The Dangers of Car Purchases Prior to Bankruptcy

August 5, 2011

By: David M. Serafin

Non-tax related bankruptcy debts generally are either secured or unsecured. A secured debt is backed by collateral which can be seized if the debtor defaults on the debt. An unsecured debt is not backed by any collateral. Most correctly think of a secured debt as including a mortgage or car loan. Non-payment of a mortgage leads to foreclosure and non-payment of a car loan leads to repossession.

I often recommend that a bankruptcy client (who needs a car) buy a car prior to filing as the additional monthly expense of a car loan can allow the debtor to either pass the chapter 7 Means Test or lower an existing chapter 13 monthly plan payment.

But, do not just assume that a car loan is secured for vehicles purchased from a dealership or relative. To provide any third parties official notice of the existence of a lien, a creditor intending to be classified as secured is required to perfect the vehicle lien with the Department of Motor Vehicles (DMV) in the debtor’s county of residence.

The creditor will be deemed unsecured if the lien in unrecorded which means that the bankruptcy trustee can seize the car on behalf of the bankruptcy estate (or compel turnover of the value of the car with a very short time frame to reimburse the estate) and sell the car to pay unsecured creditors. Under Bankruptcy Code Section 544, the trustee can step into the shoes of the lien creditor and invalidate the unrecorded lien. Put another way, you lose any vehicle exemption in bankruptcy for an unrecorded car loan.

Even if the security interest is legitimately perfected over 30 days after purchase but after 90 days before the case was filed, Section 548 allows the trustee invoke the rule against avoidable preferences and compel turnover of any amounts over $600 paid within 90 days prior to the bankruptcy filing. The rationale behind the creation and enforcement of Section 548 is that all unsecured creditors should be treated equally and that it’s unfair for one creditor to receive a disproportionate share of pre-filing payments to the detriment of another. Unlike the result intended by Congress when enacting Section 544 but equally disasterous to a careless debtor, Section 548 permits the trustee to sue the creditor on behalf of the bankruptcy estate for any preferential payments made.

Sections 544 and 548 have more of an adverse effect in chapter 7 compared to chapter 13 matters. Chapter 7 debtors are typically below median income, own less assets and can less afford the immediate loss of a car or a requirement to pay back the car’s value over 4-6 months - at the most. Conversely, chapter 13 debtors are better able to keep a needed car and pay back any non-exempt equity over three to five years (without further accumulation of interest other than on the original note).

Thus, the best advice I can provide to debtors is to wait 90 days to file bankruptcy if the creditor did not perfect the security interest within 30 days after purchase.