The bankruptcy means test – what is a consumer debt?

In this bad economy, I see potential clients who own more than one house.  For example:  A couple owned a small home.  They had children and needed to purchase a larger house.  They then have decided to rent the first house, either because they couldn’t sell the first house, or because they thought that it might be a good investment.  Later on, hard times occured, and they came to see the bankruptcy attorney.  There is the issue of whether the mortgage debt on the first house counts as business debt or consumer debt.  Unfortunately, even though the use of the rental house might have changed, the debt is still considered consumer debt.  The bankruptcy code’s definition of “consumer debt” is found in section 101(8) of the bankruptcy code.  “Consumer debt” is defined as “debt incurred by an individual primarily for a personal, family, or household purpose.”  The important word here is “incurred.”  The mortgage debt originally was incurred for a personal, family or household purpose.  This is very different from what the IRS regulations allow a taxpayer to deduct as business expenses (for example, upkeep of the rental house).  Why is this important?  Because if a majority of a debtor’s debt is business debt, then he or she does not have to complete the “means test.”  However, if a majority is consumer debt, then he or she does have to complete the “means test.” 

Another tricky subject is whether a majority of the debt is business or consumer debt.  I am seeing clients who were also business owners, and their business debts are large – and unpayable.  However, when I add the amount of their home mortgage debt on the “consumer” side of the ledger, a majority of their debts are consumer debts and they have to take, and pass, the means test to file Chapter 7.

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