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The new Bankruptcy Abuse Prevention Act means Chapter 7 filling is out for higher income earners like physicians, as is home equity as a major form of protection. Here's what it means to you.
The new bankruptcy law was intended to be a gift to credit card companies. But it will help plaintiffs, too - at your expense.
Bankruptcy may not be a word you hear very often from colleagues when swapping financial strategies in the break room. But it might be time to strike up a conversation about the subject with your colleagues and your attorney, even if you're certain it will never happen to you.
Why? For one thing, it just might happen to you. For another, the mere threat of bankruptcy has long been a way for physicians to hold trial lawyers at bay. With malpractice judgments skyrocketing and insurance premiums ballooning, asset-protection schemes have become a favorite tool of physicians' financial planners. In Florida, for example, many physicians practice "bare" - without any malpractice insurance at all - and instead use asset-protection strategies to safeguard their homes and pocketbooks should the worst happen.
The fact is, those doctors know that practicing without insurance is a kind of insurance policy in itself. Plaintiffs' attorneys go after the deep pockets; if you're bankrupt, there's nothing to collect. That's the theory. Of course, in reality, it's the ability to make a credible threat of bankruptcy - much more often than actually filing for it - that scares off potential lawsuits.
But that's changing. The passage this year of the Bankruptcy Abuse Prevention Act, or BAPA - which takes effect this month - will make it more difficult to escape debts by declaring bankruptcy, and thus easier for you to be targeted.
Under current law, unsecured creditors like malpractice claimants, credit card companies, and signature credit lenders are at a disadvantage in bankruptcy proceedings. They often see their claims wiped out when debtors file for protection under Chapter 7. Under Chapter 7, creditors can be forced into negotiations where debts might be settled for dimes on the dollar.
WHAT MEANS TESTING MEANS
Under BAPA, a new means test will be applied to determine whether a Chapter 7 filing is allowed. If your family income is higher than your state's median, you must file Chapter 13 as long as you have more than $166 a month remaining after you have made payments on secured debts (like home and car loans) and living expenses. And most physicians will fail this means test since they earn, on average, at least six times what other workers do.
Chapter 13 is a reorganization of your debt; it entails repayment to creditors that can last as long as five years. While the format of the new Chapter 13 is not clear, the old rules consider the "reasonable" costs of living in your geographic area and require you to use "excess" disposable income to repay your debts. In general, things like vacations, private school tuition, second homes, and even retirement plan contributions are considered outside the bounds of reasonable costs of living - in other words, you must pay off your creditors before funding such items.
One of the most significant changes brought by BAPA is a limitation on the homestead exemption. In the past, states like Florida, Kansas, Iowa, South Dakota, and Texas put home equity almost entirely beyond the reach of creditors. So one common asset-protection tool was to tie up a lot of money in your house.
Now, federal law overrides the states and limits so-called "exempt equity" to $125,000. For example, if you are going through bankruptcy and you own a $600,000 house with a $400,000 mortgage, your home equity would be $200,000. But BAPA allows you to protect only $125,000 of this amount.
There is one exception to the home equity rule, however. If you acquired your home more than 1,215 days - three years, four months - before filing for bankruptcy, your state's homestead exemption may still apply. As you consider your personal financial plan, this might affect your decision to pay off your mortgage early, whether or not to use a home-equity line of credit, and even how big a house you might buy. Check your state laws carefully because some states offer no protection for home equity at all. Make sure you get advice from a financial planner before deciding how to proceed.
DISTRUSTING YOUR TRUST
In recent years, a variety of state-specific laws have caused physicians to seek refuge for their assets in self-settled domestic asset protection trusts (DAPTs) formed in states like Delaware, Nevada, and Alaska. A DAPT is an irrevocable trust in which you would name yourself as the beneficiary. In theory, since you no longer "owned" the assets of the trust, the assets could not be reached by creditors.
So much for that safe haven. An amendment to BAPA brought by Sen. Jim Talent (R-Mo.) seems to render these trusts utterly ineffective. The Talent Amendment modifies a section of the Uniform Fraudulent Transfer Act so that transfers of assets into DAPTs within 10 years of the bankruptcy filing can be nullified - and there is no "grandfather protection" for trusts that are already in existence.
Other self-settled trusts like charitable remainder trusts (CRTs), irrevocable life insurance trusts (ILITs), and spendthrift trusts for the benefit of children and third parties may be unaffected by the Talent Amendment since they are not explicitly mentioned.
FORTIFYING YOUR IRA
There is some good news, at least. BAPA clarifies that all forms of retirement plans are to receive federal protection from creditors' claims, including traditional and Roth IRAs. In the past, federal law extended protection only on account balances held inside ERISA-qualified accounts like 401(k) s and 403(b) plans. Asset protection for IRAs was available at the state level - but some states offered no protection at all.
While rollover IRAs are protected without limit, self-funded IRAs are protected only up to the first $1 million. But it may be possible to garner protection for accounts larger than $1 million by doing a "reverse rollover" into a 401(k) or other plan that receives full protection. And by the same token, it may be a good idea to keep rolled-over IRA money separate from IRAs that were funded with annual contributions in order to maintain their creditor exemptions.
In this same vein, 529s and Educational IRAs may be excluded from the bankruptcy estate if the amounts are reasonable in comparison to the cost of college and if the money was contributed more than two years before filing for bankruptcy.
Ben Utley is a certified financial planner, and the founder and president of Utley Financial Planning Inc., a fee-only financial planning firm based in Eugene, Ore. He can be reached at email@example.com or via firstname.lastname@example.org
This article originally appeared in the October 2005 issue of Physicians Practice.