Bankruptcy & Divorce

Debt relief in the context of a divorce involves dissolving community property ties.   In most cases, it is better to file bankruptcy prior to filing for divorce or at least prior to the entry of a final property settlement.

By filing bankruptcy first, the case can be filed jointly. This will avoid duplicating attorney fees and simplify the divorce, by eliminating the need to assign debts.  In bankruptcy, assigned debts can become non-dischargeable “domestic support obligations” with respect to the divorcing spouses (See § 523(a)(5) & (15)).  This is very important because creditors are not bound by the terms of the divorce and ex-spouses can seek future reimbursement.  Also, by eliminating community debts jointly, there is no risk that the court will offset community assets against only one spouse that filed for bankruptcy relief.

There are some instances when a bankruptcy should not be filed until after the divorce has been finalized, which is discussed below (See Below “When to File Divorce Before Bankruptcy”).  The decision to file bankruptcy before or after a divorce pivots on community property concerns and qualification issues.

Overview of Community Property

Arizona is a community property state.  This means assets and debts that are incurred during marriage are presumed to be property of the marital community.  Each spouse has the legal authority to “bind” the community, which means incur debt on behalf of the marital community (See A.R.S. § 25-214).    Community debts even include those liabilities incurred by one spouse for the benefit of the community that were incurred without the other spouse’s approval (Ellsworth v. Ellsworth, 5 Ariz.App. 89 (1967)).  Community property liability is coupled with the obvious contractual liability of the signing spouse(s).  This concept holds true, irrespective of the net benefit to the marital community (Donato v. Fishburn, 90 Ariz. 210 (1961)).

There are several exceptions to community property.  Property owned prior to marriage remains separate property.  Gifts and inheritance also remain separate property of the recipient (See A.R.S § 25-213).  Real property acquired in title as separate property remain such as well.  Debts guaranteeing a loan are not community property, unless both spouses sign the guarantee ((See A.R.S § 25-214(C)).  Also, debts that do not benefit the community are not community debts.  However, the disputing party has the difficult burden of overcoming the community property assumption.  Finally, debts that predate the marriage are not community debts.

A divorce in a community property state involves dissolving the marital community.  Our family law courts are governed by the general principle of equitable distribution, which means the marital assets and debts are meant to be divided equally among spouses.

Final Settlement & Dissolving Community Property

Upon divorce, the court dissolves the estate by allocating community assets and debts among spouses via the property settlement order (Cadwell v. Cadwell, 126 Ariz. 460 (1980) & A.R.S. § 25-318).  In dividing community property, the court has broad discretion.  Considerations can include reckless conduct by a spouse, including excessive spending, destruction or concealment of property, or fraudulent disposition of marital property (See A.R.S § 25-318).  The court can create a lien upon the separate property of either spouse to secure payment for any interest or equity in property, for child support or spousal maintenance, and other causes (A.R.S. § 25-318).  With this authority, the court issues a final property settlement that will be binding on each spouse.

The property settlement order does not bind creditors, nor does it eliminate the community debt.  Upon divorce, the debts transition into joint debts.  The property settlement operates to determine future rights and obligations of the husband and wife relative to these debts (Lee v. Lee 133 Ariz. 118 (App. 1982)).  If community debts are not allocated within the divorce decree, they remain obligations of each spouse (Community Guardian Bank v. Hamlin, 182 Ariz. 627 (Ariz. App. 1995)).  After entry of a final property settlement order, divorced spouse can sue an ex-spouse for payment on a community property debt that was not assigned in the property settlement or in the decree, or for reimbursement for payment of a debt that was assigned to the other spouse (Fisher v. Sommer, 160 Ariz. 530 (Ariz.App. 1997).  Typically, this takes the form of a cross-complaint in the suit regarding the debt.)).

These obligations. i.e. assigned debts, within the divorce decree can become “domestic support obligations” under the bankruptcy code (See 11§ USC 101 (14 A).  This means that if an ex-spouse files bankruptcy on an assigned debt after the divorce, the ex-spouse may still be liable to the former spouse.  For example, if a husband was assigned a credit card debt during the divorce and he files a chapter bankruptcy on the debt, the credit card company could still sue the wife.  In this scenario, which certainly happens, the wife could then sue her former husband for reimbursement.

The bankruptcy will not protect the husband from the terms of the divorce decree, unless he files a chapter 13 bankruptcy that affords a broader discharge, including some domestic support obligations.  To avoid future domestic support obligation issues, the bankruptcy should generally be filed before the divorce.

