How Does Chapter 7 Work?

When you file for a Chapter 7 bankruptcy, you are declaring bankruptcy in the classic sense: The financial hole you're in is too deep to ever dig yourself out of, so you need to wipe the slate clean and start over. You will probably lose much of your stuff, and some debts can't ever be erased. But when you emerge from Chapter 7, the idea is that you'll have a chance to start over.

Getting Started

You start the process by filing a petition -- Form B-1 -- with the U.S. Bankruptcy Court in your area of the country. With this petition, you submit specific information: a list of all your assets and debts; details about your income and spending; a "statement of financial affairs"; and a list of all contracts and leases you have signed. You generally can't file for Chapter 7 bankruptcy if you've had a bankruptcy case dismissed in the past 180 days, and you must also have received credit counseling in the past 180 days. Finally, you have to pay filing and administrative fees at the time you submit the petition, which are about $300 as of 2012.

The "Stay" and Creditors

As soon as you file your petition, the court orders your creditors to immediately stop trying to collect on your debts. This "stay" doesn't apply to everything -- if you owe child support or alimony, for example, or criminal fines, you'll have to keep paying those. The court appoints a trustee to oversee your case, and within a few weeks that person will hold a meeting with you and any creditors who choose to come. The creditors and the trustee can ask you questions about your financial affairs, and the trustee will make sure you understand the bankruptcy process and the consequences. You'll be put under oath to ensure you tell the truth. If the trustee decides your petition has been filed in good faith -- that is, you're not abusing the system to avoid debts you could repay -- the case proceeds. Otherwise, it's dismissed.

Sorting Claims and Assets

You have essentially two types of debts: secured and unsecured. A secured debt has collateral, such as a house for a mortgage loan or a vehicle for a car loan. With a secured debt, the creditor can take back the collateral, or you might be able to reaffirm the debt. If you reaffirm a debt, you keep the collateral, but you must continue to make payments once you get out of bankruptcy. Unsecured debts, such as credit card debt or back child support, have no collateral. You also have two types of assets: exempt and non-exempt. Because bankruptcy is supposed to give you a fresh start, you can exempt some property from seizure, such as a certain amount of cash, some clothing and furniture, and tools needed for work. Anything that isn't exempt is classified as non-exempt.

Disposition and Discharge

The trustee sells off all your non-exempt property and distributes the proceeds to your unsecured creditors according to criteria set out in the U.S. Bankruptcy Code. Some unsecured creditors have priority over others. For example, unpaid support obligations and unpaid wages to anyone you employed must be paid first. If there's anything left over after everyone to whom you owe money has been fully repaid -- which is extremely unlikely -- it will be returned to you. Otherwise, the court "discharges," or wipes out, your remaining debts, with some exceptions. For example, most back taxes can't be discharged, nor can unpaid domestic support or monetary judgments against you for injuring or killing someone while driving drunk. The discharge ends the bankruptcy case. You've got your fresh start.