Converting Credit Cards to a HELOC Before Bankruptcy: Legal Traps

Debtors facing insurmountable debt may consider using a home equity line of credit (HELOC) to pay off credit cards before filing for bankruptcy. While it may seem like a debt-consolidation strategy, it could backfire. Unlike a personal loan or refinance, this approach carries risks.

Converting credit cards to a HELOC before a bankruptcy can lead to fraudulent and preferential transfer challenges, non-dischargeability complaints, loss of the homestead exemption, and court sanctions. It can also turn unsecured debt into a lien against your home. Therefore, before converting credit cards to a HELOC before bankruptcy, contact an experienced bankruptcy attorney.

Fraudulent and Preferential Transfers

Bankruptcy trustees actively review the financial moves debtors make in the months and years before filing a Chapter 7 or Chapter 13 bankruptcy.

Fraudulent Transfers Under 11 U.S.C. § 548

Bankruptcy law contains a two-year look-back window for federal transfer claims. State law may allow a longer look-back window. Under the law, fraud can take different forms.

• Actual fraud. Transfers that are made with actual intent to hinder, delay, or defraud creditors.
• Constructive fraud. This type of fraud involves transfers made for less than reasonably equivalent value for such transfer or obligation.

When the debtor’s finances are under the microscope, paying unsecured loans, such as a credit card, with borrowed funds draws additional scrutiny. Turning that balance into a home equity loan or a second mortgage effectively converts unsecured debt into secured debt backed by your property.

Preferential Transfers Under 11 U.S.C. § 547

Preference actions are a common tool trustees use to recover money in bankruptcy cases. Section 547(b)(4) of the Bankruptcy Code establishes the 90-day preference period, and Section 547(e) provides rules for determining when a transfer is made.

Under this law, a transfer is potentially avoidable under certain circumstances. The trustee can claw back certain credit card payments, even those made to reduce your balance below your credit limit.

The trustee can find that a transfer is potentially avoidable. Some of the elements that must be met include:

• The transfer was made to or for the benefit of a creditor
• It occurred within 90 days before the bankruptcy filing
• The debtor was insolvent at the time of the transfer
• The transfer allowed the creditor to receive more than it would have received in a Chapter 7 liquidation

If these elements are satisfied, the transfer may be subject to clawback, unless a statutory defense applies. These defenses can include a lack of preference.

Signs of Fraud

Courts look for certain warning signs of fraud. These warning signs include:

• The length of time between the payments and the filing
• The relationship between the parties
• Unusual transaction patterns

Non-Dischargeability Risks

Bankruptcy may mean getting a fresh start for dischargeable debts, but certain maneuvers can jeopardize the plan.

Intentional Fraud Under § 523(a)(2)

When a debtor moves credit card debt to a HELOC before bankruptcy, it can look like an attempt to shield non-exempt assets. When creditors notice this, they may file an adversary proceeding. They could seek to have specific debts declared non-dischargeable.

Luxury Goods and Cash Advance Presumptions

Under bankruptcy law, certain purchases of luxury goods over the statutory limit within 90 days of filing are assumed to be non-dischargeable. Additionally, even cash advances over a certain limit within 70 days of the filing are similarly presumed fraudulent.

Thus, last-minute credit card use, even to fund a HELOC payment, can trigger the presumption of fraud.

The Burden Shift

Burden shifting concerns who must prove what. In a bankruptcy matter, the law shifts the burden to the debtor to prove legitimate intent.

To overcome the burden, you need documentation, such as your credit report and account balances. This can help support the position that you made the transfers for legitimate purposes.

Loss of Homestead Exemption

Under state and federal homestead exemptions, home equity is often protected. Using a HELOC to pay credit cards generally converts unsecured debt into debt secured by the home, and it does not itself convert nonexempt assets into exempt home equity. Courts distinguish between legitimate planning and abusive conversion.

Bad-faith conversions can lead the court to reduce or eliminate the homestead exemption. Federal law allows this reduction to occur for conversions within ten years of filing. The closer the conversion is to the filing, the greater the amount of scrutiny.

Court Sanctions

Fraudulent transfers relating to converting credit cards to a HELOC before bankruptcy can lead to consequences that extend far beyond a single denied exemption. It can even result in a denial of the entire discharge.

When a discharge is denied, the automatic stay that halts collection efforts and foreclosure actions may no longer protect you.

Other possible sanctions, legal penalties, and criminal penalties include:

• Turnover orders requiring repayment of transferred funds
• Liability for the legal costs for trustees and creditors
• Criminal penalties
• Potential fines and imprisonment for knowing, fraudulent conduct

When a debtor is found to have engaged in fraudulent transfers, they may face sanctions, damage their credibility with the court, and have difficulty obtaining future relief.

Speak to a Bankruptcy Attorney

If you need legal guidance regarding a bankruptcy case or the risks associated with converting credit card debt to a HELOC before bankruptcy, use the Super Lawyers directory to locate an experienced bankruptcy attorney.

A lawyer can provide individualized legal advice and explain legitimate options, such as a structured repayment plan, secured loans, or another refinance option, that may fit your situation. You don’t have to explore options alone.