When you can no longer pay your debts, bankruptcy laws generally allow you to resolve your debts by dividing up your assets (if you still have any) among all your creditors. Debts that are not paid off in this process are discharged by order of a federal court. When a debt is discharged, you are no longer obligated to pay it.
Student loan debt receives special treatment under the bankruptcy laws. Generally, student loan debt cannot be discharged in bankruptcy unless the debt imposes an undue hardship on you and your dependents.
The discussion here focuses on student loans and bankruptcy.
There are different types of bankruptcy cases. A Chapter 7 case involves a liquidation of assets. Chapter 13, sometimes called a wage-earner's bankruptcy, allows you to pay off all or some portion of your debt in installments over time. Chapter 12 is for family farmers and (as of October 17, 2005) family commercial fishing operations, and Chapter 11 is typically used in business reorganizations. Your attorney can help you decide which, if any, is appropriate for you.
Two sets of rules
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (2005 Bankruptcy Act), also known as the Bankruptcy Reform Act changed the rules regarding student loans. The rules for bankruptcy filings made prior to October 17, 2005 are different from the rules for bankruptcy filings made on or after October 17, 2005.
Bankruptcy filings made prior to October 17, 2005
Generally, for bankruptcy filings made prior to October 17, 2005, government-backed student loans are nondischargeable in bankruptcy. Specifically, an educational benefit over-payment or loan may not be discharged in bankruptcy if it was:
- Made by a government unit
- Insured by a government unit
- Guaranteed by a government unit
- Made under any program funded in whole or in part by a government unit, or
- Made under any program funded in whole or in part by a nonprofit institution
Additionally, obligations to repay funds received as an educational benefit, scholarship, or stipend are nondischargeable.
For filings before October 17, 2005, however, you can avoid privately issued student loans that have no connection to any governmental unit.
Bankruptcy filings made on or after October 17, 2005
For bankruptcy filings made on or after October 17, 2005, the pre-2005 Bankruptcy Act rules are extended to include privately issued student loans. Specifically, any educational loan that is a qualified education loan, as defined by Section 221(d)(1) of the Internal Revenue Code (IRC), incurred by a debtor who is an individual is nondischargeable. Generally, IRC Section 221(d)(1) defines a qualified education loan as any indebtedness incurred to pay for qualified higher education expenses. Accordingly, in the absence of undue hardship, student loans are nondischargeable regardless of the nature of the lender.
Exception: paying the loan would impose an undue hardship on you and your dependents
A hardship exception applies if denial of a discharge would place an undue hardship on you and your dependents. The Bankruptcy Code, however, provides no definitions or examples of what constitutes undue hardship. Instead, local bankruptcy judges are left to make their own determinations. A good rule of thumb is that if your hardship is so severe that you would qualify for disability benefits under the Social Security Disability Income (SSDI) rules, you probably qualify for the hardship exception.
For this exception to apply, the hardship should affect both you and your dependents. The idea is that you should not be forced to repay student loans if it means taking food out of the mouths of your children and other people who rely on you for support.
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