruptcy estate. Once part of the estate, the payments are distributed to all creditors according to the priorities set out by law.

Because facing a lawsuit is something that would likely cause anxiety and alarm to your friends and family, it would be wise to delay repaying them until after you have completed your bankruptcy.

Since preferential transfers are only one of the several traps that await those inexperienced with the law surrounding bankruptcy, it is best to file bankruptcy only with the assistance of an experienced bankruptcy attorney. An attorney can guide you through the process and ensure that any potential problems are avoided.