Navigating Student Loan Bankruptcy Discharge: A Comprehensive Guide

Student loan debt can be a significant burden, and while bankruptcy is often considered a last resort, it may be an option for some borrowers. However, discharging student loans in bankruptcy is a complex process with strict criteria. This article provides a comprehensive overview of student loan bankruptcy discharge, including eligibility, the "undue hardship" standard, and recent changes in the process.

Bankruptcy and Financial Aid Eligibility

Filing for bankruptcy can have implications for a student's future eligibility for financial aid, but it generally has no impact on eligibility for federal student aid.

Federal Student Aid

The Bankruptcy Reform Act of 1994 amended the FFELP regulations, eliminating the requirement for borrowers with previously discharged FFELP loans to reaffirm those loans before receiving additional federal student aid. Financial aid administrators cannot cite bankruptcy as evidence of an unwillingness to repay student loans and Title IV grant or loan aid may not be denied to a student who has filed bankruptcy solely on the basis of the bankruptcy determination. Schools may, however, consider the student’s post-bankruptcy credit history when determining willingness to repay the loan.

As long as there are no current delinquencies or defaults on student loans, the student should be eligible for additional federal student loans, regardless of past bankruptcies. However, students with federal student loans in default that were not included in a bankruptcy will not be able to get further federal student aid until the issue is resolved. If the loan was discharged in bankruptcy after the borrower defaulted on the loan, it is no longer considered to be in default.

Parents applying for a PLUS loan (or graduate students applying for a Grad PLUS loan) may be denied if they have an adverse credit history, including debts discharged in bankruptcy within the past five years. In such cases, the parents may still be eligible for a PLUS loan if they secure an endorser without an adverse credit history. If the parents are turned down for a PLUS loan because of an adverse credit history, the student may be eligible for an increased unsubsidized Stafford loan.

The anti-discrimination rules appear in 11 USC 525(c).

Private Student Loans

Private loans are an entirely different matter and the student should contact the financial aid administrator at his school for advice on the impact of a bankruptcy on eligibility for private loans. The student should also talk to the lender and provide evidence that he is a good risk, and be prepared to explain the circumstances behind the bankruptcy.

Most bankruptcies will impact eligibility for private loan programs, including some school loan programs. Many private loan programs have credit criteria that preclude people with a bankruptcy within the past 7 or 10 years from borrowing without a creditworthy cosigner. There are, however, exceptions if the bankruptcy was initiated for reasons beyond the borrower’s control, such as extraordinary medical costs, natural disasters, or other extenuating circumstances.

If a parent went through bankruptcy, it should have absolutely no impact on their children’s eligibility for private loans, unless the parent is required to cosign the loans.

If the bankruptcy filing included a payout plan, even if not 100%, the student will be at an advantage in applying for private loans. On the other hand, if the borrower went the Chapter 7 route, he may have more difficulty in getting a private loan. Lenders tend to look less favorably on complete liquidations. Thus borrowers who filed for a Chapter 11 (or Chapter 13) and had a payout plan will be more likely to get a private loan than borrowers who filed a Chapter 7.

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Lenders also look at whether the borrower is able to refile for bankruptcy. Chapter 11 filers cannot immediately refile again for bankruptcy. Although any lender should know this, they may need to be reminded. Chapter 7 files are prohibited from refiling a Chapter 7 bankruptcy for 6 years. However, Chapter 13 plans have no such restriction, so a debtor can file a Chapter 7 bankruptcy, have their debts discharged, and then file a Chapter 13 within a very short time if new debt is incurred. A debtor can file an unlimited number of Chapter 13 bankruptcies.

The "Undue Hardship" Standard

To discharge student loan debt in bankruptcy, a borrower must demonstrate that repaying the loans would cause "undue hardship". This is a high legal standard, and courts are often reluctant to discharge student loan debt. The test for deciding what constitutes an undue hardship varies between courts.

Most court cases cite Brunner v. New York State Higher Education Services Corp. for a definition of “undue hardship”.

The Brunner Test

Many courts use the Brunner test to determine what qualifies as an undue hardship. This test, established in Brunner v. New York State Higher Education Services Corp., requires the debtor to demonstrate three elements:

Present Ability to Pay: The debtor cannot both repay the student loan and maintain a minimal standard of living based on current income and expenses.
Future Ability to Pay: This situation is likely to persist for a significant portion of the repayment period of the student loans.
Good Faith Effort to Repay: The debtor has made good faith efforts to repay the loans.

The first element of the standard usually involves the lowest monthly payment available to the borrower, namely the monthly loan payment under Income Contingent Repayment, as opposed to standard ten-year repayment. (With the introduction of Income Based Repayment on July 1, 2009, it is expected that the courts will switch to this repayment plan as it usually yields a lower monthly payment and meshes well with the 150% of poverty line threshold for a bankruptcy fee waiver.) Note that if the borrower has multiple student loans and could afford to repay some but not all of them, the court will generally discharge only those loans that exceed the borrower’s ability to repay. It is also possible that a court will discharge part of a loan instead of the entire loan.

