Why you should hold off on repaying debts before bankruptcy

If you are having debt problems, it may put you in a position where you feel you have to turn to friends or family members for financial assistance. If you are unable to resolve your debt issues, you may decide to repay the kindness of your family or friends by paying back what you can just before you file bankruptcy. Although paying them back may be on the top of your list of priorities, if you later file bankruptcy, it can cause complications and bankruptcy litigation, as it may be regarded as a preferential transfer.

Preferential transfers

Under the bankruptcy laws, all debtors must treat their creditors equally. Simply put, this means that you cannot significantly favor one creditor over another. For example, it is prohibited that you repay a friend or family member before paying a credit card debt. If you violate this rule, it is called a preferential transfer. The rules regarding preferential transfers not only apply to transfers made during bankruptcy, but ones made during a certain period before bankruptcy. Under the law, a preferential transfer is technically defined as:

• A transfer you made to a creditor because of a debt;

• Made within 90 days before you filed bankruptcy (or one year if the transfer was to family, friends, business associates or other "insiders" under the law);

• Made during the period you were insolvent (the law presumes that you are insolvent 90 days before you filed bankruptcy); and

• Which allowed the creditor you repaid to receive more than they would have received if you filed Chapter 7 bankruptcy

As a point of reference, most unsecured creditors (like friends and family) do not receive anything in a Chapter 7 bankruptcy. In most cases, unsecured debts are wiped out completely. Because of this, it is highly likely that most repayments to family members and friends made within a year of filing bankruptcy would qualify as preferential.

Recovery of preferential transfers

Once you file bankruptcy, the bankruptcy trustee examines all transactions you made within the one-year look-back period. If the trustee finds a transaction that is preferential, he or she may compel the creditor to repay the transaction. This essentially means that the trustee may bring legal action against the creditor to force repayment. Once the transaction has been recovered, the funds are distributed to all creditors according to the priorities enumerated in the bankruptcy laws.

Fortunately, certain transactions are exempt by law from being regarded as preferential. Most transactions in an aggregate amount of less than $600 are exempt. Also, payments made for child support, domestic support or alimony are similarly not considered preferential.

Speak with an attorney

Although you may feel a personal and moral obligation to repay a friend or family member, it is generally better to wait until after you have completed the bankruptcy process to fulfill this obligation. Since the rules regarding preferential transfers are fairly complicated, it is important to have the advice of an experienced bankruptcy attorney before filing. An attorney can review your situation, identify any issues or complications, and outline the best way to ensure the smoothest journey possible through the bankruptcy process.