Bankruptcy exemptions are a legal mechanism available to bankruptcy debtors. Exemptions have a different purpose in a Chapter 7 bankruptcy than they have in a Chapter 13 bankruptcy, but the overarching objective is to reduce the size of the bankruptcy estate to allow the debtor to keep more money and property.
When a debtor files a bankruptcy case, a bankruptcy estate is created. The estate consists of the assets and liabilities the debtor had at the exact moment he or she filed bankruptcy. The court appoints a trustee to administer the estate. The trustee's job is to make sure that any nonexempt value in the estate goes to the debtor's creditors.
Example: If a debtor files bankruptcy and owns $40,000 worth of property but can only exempt $30,000, the trustee must make sure that creditors receive the $10,000 difference.
Bankruptcy is governed by federal law. Section 522 of the Bankruptcy Code provides a list of exemptions that debtors can use to exempt property from the estate. These exemptions allow debtors to exclude from the estate certain property up to a certain dollar amount in value.
Example: The Bankruptcy Code allows debtors to exempt up to $3,775 in value of one motor vehicle. If a debtor owns a car with $5,000 in equity, $3,775 of that equity is protected. The remaining $1,225 is nonexempt, meaning it becomes part of the bankruptcy estate.
States also have lists of exemptions. Federal bankruptcy law allows debtors to use state exemptions instead of federal exemptions. But it also allows states to opt out of the federal scheme--which means debtors can only use state exemptions. Currently, sixteen states allow debtors to choose between state and federal exemption schemes. In these states, you must use one or the other--you can't mix and match. The rest of the states require debtors to use the state exemptions; using the federal exemptions is not an option. California is unique in that it allows debtors to choose from two different state exemption lists.
Debtors using state exemptions may also use a list of exemptions called the federal nonbankruptcy exemptions.
Once the exemptions are determined, the fate of the debtor's property depends on whether the debtor is in Chapter 7 bankruptcy or Chapter 13 bankruptcy.
Chapter 7 bankruptcy is a liquidation bankruptcy. A Chapter 7 trustee's duty is to liquidate the debtor's nonexempt assets and use the money to repay creditors. Most Chapter 7 cases are no-asset cases, because most debtors are able to use exemptions to protect all their money and property.
If the debtor is not able to exempt all his property, the debtor can either pay the trustee the nonexempt value of the property or allow the trustee to sell the property. Once the trustee has the funds from liquidating the property, he or she will distribute the money to unsecured creditors in the manner the Bankruptcy Code requires.
Example: If a debtor's car is worth $5,000 and the debtor exempts $3,775 of that value, the debtor can either pay the trustee $1,225 to keep the vehicle, or the trustee can sell the vehicle and pay the debtor $3,775 while distributing the $1,225 of nonexempt value to unsecured creditors.
To learn more about how Chapter 7 bankruptcy works, see Chapter 7 Bankruptcy.
Chapter 13 bankruptcy does not work like Chapter 7. In a Chapter 13 case, the debtor proposes a repayment plan in which, over a three- to five-year period, the debtor pays back some or all of his debts to a Chapter 13 trustee, who distributes the funds to creditors. The Bankruptcy Code provides that creditors in a Chapter 13 case must receive at least what they would have received if the debtor had filed Chapter 7; therefore, if the debtor has nonexempt assets, he or she must pay enough into the Chapter 13 plan to provide at least that nonexempt amount to the unsecured creditors. The more nonexempt property the debtor has, the higher the Chapter 13 plan payment will be. Exemptions help reduce the amount the debtor must pay into the Chapter 13 plan.
Example: If a debtor has $1,550 of nonexempt equity in a car, the debtor must pay enough into the Chapter 13 plan to provide $1,550 to unsecured creditors over the life of the Chapter 13 plan.
Which state exemption system you can use depends on where you've been living for the last few years. Homestead exemptions (exemptions protecting the home you live in) have different requirements. (See Which State Exemption System Can I Use?)