What Should You Do if Someone Who Owes You Money Declares Bankruptcy?

If you've lent money to a family member to help save a struggling business or to a friend who is going through a difficult divorce, you were likely glad to be in a position to assist—but still count on eventual repayment. You may be dismayed to find out that the person who still owes you money recently filed for Chapter 13 bankruptcy protection. Will your debt be considered a valid part of your friend or relative's bankruptcy case, or are you out of luck unless the debtor voluntarily decides to repay you later?

Continue reading more about your rights when a debtor declares Chapter 13.

What types of debts are part of the bankruptcy estate?

A Chapter 13 bankruptcy requires the debtor to gather information about all valid debts—everything from tax liens to mortgages to credit card bills or off-the-books personal loans. These debts are arranged in order of priority, and the debtor will enter a repayment plan that requires him or her to turn over most monthly household income to the trustee, who then goes down the priority list to make repayments on each loan until the funds are exhausted.

If the repayment plan is successfully completed, some debts will be completely repaid by the end of the plan period, while others may be discharged, giving the debtor a fresh start. If the repayment plan fails (whether through job loss or other failure to adhere to the plan), the Chapter 13 bankruptcy will usually be converted to a Chapter 7 bankruptcy and the remaining debt will be discharged.

The speed with which repayment is achieved (and the amount each creditor is paid every month) largely depend upon the debtor's disposable income and the total amount of debt. A high-income debtor may be able to afford to repay every creditor on the list, while a lower-income debtor with high debt may wind up having some loans discharged due to insufficient funds.

Unless the loan you made was secured (like a mortgage) and recorded, you may find yourself near the bottom of the priority list—or even completely eliminated. Even if you do find yourself on the list of creditors, for unsecured debt you may receive anywhere between 0 and 100% of the total debt owed.

How can you help protect your rights?

While it may be tempting to want to seek repayment as quickly as possible when you learn of an impending bankruptcy, it's important not to accept any money from the debtor after the bankruptcy has been filed, unless you're listed as part of the bankruptcy estate. Doing so could potentially subject these assets to seizure by the federal bankruptcy court as a prohibited transaction, and if you've already spent this money, you could find yourself facing legal troubles of your own.

Instead, you'll need to try to get your loan placed in the priority list so that you'll begin to receive regular payments through the bankruptcy court. Unless you have detailed documentation of the loan and it is for a substantial amount, this can be difficult. However, if you present to the bankruptcy trustee any records of the debtor's cashing of your check or transfer of funds, as well as some evidence that this transfer was not a gift, you may find yourself listed as an unsecured creditor.

Fortunately, even if you're unable to have your loan placed in the bankruptcy estate, you may still be able to secure a written agreement from your friend or relative to repay you only after the bankruptcy case has concluded. Doing this can reinstate the debt, putting it outside the bankruptcy estate (even if a Chapter 7 is later declared and other debts are discharged). You will want to seek legal advice before taking this step to ensure it's the right solution for you.