Bank Account Blues - Debt, Credit, and Bankruptcy

By: Carol Ann Wilson

We have referred to property as either marital or separate. The same classifications apply to debt. In general, both you and your spouse are responsible for any debts incurred during the marriage - it does not matter who really spent the money. When the property is divided up during the divorce, the person who gets the asset usually also gets the responsibility for any loans against it.

It’s in both of your best interests to pay off as many debts as possible before or at the time of the final decree. To do so, use whatever liquid assets you have - bank accounts, money market funds, stocks, bonds, or cash values from life insurance. It may make sense to sell assets to accumulate some extra cash. The most easily sold assets include extra cars, vacation homes, and excess furniture. (Don’t expect to get much for used furniture unless it has value as an antique or collector’s piece.)

If you ! can’t pay off the debts, then the decree must state who will pay which debt and within what period of time. There are generally four types of debt to consider: secured debt, unsecured debt, tax debt, and divorce expense debt.

Secured debt includes the mortgage on the house or other real estate, and loans on cars, trucks, and other vehicles. It should be made very clear in the separation agreement who will pay which debt. If one spouse fails to make a payment on a debt that is secured by an asset, the creditor can pursue the other spouse.

Unsecured Debt

Unsecured debt includes credit cards, personal bank loans, lines of credit, and loans from parents and friends. These debts may be divided equitably. The court also considers who is better able to pay the debt.

For unsecured debt, any separation agreement needs to include a hold-harmless clause. This will indemnify the nonpaying spouse, which means that the paying spo! use gives nonpaying spouse the right to collect not only all missed payments, but also damages, interest, and attorney’s fees if payments are not made. Without a hold-harmless clause, the nonpaying spouse has the right to collect only the missed payments.

Often, the legal decision and the financial outcome are very different things. This is a lesson Paul learned the hard way. Tracy and Paul were married eight years, during which time Tracy ran her credit cards to the limit with her compulsive spending. The court held Tracy solely responsible for paying the $12,000 in credit card debt. After the divorce, however, Tracy didn’t change her ways and was unable to pay off her debt. The credit card companies came after Paul, who ended up paying them off.

In a case like this, one solution would have been to pay off the credit cards with assets at the time of divorce or for Paul to have received more property to offset this possibility.

Tax Debt

Just because the divorce settlement is final doesn’t mean you ! are exempt from possible future tax debt. For three years after the divorce, the IRS can perform a random audit of your last joint tax return. In addition, the IRS can question a joint return - if it has good cause to do so - for seven years. It can also audit a return whenever it believes fraud is involved.

To avoid surprises, the divorce agreement should spell out what happens if any additional interest, penalties, or taxes are found, as well as where the money comes from to pay for defending an audit. We know of countless horror stories where the unsuspecting spouse (usually the ex-wife) is all of a sudden obligated for a huge tax bill and doesn’t have a clue how it happened.

Divorce Expense Debt

Although it isn’t always clear who is liable for debts incurred during the separation, typically these debts are the responsibility of the person who incurred them. An exception would be if one spouse runs up debts he or she is unable to pay! to buy food, clothing, shelter, or medical care for the kids. The other spouse is probably obliged to pay those expenses.

You will accrue other costs during the divorce process, including court filing fees, appraisals, mediation, and attorneys. Other less obvious expenses are accounting, financial planning, and counseling. The separation agreement needs language that states who is responsible for these expenses.

Divorce expenses may accrue after the decree, such as attorney fees for doing QDROs, title transfers, and tax preparation for the final joint tax return, mediation fees, and long-term divorce counseling for the parents or the kids. Who pays? You do, unless it is spelled out clearly so there are no disputes at a later date.

Dividing Marital Property and Debts

Many people try to divide each asset as they discuss it - your half of the house is $4,000, my half of the house is $4,000. Since you will rarely divide the house like this, this may not be the most useful way to go about it. It may be ! more practical to list each asset as a whole item under the name of the person who will keep it.

