What Happens to Cryptocurrency During Bankruptcy?

The financial landscape has been dramatically reshaped by the rise of cryptocurrency. What began as a niche technological experiment has exploded into a mainstream phenomenon, with millions of people holding assets like Bitcoin, Ethereum, NFTs, and countless other digital tokens. For many, crypto represents a significant investment, a part of their savings, or even a tool for transactions. But what happens when the volatile world of digital assets collides with the structured legal process of bankruptcy?

Valuation Challenges and Considerations

One of the most significant practical challenges with cryptocurrency in bankruptcy is its notorious price volatility. Unlike a bank account with a fixed balance, the value of Bitcoin, Ethereum, or other altcoins can fluctuate dramatically, sometimes hour by hour. This presents unique difficulties within the structured bankruptcy process.

Determining Value at Filing:

For bankruptcy purposes, your assets, including cryptocurrency, are generally valued as of the date you file your bankruptcy petition. This “snapshot” value is crucial for several reasons:

• It determines how much property is potentially available to creditors.
• It’s used to calculate whether your assets fit within available exemption limits.
• It forms the basis for the “liquidation analysis” in Chapter 13 cases.

To establish this value, you’ll typically need to reference the fair market price on a reputable cryptocurrency exchange at or very near the time of filing. Documenting how you arrived at this value (e.g., screenshots from major exchanges like Coinbase or Kraken) is a good practice.

Impact of Post-Filing Fluctuations:

While the filing date value is the primary reference point, significant price swings after filing can still complicate matters:

• In Chapter 7: If the trustee takes control of non-exempt crypto to sell it, a sudden price drop could mean less money recovered for creditors, while a price surge could yield more. The timing of the trustee’s sale can significantly impact the outcome.
• In Chapter 13: A substantial decrease in crypto value after your plan is confirmed could make it difficult to fulfill the plan’s requirements if those payments were based on a higher initial valuation. Conversely, a large increase might theoretically draw scrutiny from the trustee or creditors, although modifying confirmed plans based solely on post-confirmation asset appreciation is complex and not always pursued.
• Valuing Illiquid Assets: NFTs or tokens with thin trading volume present even greater valuation challenges, potentially requiring appraisals or specialized analysis, adding cost and complexity.

Navigating these valuation dynamics requires careful documentation and often strategic discussion with your bankruptcy attorney.

Chapter 7 Bankruptcy and Cryptocurrency

Chapter 7 bankruptcy, often called “liquidation” bankruptcy, is the most common type filed by individuals. Its primary purpose is to provide debtors with a “fresh start” by discharging (wiping out) most unsecured debts after liquidating non-exempt assets to pay creditors.

The Liquidation Process: When you file Chapter 7, a bankruptcy trustee is appointed to oversee your case. The trustee’s main job is to review your filed documents, investigate your financial affairs, and identify any assets that are not protected by exemptions. These non-exempt assets are then gathered and liquidated – sold off – with the proceeds distributed to your creditors according to a priority scheme defined in the Bankruptcy Code.

Cryptocurrency in Chapter 7: Since cryptocurrency is property, any crypto you own that exceeds your available exemption limits is subject to this liquidation process. Here’s how it typically works:

1. Disclosure: You must list all crypto on Schedule A/B.

2. Exemption Claim: You claim any applicable exemptions (primarily the Alabama personal property/wildcard exemption, discussed below) on Schedule C.

3. Trustee Review: The trustee examines your claimed exemptions. They may challenge an exemption claim if they believe it doesn’t apply or the valuation is incorrect.

4. Turnover: If you have non-exempt crypto, the trustee will demand you “turn over” control. This might mean transferring coins from your exchange account or wallet to the trustee’s control or providing necessary access credentials (like private keys or hardware wallet access, handled with extreme security protocols).

5. Liquidation: The trustee will sell the non-exempt cryptocurrency. This is typically done relatively quickly to mitigate volatility risk, often using established exchanges or specialized brokers catering to bankruptcy trustees.

6. Distribution: The cash proceeds from the sale become part of the bankruptcy estate funds paid out to your creditors.

7. Discharge: After the liquidation process (if any) is complete and other requirements are met, you receive your bankruptcy discharge, eliminating your liability for discharged debts.

Essentially, in Chapter 7, you generally only keep cryptocurrency that you can fully protect with an exemption. The rest is likely sold by the trustee.

