Why you should refrain from repaying debts before filing bankruptcy

If you are in a position where you are having debt problems, you may be forced to turn to family or friends to borrow money. If your debt problems worsen and you are considering filing bankruptcy, you may think that it is the right thing to do to use the last part of your remaining funds to repay them. Although this may feel like the right thing to do, if you later file bankruptcy, it may violate the rules against preferential transfers.

About preferential transfers

The bankruptcy laws require all filers to treat all creditors equally and not favor one over another. This rule also applies to transactions made just before bankruptcy is filed. As a result, it is standard procedure for the bankruptcy trustee to review your transactions during this time to look for any impropriety.

A preferential transfer occurs if you significantly treat one creditor better than another during a certain period before you file bankruptcy. Although creditors that are the subject of a preferential transfer are often friends or family members, it is not required that you have a close personal relationship with the creditor in order for this type of transfer to occur. The bankruptcy laws define a preferential transfer as:

• A transfer to a creditor because of a debt owed;

• Made during 90 days (one year, if the creditor was an "insider" under the law) before bankruptcy was filed;

• Made while you were insolvent (you are presumed insolvent 90 days before you file bankruptcy); and

• Which allowed the creditor to obtain more than they would have obtained had you filed Chapter 7 bankruptcy

Under Chapter 7 bankruptcy, most unsecured creditors receive nothing, as most of this type of debt is discharged. Unsecured creditors are holders of debt that is not secured by collateral, such as credit cards, medical debt and personal loans. As a result, if you significantly favor a creditor within 90 days before bankruptcy, it is very likely that it is a preferential transfer. The same can be said for one year before you file bankruptcy if the creditor was an "insider," which includes family and business associates.

What happens to preferential transfers?

In examining your transactions, if the trustee finds one to be preferential, he or she may void it. This means that the trustee can formally demand the creditor repay the amount of the transfer. Once recovered, the transfer amount becomes part of the bankruptcy estate and is distributed according to the law.

Not all transactions made before bankruptcy are considered preferential, however. All payments for domestic obligations, child support and alimony are exempt from being considered as preferential. In addition, the same is true for most transactions that are in an aggregate amount of less than $600.

Speak to an attorney

Although you may think you are repaying a kindness, your generous gesture can turn into an empty one if the transaction is later considered preferential. Therefore, it is a better plan to wait until after bankruptcy has been completed before you repay your friends and family. An experienced bankruptcy attorney can advise you further on the rules surrounding bankruptcy and how they will apply to your situation.