Paying Personal Debt: Is It a Mistake To Repay Money I Was Lent By a Loved One Before Filing for Bankruptcy?

Does bankruptcy eliminate all debt or will friends and family who lent you money be out of luck if you file? Here’s what you need to know.

If you’re considering bankruptcy or you’ve recently filed, it’s tempting to repay any money owed to relatives or friends first. This way you won’t need to worry about the most important people in your life getting paid back when the trustee assumes control of your finances. Unfortunately, this action can get you into trouble with the bankruptcy court.

Why is it a mistake to repay money you borrowed from loved ones when you’re dealing with bankruptcy?

The Court Prioritizes Your Lenders, Even If You Know Them Personally

One of the most important things you do when you file for bankruptcy is to provide a list of creditors to the bankruptcy court. It doesn’t matter what type of debt it is, the court wants to know about it. Not only does this include debts like credit cards, medical bills, mortgages, and car loans, it also includes money you’ve been lent by loved ones.

Although you might consider your loved ones among your most important creditors, the court doesn’t. Bankruptcy laws prevent people filing from treating one creditor differently than any others. You must submit information about all creditors and not put one ahead of the other when you file for bankruptcy.

Bankruptcy Court Forbids Prioritizing Certain Debts Over Others

The court considers your friends and loved ones insiders. They know people are more likely to repay loved ones when filing bankruptcy or shortly before filing. The court carefully scrutinizes your recent financial activity to make sure you didn’t repay debts to loved ones before filing. If you did, the court considers these preferential payments and can take back the money you paid.

Preferential payments are prohibited and are subject to reversal or “clawback” by the court.

Keep in mind, preferential payments do not just apply to friends and family. The court categorizes any creditors you’ve repaid within 90 days of filing as preferential and the debt is subject to a clawback.

Additionally, payments repaid to loved ones are subject to a year of scrutiny. If you’ve paid back a debt to a loved one within the last 12 months, the court can confiscate that money and include it in your bankruptcy estate. This not only applies to cash repayments, but also any transfer of property. The court treats the transfer of assets to loved ones before filing for bankruptcy the same way as preferential cash payments.

Investopedia explains more about the clawback here.

Can You Repay Any Debt Before Filing?

Not all payments are preferential when made within 90 days of filing for bankruptcy. Your usual bills, including mortgage, rent, utilities, and car payments will not be clawed back. The court looks for payments that go above and beyond the norm. It wants to know if you decided one debt was more important than another to not include in your bankruptcy.

The good news is that debts included in bankruptcy are eligible for discharge. Does bankruptcy eliminate all debt? For many people, the answer is yes. They’ll be debt-free once their bankruptcy is complete.

Protecting Your Friends and Family

Much of how debts to your loved ones are handled in bankruptcy is based on the existence of a promissory note. Many family debts are informal and the court does not consider these loans legal debts. For example, if your parents lent you $3000 without drawing up any paperwork, the court will consider it a gift. This means the court won’t include it in your bankruptcy estate and your parents won’t be repaid through the liquidation of your assets.

If you want to include debts to your family in your bankruptcy, you must create a formal paper trail and treat this debt like all of your other debts. A promissory note increases the odds they’ll receive money when the court liquidates your estate. This releases you from the legal obligation to repay the debt. Like all of your other qualifying debts, bankruptcy offers a discharge for debts to loved ones.

Of course, you still have the option of repaying the debt after your bankruptcy is complete, whether you have a promissory note or not.

How to Avoid Problems

What can you do to avoid problems when you file for bankruptcy and how do you avoid a clawback? Does bankruptcy eliminate all debt or will your family and friends lose out?

How the court handles debts owed to loved ones varies from case to case. This is why it’s so important to work with an experienced bankruptcy attorney. They’ll review all of your debts and assets and help you create the best possible scenario regarding your finances.

For more information or to schedule a consultation, contact R. Flay Cabiness, II, P.C. at (912) 417-5041 (Brunswick, GA); (912) 809-2141 (Hazlehurst, GA) or; (912) 324-3176 (Jesup, GA) to schedule a consultation.