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The poverty line is often (but not always) used as a threshold for a minimal standard of living, since it is defined as the income level at which the family has no discretion concerning how to use the income. However, the courts will generally examine all of the debtor’s expenses to ensure that they are minimal and necessary. The existence of discretionary expenses may derail an undue hardship petition, as borrowers are expected to make sacrifices to repay their debts.

The second element of the standard requires the debtor to provide evidence of additional exceptional circumstances that are strongly suggestive of a continuing insurmountable inability to repay, such as being disabled or having a disabled dependent. A serious physical or mental illness might also qualify. An inability to work in one’s chosen profession does not necessarily preclude being able to work in another field. There must be a “certainty of hopelessness”, meaning that there is no chance of any future improvement in the borrower’s financial situation.

The third element of the standard requires the borrower to have demonstrated a good faith effort to repay the loans. Filing for a bankruptcy discharge immediately after graduation is generally not considered a good faith effort to repay the loans. However, there might be extenuating circumstances, such as the debtor suffering brain damage in a car accident shortly after graduation. The court will consider the totality of the circumstances. The court will consider whether the debtor made payments on the loans when he or she had some income available and obtained a deferment or forbearance when his or her income was insufficient. The court will also consider whether the debtor took advantage of various alternatives to bankruptcy, such as the extended repayment, income-contingent repayment and income-based repayment plans, and whether the debtor tried to increase available financial resources, such as seeking a better job and reducing expenses.

The Totality of the Circumstances Test

Other Tests. There are some other tests used to assess what constitutes an undue hardship.

Types of Student Loans and Dischargeability

The federal government is the primary lender for a large number of student loans. Private financial institutions, however, also offer loans to students. Regardless of whether you have a government or private loan, it is challenging to discharge both in bankruptcy.

Loans that don’t meet the definition, such as credit card debt, are still dischargeable even if they were used to pay for higher education expenses.

Thus FFELP and FDSLP loans, and education loans funded or guaranteed by private nonprofit organizations, are automatically nondischargeable in a bankruptcy proceeding. The only cases in which they can be discharged through bankruptcy are:if the borrower files an undue hardship petitionand then it is up to the judge to decide whether the loan can actually be discharged. (The Higher Education Amendments of 1998 repealed the provision that allowed for the discharge of education loans that had been in repayment for 7 years. This affects all bankruptcy proceedings initiated after October 7, 1998, regardless of whether they involve loans incurred before that date.)

Section 220 of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), P.L. 109-8, extended similar protections to “qualified education loans” starting on October 17, 2005, even when they are not funded or guaranteed by a nonprofit organization. Qualified education loans is defined to include any debt incurred by the taxpayer solely for the purpose of paying for qualified higher education expenses of the taxpayer, the taxpayer’s spouse, or any dependent of the taxpayer. (Dependency is determined as of the time the taxpayer took out the loan.) Interestingly enough, most private student loan programs seem to have some sort of nonprofit involvement.

BAPCPA also made it more difficult to file under Chapter 7. If the borrower’s income is above the median income in his/her state or is sufficient to repay 25% or more of his/her debt, the borrower will be forced to file under Chapter 13, which requires repayment over three to five years. BAPCPA also mandates credit counseling before a borrower can file for bankruptcy.

Finaid analyzed FICO score distributions before and after BAPCPA showing no appreciable increase in availability of private student loans. Some of this might be explained by the lenders believing that their loans were excepted even prior to BAPCPA. If so, why did the lenders push the BAPCPA changes based on arguments that it would increase the availability of private student loans?

It is worth noting that the extension of the bankruptcy exception to qualified education loans in 11 USC 523(a)(8)(B) cross-references IRC section 221(d)(1) for the definition of a qualified education loan. This section of the Internal Revenue Code requires the loan to be used “solely to pay qualified higher education expenses”. 1087ll, as in effect on the day before the date of the enactment of this Act) at an eligible educational institution, reduced by the sum of -the amount excluded from gross income under section 127, 135, 529, or 530 by reason of such expenses, andthe amount of any scholarship, allowance, or payment described in section 25A (g)(2).

So to qualify for this exception, the private student loan must be capped at the cost of attendance minus student aid, such as scholarships, and expenses paid for using amounts from employer tuition assistance, 529 college savings plans and prepaid tuition plans, US savings bonds and Coverdell education savings accounts. If a borrower were able to show that the loan exceeded the limits set by IRC section 221(d)(2), they might be able to argue that the loan was ineligible for bankruptcy protection and so should be subject to discharge. See IRS Tax Topic 456 and IRS Publication 970 for further IRS guidance on what types of expenses qualify, such as the requirement that the expenses must have been “paid or incurred within a reasonable time before or after you took out the loan” (per IRC section 221(d)(1)(B)). IRS Publication 970 provides a safe harbor of 90 days before and after the academic period to which the expenses relate. Consolidation loans and other loans used to refinance a qualified education loan also qualify, provided that there was no cash out from the refinance (or that the cash out was used solely for qualified higher education expenses). Eligible student is defined by IRC section 25A(3) as a student enrolled at least half time in a degree or certificate program at a Title IV institution (per Section 484(a)(1) of the Higher Education Act of 1965).