When to File Divorce Before Bankruptcy

In some situations it is better to hold off on bankruptcy until after the divorce has been completed.  In the event that both spouses do not qualify for a chapter 7 bankruptcy, it is better to file a chapter 13 bankruptcy after the divorce has been completed.  By waiting, a debtor will have better clarity on their expenses, including any child support or alimony obligations.

A second reason to postpone bankruptcy is to use the property settlement phase of the divorce to assign non-exempt assets to a spouse that does not want to file bankruptcy, or will be filing a chapter 13 bankruptcy.  An alternative would be to have the family court enter a temporary order allocating assets, which could also protect non-exempt assets.  This will allow the other spouse to file a chapter 7 bankruptcy without losing the non-exempt assets.  If the divorce petition has been filed, a bankruptcy can still be filed, which will “stay” the family court proceeding, at least to the extent of property settlement.  This is because, upon commencement of a Chapter 7 bankruptcy, the community property becomes part of the bankruptcy estate.

Another consideration to filing bankruptcy first, is that an Arizona family court judge can balance a debtor’s discharge of community debts against assets of the non-filing spouse, i.e. providing a non-filing spouse a greater portion of assets to offset their sole and separate liability of otherwise discharged debts.  However, this risk is perhaps secondary to risk of creating non-dischargeability issues

As a word of caution, the trustee will review a divorce decree and non-exempt assets cannot be disproportionally assigned to one spouse.  If the property settlement and/or divorce appears to circumvent the bankruptcy code, the bankruptcy trustee can void transfers and take other such action as necessary.  To avoid any issues, a debtor’s bankruptcy attorney should be working in parallel with a debtor’s divorce lawyer.

General Advice for Divorcing Spouses & Debt

The best advice for divorcing spouses is to work together with debt issues.  Filing a joint bankruptcy prior to divorce is generally the ideal option.  However, a law firm will not undertake dual representation of divorcing spouses if they do not cooperate with each other and the attorney.  When appropriate, a lawyer will have clients sign a “conflict of interest” waiver with specific language that requires termination of services in the event spouses fail to cooperate.  It is always beneficial for spouses to work together.

Creditors are not bound by a divorce, nor necessarily aware of the divorce.  Spouses should notify creditors of the divorce.  Arizona statutes requires spouses to furnish credit reports to each other for such purposes (See A.R.S § 25-318(H)).  Credit lines should be closed, paid off, or otherwise transferred to only one spouse.  However, if both spouses signed for a credit line, it may be difficult to remove a name without closing the account.

One of the unknown benefits of bankruptcy and divorce has to do with credit reporting.  By filing bankruptcy, ex-spouses are no longer at the mercy of each other with respect to their credit.  For example, if a wife was assigned a house, which has a mortgage in the husband and wife’s name, the husband’s credit is at the mercy of whether the wife decides to make the mortgage payment.  By filing bankruptcy, the mortgage payment will no longer show on the husband’s credit.  Thereafter, if the wife decides to let the home go into foreclosure, it will not affect the husband.  Remember, a creditor is not bound be the divorce and will likely not voluntarily remove a name from a mortgage.  The bankruptcy forces the creditors to cooperate.

A bankruptcy should not be filed prior to the divorce if both spouses are not in agreement on the decision.  If one spouse files bankruptcy prior to the property settlement order, all community property becomes part of the bankruptcy estate (11 U.S.C. § 541(a)(2)(A)).  Arizona courts have ruled that initiation of the marital dissolution does not terminate a spouse’s authority to bind the community, which includes a spouse filing bankruptcy on behalf of the community (See A.R.S § 25-214(B).  By filing bankruptcy, the family court proceeding will be “stayed” with respect to the division of property.

Upon filing bankruptcy, all community property is pulled into the bankruptcy estate, even if one spouse contests the filing of bankruptcy (See In re Peterson, 2010 WL 3842157 (D.Ariz.)).  Bankruptcy will then alter the division of property.  In bankruptcy, the court is bound by fairness to creditors under the federal bankruptcy code, whereas, a family court is bound by a Arizona’s general principles of equitable distribution among spouses.  The contradiction among laws is settled in favor of federal bankruptcy code (See Supremacy Clause, Article VI, Clause 2, of the United States Constitution). Therefore, a bankruptcy filing that is not properly planned can jeopardize all community assets.

In conclusion, divorcing spouses should meet with a bankruptcy attorney if there are any debt issues accompanying the dissolution of a marriage.  Ideally, this conversation should take place prior to the property settlement phase of the divorce.  The goal of a planned bankruptcy is to eliminate debt, protect property, assist future credit reporting, and to help the dissolution of community estate.