For example, in the wife’s column, list the marital equity in the house if she is thinking of continuing to live there. List the entire value of the husband’s retirement in his column, if that is your initial inclination. An advantage to this method is that it allows you to see the balance, or lack of it, of your initial plan as you develop it. If you want to know dollar values, you may need a third party, such as an appraiser, to help you determine them.

This is the time to have a real heart-to-heart discussion with your about-to-be-ex about the range of his or her sense of fairness. Ask:

• Is the only possibility for a 50-50 division of things by value? By number?

• Are you more interested in cash than in things?

• Will you take less than 50 percent if your share is all cash?

• Are you more interested in future security than in present assets?

• Are you willing to wait for a buyout of your share, such as house selling or retirement, and are you looking for more than 50 percent to compensate you for waiting?

• Are you interested in a “lopsided” agreement (more to one of us than the other) to compensate for the larger earnings made by you or your spouse?

• Do you want to be “made whole” - meaning ending up where you were at the beginning of the relationship?

• Do you need to be compensated “off the top” for some contribution you made to the acquisition of property?

• Is there a possibility that any assets or investments are hidden?

If you both can agree on a generic plan that meets each of your ideas of fairness, you will find you have an agreement that practically writes itself. The bonus is that you save on lawyer’s fees.

As you allocate the debts, decide first whether they are marital, separate, or a mix. Then agree who will pay off the balance of each. Remember that the problem of unsecured debts may be handled more easily as if it were a monthly credit card payment than a division of your property.

Think about the long-term effect of the division of assets and debts you are considering. For example, suppose you get all assets that appreciate slowly or depreciate, and which take money to maintain (home, car, furniture). Then suppose your spouse takes all assets that increase in value or produce income (stock, retirement accounts, rental home). Guaranteed, in a few years after the divorce, what in the short! term appeared to be “fair” or “equal” will look quite different. Your spouse’s net worth will far exceed yours - and the gap will just continue to widen.

The word bankruptcy strikes fear in the hearts of many people - especially those going through divorce. You may be trying to decide whether it is better to ask for alimony or a property settlement note and are caught in indecision. Perhaps your spouse has threatened either to leave the country if alimony is required or to file bankruptcy if money is owed or a property settlement note is due. Let’s look at some of the rules of bankruptcy as they apply in divorce situations.

Two types of bankruptcy are available: Type One allows you to develop a payoff plan over a three-year period and Type Two allows you to liquidate all of your assets and use the proceeds to pay off debts, erasing debts that cannot be paid in full.

Type One bankruptcy may preserve the assets and allow the debtor to pay off all ! the secured debt, as well as a portion of the unsecured debt, and discharge the rest of the unsecured debt. The debtor needs to make payments under a plan that is approved by the bankruptcy court.

Type Two bankruptcy forgives all unsecured debts and requires the forfeiture of all assets over a certain minimum protected amounts. Creditors have the right to repossess their fair share of the assets. The net proceeds from the sale of assets are divided pro rata among the creditors.

Here are some things to remember:

• If a spouse files bankruptcy before, during, or after divorce, the creditors will seek out the other spouse for payment - no matter what was agreed to in the separation agreement.
  

• While you are still married, you can file for bankruptcy jointly. This will eliminate all separate debts of the husband, separate debts of the wife, and all jointly incurred marital debts.

Caution - promissory notes or property settlement notes, especially unsecured notes, are almost always wiped out in bankruptcy. Some secured notes, depending on the property that secures them, can also be discharged. Here’s what happened to Cheryl: Sam and Cheryl divided all their assets. To achieve a 50-50 division, Sam still owed Cheryl $82,000. He signed a property settlement note to pay Cheryl the $82,000 over a ten-year period at 7 percent interest. After the divorce, Sam filed for bankruptcy and listed the property settlement note as one of his debts. Cheryl never received a penny of the money that was due her.

Note: Certain debts cannot be discharged in bankruptcy. These include child support, maintenance, some student loans, and recent taxes.