More details and other limitations on the exception to discharge can be found in Limitations on Exception to Discharge of Private Student Loans.

Steps to Discharge Student Loans in Bankruptcy

If you want to discharge student loans in bankruptcy, you must first file an adversary proceeding to determine dischargeability. Additionally, you must also present evidence that repaying the debt would result in an undue hardship.

Your student loans will not be automatically discharged if your bankruptcy is approved. You have to take special steps in the bankruptcy case to ask the judge to discharge your student loans. This is done by filing a petition for an adversary proceeding. Though it is up to the court to decide whether you have an undue hardship, if you are trying to discharge your federal student loans, during the adversary proceeding the judge will ask the federal government ( the creditor for your federal student loans) whether or not it will agree that you have an undue hardship. The government is represented by the Department of Justice (DOJ) in the adversary proceeding.

At the beginning of the proceeding, the DOJ will ask you to fill out an attestation of undue hardship.

New Process for DOE-Held Loans (as of November 2022)

On November 17, 2022, the Department of Justice (DOJ), in cooperation with the Department of Education (DOE), announced a new process under which DOJ attorneys will evaluate student loan discharge actions filed in bankruptcy proceedings. The new process will apply to all “DOE-held” federal loans, including Direct Loans and those FFELP and Perkins loans that are held by the government. Private student loans are not subject to this process.

Key Aspects of the New Process:

Initiating an Adversary Proceeding: Within the debtor’s bankruptcy, an adversary proceeding must be initiated by the filing of a complaint to determine dischargeability of debt under Section 523(a)(8). The complaint and summons must be served in a manner consistent with Federal Rule of Bankruptcy Procedure (FRBP) 7004.
Communication with the AUSA: When DOE-held student loans are the subject of the adversary proceeding, debtor’s counsel should promptly establish communication with the Assistant United States Attorney (AUSA) assigned to defend the case on behalf of the government.
Attestation Form: The DOJ will ask you to fill out an attestation of undue hardship. The attestation form generally tracks the three Brunner prongs for evaluating hardship by examining present financial circumstances, future circumstances, and past good faith effort to pay the loans. The most exhaustive inquiry involves the debtor’s current financial circumstances. Detailed instructions for completing the attestation have been issued by the DOJ.
Present Circumstances Analysis: The present circumstances analysis considers all household income (including income not counted in Schedule I), minus withholdings, against defined IRS standards and other specific expenditures. The debtor may list reasonable expenses that have not yet been incurred, such as when the debtor is living in substandard or shared housing and will need an increased housing expenditure to obtain adequate housing.
Future Circumstances and Past Good Faith: The “future circumstances” and “past good faith” inquiries are more straightforward. The attestation form offers a number of bases which will trigger a presumption that the debtor lacks the future ability to repay the loan, including if the debtor is 65 years of age or older, or has a disability which limits the ability to earn income.
Review and Recommendation: After the completed attestation form is submitted, the AUSA will review it and may request additional information to supplement or verify the debtor’s statements. After this review, the AUSA will forward a recommendation to the DOE, and the agencies are directed to work together to determine whether discharge is indicated based on the responses provided in the debtor’s attestation.
Suspension of Deadlines: While awaiting a determination regarding dischargeability, the parties should file a joint request to suspend pre-trial deadlines and the trial date, to accommodate the review.
Likelihood of Success: A debtor’s likelihood of success should be reasonably apparent before the complaint is ever filed since the basis for case evaluation is set forth in the publicly available attestation.

Other Considerations

Chapter 7 vs. Chapter 13 Bankruptcy: The judge’s decision of what to do if you have an undue hardship will also depend on which type of bankruptcy case you file (Chapter 7 or Chapter 13). In a Chapter 7 bankruptcy, you are asking a judge to cancel all of your debt, but you have to have income below a certain amount in order to qualify. In a Chapter 13 bankruptcy, you usually ask the judge to help you reorganize and lower your debt.
Appealing a Decision: If a judge doesn’t find that you have an undue hardship, you may be able to appeal the decision.
Reopening a Bankruptcy Case: If your bankruptcy was already approved, but you did not ask the court to make a determination of undue hardship before the case was closed, you can ask the court to reopen your bankruptcy case.
Alternatives to Bankruptcy: There are other repayment options available for student loan borrowers, such as income-based repayment plans, deferment, and forbearance.

Seeking Legal Guidance

Navigating bankruptcy discharge involving student loan debt is challenging, but a skilled lawyer can help. If you have questions about student loans and debt relief, contact an experienced bankruptcy lawyer for guidance and support. The cost of getting help with bankruptcy will vary depending on the type of bankruptcy you’re seeking and the complexity of your case. Most bankruptcy lawyers will do a Chapter 7 bankruptcy for a flat fee.

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