Priority vs. Nonpriority Debts in Bankruptcy

When you fill out your bankruptcy paperwork, you'll list your debts according to type. You'll start by separating your debts into two categories: secured debts guaranteed by collateral and unsecured debt. Bankruptcy law further divides unsecured debt into two additional categories: priority debts that are entitled to be paid first, and nonpriority debts.

In this article, you'll learn the differences between priority and nonpriority debts, and why it matters in Chapter 7 and Chapter 13 bankruptcy.

Secured and Unsecured Debt in Bankruptcy

If you already know the debt is unsecured, skip this section. If you're not sure, the factor that defines secured from unsecured debt is this: Collateral or property guarantees the payment of secured debt, but not an unsecured debt.

You can figure out whether you have a secured or unsecured debt by asking yourself these two questions:

• Does your contract allow the lender to take your property if you fail to pay as agreed?
• If you sold the property, would you be forced to pay the debt out of sales proceeds before transferring the title to someone else?

If the answer is yes to either question, the debt is secured. The creditor has a lien that gives the creditor an ownership interest in the property until you pay off the debt. A creditor without a property lien has an unsecured debt.

Keep in mind that a lien can be voluntary or involuntary. It's common to agree to a voluntary lien when financing a car, house, or other expensive property. You'll find this type of lien in your contract. However, some creditors have a statutory right to place an involuntary lien on your property without your consent—think tax liens and mechanics liens.

If you haven't given the creditor collateral to guarantee the debt, or if the creditor doesn't have a lien encumbering your property, then you've got an unsecured debt. Medical bills, most credit cards (see caution below), gym memberships, utility bills, and payday loans are unsecured debts.

Caution: Paying for an item using a plastic credit card doesn't ensure that it's an unsecured debt. A major credit card account that you can use to purchase anything—such as a Mastercard or Visa—is likely unsecured. However, many specific accounts—such as jewelry, electronics, appliance, and mattress credit accounts—are secured. The contract will require you to return the product if you don't pay as agreed. Also, if you deposited money in an account to secure a credit card, it's a secured account.

For an in-depth discussion of secured debt, try Understanding Secured, Unsecured, and Priority Debts in Bankruptcy.

Determining If It's Priority or Nonpriority Unsecured Debt

Under bankruptcy law, unsecured debt falls into one of two categories—priority or nonpriority obligation. Here's how you determine the difference.

Priority Debt Gets Special Treatment in Bankruptcy

Congress decided that all unsecured debts are not created equal and that some should be paid before others. So, under the bankruptcy code, creditors get priority treatment if money is owed to the government or when it's in the interest of the overall public good. The bankruptcy trustee must pay these debts in full before nonpriority unsecured obligations:

• child support
• spousal support
• certain income taxes
• payroll taxes and sales taxes
• personal injury or death award due to drug or alcohol intoxication
• criminal fines, and
• overpayment of government benefits (some can be discharged).

Most priority debts are nondischargeable and can't be wiped out in bankruptcy. You'll be responsible for paying the balance after a Chapter 7 case, or the entire amount owed through a Chapter 13 repayment plan.

Most Unsecured Debts Are Nonpriority

General unsecured debts aren't entitled to special treatment—they aren't afforded any priority treatment under the bankruptcy code. If a debt isn't entitled to priority treatment, it's general, nonpriority unsecured debt.

The bankruptcy trustee won't pay anything to creditors unless money remains after all higher priority debts and obligations get paid. If funds remain, the trustee will divide them between the creditor on a pro-rata basis, so that each receives the same percentage of the outstanding debt balance.

Common nonpriority debts include:

• most credit card debt
• medical bills
• personal loans
• utility bills, and
• student loans.

Nonpriority debts are usually dischargeable and can be wiped out in bankruptcy—but not always. For instance, student loans are nonpriority debts, but most people cannot discharge student loans in bankruptcy. Learn more about bills filers can eliminate in bankruptcy.

Paying Priority and Nonpriority Claims in Bankruptcy

Priority debts get paid in full after the trustee pays administrative claims (trustees fees, attorney fees, and other costs of administering the bankruptcy estate).

• Priority debt payment in Chapter 7. If you have priority debts in Chapter 7 asset case (money is available to pay creditors), priority creditors must be paid first. If there isn't enough money to repay priority debts in full, nonpriority debts won't receive anything. If there is money left over after priority debts are paid in full, it will be distributed pro-rata to the nonpriority creditors.
• Priority debt payment in Chapter 13. If you have priority debts in a Chapter 13 case, they must be paid in full, sometimes with interest, through your Chapter 13 plan.

Example 1. Jose filed Chapter 7 bankruptcy. He owes $30,000 in back child support and $40,000 in credit card debt. The trustee sells $20,000 in nonexempt assets that he can't protect with a bankruptcy exemption. After $3,000 in fees and costs, the trustee pays the remaining $17,000 toward the back child support. Jose will have to pay the $13,000 balance after the bankruptcy ends. (His attorney suggests paying it through Chapter 13 after Chapter 7—a strategy known as a "Chapter 20" bankruptcy.) The entire $40,000 in credit card debt is discharged.

Example 2. Michael filed Chapter 7 bankruptcy. He owes the IRS $15,000 in back taxes, $20,000 in medical bills, and $10,000 in credit card debt. The Chapter 7 trustee recovers $25,000, and after paying fees and costs of $4,000, the trustee pays the IRS in full and distributes the remaining $6,000 pro-rata to the nonpriority unsecured creditors. Each credit card debt and medical bill receives 20% of the owed balance ($6,000 allows payment of 20% of $30,000, the total unsecured debt).