Chapter 13 Bankruptcy and Cryptocurrency

Chapter 13 bankruptcy offers a different path for debtors, focusing on reorganization rather than liquidation. It’s often suitable for individuals with regular income who want to catch up on secured debts (like mortgages or car loans) or who have valuable non-exempt assets they wish to keep.

The Repayment Plan: In Chapter 13, you propose a repayment plan lasting three to five years. During this period, you make regular payments to the Chapter 13 trustee, who then distributes the funds to your creditors according to the plan’s terms and bankruptcy law priorities. Instead of selling assets, you use your disposable income to pay back a portion (or sometimes all) of your debts.

Cryptocurrency’s Impact on the Plan: While Chapter 13 allows you to retain possession of your assets, including cryptocurrency, the value of your non-exempt crypto still plays a critical role due to the “best interests of creditors” test (also known as the liquidation test). This test requires your repayment plan to pay unsecured creditors at least as much as they would have received if you had filed a Chapter 7 liquidation case.

Here’s the implication:

• If you own cryptocurrency whose value exceeds your available Alabama exemptions, that non-exempt value must essentially be paid into your Chapter 13 plan over its duration for the benefit of your unsecured creditors.
• Example: If you have $10,000 worth of Bitcoin and can only exempt $5,000 using the Alabama wildcard exemption, your Chapter 13 plan must ensure unsecured creditors receive at least the non-exempt $5,000 value over the 3-5 year plan term (in addition to any payments required based on your disposable income).

So, while you might physically keep your crypto keys or exchange account access in Chapter 13, you are effectively “paying for” the non-exempt portion through your plan payments. This makes Chapter 13 potentially more expensive than Chapter 7 if you have significant non-exempt crypto assets you want to protect. Failure to account for this non-exempt value accurately can lead to the court refusing to confirm (approve) your plan.

Disclosure and Record-Keeping Best Practices

We’ve stressed the absolute necessity of disclosing all cryptocurrency assets. Beyond simply listing them, maintaining good records is important for a smoother bankruptcy process and for substantiating your claims. Sloppy record-keeping can create suspicion and complications.

Why Good Records Matter:

• Accurate Valuation: Helps you determine the correct value as of the filing date.
• Proving Ownership: Demonstrates which assets are truly yours.
• Supporting Exemptions: Clear records can help justify your claimed exemptions if questioned by the trustee.
• Tracing Funds: If needed, helps show the source of funds used to acquire crypto or what happened to proceeds from sales.
• Establishing Cost Basis: While less critical for the bankruptcy process itself, knowing your cost basis is important for tax implications if the trustee sells the crypto at a gain.

Record-Keeping Recommendations:

• Transaction Histories: Download or export complete transaction histories from all exchanges where you’ve traded or held crypto (Coinbase, Binance, Kraken, etc.).
• Wallet Addresses: Keep a secure record of all your public wallet addresses.
• Purchase/Acquisition Details: If possible, retain records of when you acquired crypto and at what price (especially for assets held outside major exchanges).
• NFT/DeFi Details: For NFTs, record the token ID, collection name, and platform. For DeFi, note the protocols used, amounts staked/loaned, and associated wallet addresses.
• Secure Storage: Keep digital records securely backed up and physical records (like paper wallet printouts) safe.

Consequences of Poor Records or Non-Disclosure:

Remember, the burden is on you to provide accurate information. Inconsistent records or failure to disclose assets can lead trustees to conduct more intensive investigations. As previously mentioned, deliberate non-disclosure is bankruptcy fraud, carrying severe penalties:

• Loss of the asset itself.
• Denial of your bankruptcy discharge (meaning debts aren’t wiped out).
• Dismissal of your entire bankruptcy case.
• Potential federal criminal prosecution, fines, and even imprisonment.

The risks associated with inadequate disclosure far outweigh any perceived benefit of trying to hide assets.

Alabama Bankruptcy & Cryptocurrency: Contact Padgett & Robertson to Discuss Your Case

The journey through bankruptcy when you own cryptocurrency requires extra diligence and careful navigation. If you are drowning in debt, facing creditor actions, and see no other way out, understanding your bankruptcy options is a critical step. If your financial situation involves cryptocurrency holdings in Alabama, the experienced bankruptcy lawyers at Padgett & Robertson can provide the knowledgeable guidance you need. Contact us today for a confidential consultation to explore your options.