A Fresh Start with an Income Tax Lien on Your Home

You owe income taxes, and now the IRS or state has recorded a tax lien on your home. Chapter 13 may get rid of both the tax and the lien.

 

Income Taxes that Can Be “Discharged” (Legally Written Off)

If you owe an income tax debt, it can be discharged like most other debts. The tax debt just needs to meet certain conditions for that to happen. Essentially, two conditions have to be met:

• 3 years must have passed since the tax return for the tax was due, and
• 2 years must have passed since that tax return was actually submitted to the IRS or state.

There are a couple other possible conditions but they very seldom come into play. So most of the time you can get rid of income tax debts simply by waiting until both of those two periods of time have passed.

If you owe a bunch of income taxes, having that legal obligation lifted off you would sure help you get a fresh start.

But What If a Tax Lien is Recorded against Your Home in the Meantime?

A tax lien recording by the IRS or state can turn a tax debt that you could discharge and legally not pay anything into one that has to be paid in part or in full.

That’s because a recorded tax lien involuntarily turns your home into collateral for payment of the tax. The tax becomes secured by your home.

Look at it this way. You can’t just discharge a mortgage debt through bankruptcy but then keep the home. That’s because the mortgage lender has a right to foreclose on your home if you don’t pay the debt. The lien created by the mortgage survives the bankruptcy discharge of the related debt. Similarly, once the IRS or state record a tax lien, that lien survives a bankruptcy discharge. So even if the tax at issue meets the conditions discussed above so that it could be discharged, the tax lien continues to encumber the home.

This means that after the bankruptcy case would be over, the IRS or state would likely be able to enforce the lien against your home, forcing you to pay the tax debt in order to clear the title to your home.

But What If There’s No Equity in the Home to Cover the Tax Lien?

In a Chapter 7 “straight bankruptcy if a tax lien is recorded before the Chapter 7 case is filed, as just mentioned that tax lien continues in force after the discharge of debts and the closing of the case.

But under certain limited circumstances the IRS/state might release its lien, eventually. For example, your home could be worth much less than the liens that are on the title ahead of the tax lien. Then if there’s no likely chance that there would ever be any equity in the home for the IRS/state upon the sale of the home, it may be persuaded to release the lien. Perhaps this might require paying a relatively small “nuisance value” amount.

However, the IRS/state would not release its tax lien if the home was worth close to the amount of the prior liens. Then any upcoming increase in the home’s value (together with any progress in paying down the mortgage and any other liens) would build equity for the tax lien to attach to. The IRS/state would then likely just wait until you sell or refinance the home. It would then release its lien only when it’s paid in full (including all the interest and penalties that’s accrued in the meantime).

So Chapter 7 is not likely a good way to deal with a tax lien even when there is presently no equity to cover that tax lien.

If No Equity for the Tax Lien under Chapter 13

Chapter 13 “adjustment of debts” can do better.

That’s because Chapter 13 has a very handy legal method through which the IRS/state could be required to release the tax lien if there is no equity in the home for the lien to attach to at the time that the case is filed.

Chapter 13 provides a procedure (unavailable under Chapter 7) by which the bankruptcy judge could determine that the liens ahead of the tax lien eat up all of your home’s equity, leaving none for the tax lien.

As a result the tax debt would treated as a “general unsecured” debt.  It would be lumped in with all your other “bottom-of-the-barrel” debts. You would pay on that tax debt only as much as you could afford to pay during the life of your 3-to-5-year Chapter 13 plan. In many situations you would pay little or nothing because you would first be required to pay other legally higher-priority debts.

And even if you do pay a portion of your “general unsecured” debts, adding the tax debt to the rest of your “general unsecured” debts usually doesn’t increase what you pay. That’s because most of the time you pay a fixed amount of that pool of debts. So adding the tax debt simply reduces what the other creditors receive without obligating you to pay more.

At the end of the Chapter 13 case, any portion of the tax debt that hasn’t been paid is forever discharged, and the IRS/state releases its tax lien.

Conclusion

Chapter 13 is likely your best option if 1) you have a tax debt that would qualify for discharge under the timing rules, and 2) the liens ahead of the tax lien are at or close to the value of your home. Unlike Chapter 7, you can legally establish that your home has no equity for the tax lien to attach to, and thus that the tax debt is effectively unsecured. Then at the end of the Chapter 13 case that tax debt is discharged and the tax lien released from your home’s title. You and your home would then indeed have a fresh financial start.