You CAN lose your income tax refund if you file a “straight bankruptcy” Chapter 7 case. But you can usually keep it with the right advice.
The Right Starting Point
Any issue involving the combination of taxes and bankruptcy can get very complicated very fast. So if you are thinking at all about bankruptcy, it simply makes sense to see a competent bankruptcy attorney about anything involving tax obligations or tax refunds, and to do so early. Many potential mistakes can be avoided with timely advice.
Tax Refunds as Chapter 7 Assets
Why are tax refunds something to be concerned about as you think about bankruptcy?
At its most basic, bankruptcy concerns itself with debts and assets. Chapter 7 discharges (legally writes off) debts, in return for a debtor’s surrender to the bankruptcy of all assets that are not “exempt”—not protected. Most Chapter 7 cases result in the discharge of all debts that are intended to be discharged, and the loss of no assets because everything is exempt.
So the whole story about tax refunds under Chapter 7 comes down to whether a particular refund is an asset for purposes of that bankruptcy case, and if so, whether it is exempt.
Property of the Bankruptcy Estate
For asset purposes, Chapter 7 fixates on the moment the bankruptcy case is filed. Everything the debtor owns at that time becomes part of the Chapter 7 “bankruptcy estate.” Besides tangible assets like a vehicle and furniture, the “estate” can also include intangible assets like money that you are legally entitled to but just haven’t received yet. Examples of these include a paycheck fully earned but not yet paid, a debt owed by a relative, OR any tax refunds owed to the taxpayer at the time the Chapter 7 case is filed.
Timing of Filing
Precise timing is crucial when it comes to tax refunds.
After a person receives and spends a tax refund before filing the Chapter 7 case, it is no longer an asset for purposes of that case. There ARE other issues such as how that tax refund is spent on the brink of filing the bankruptcy case, issues that the person should talk about with a bankruptcy attorney before taking any action. But once the refund is spent it’s no longer an asset problem.
But other than that, a tax refund could be considered property of a bankruptcy estate in a Chapter 7 filing just about any time of the year.
The usual time of heightened attention is during the period from the beginning of a calendar year through about April 15 and a couple months beyond that each year. That’s of course because a large percentage of taxpayers who file their tax returns expecting refunds file during that period. From the bankruptcy perspective, a tax refund is considered owed to the taxpayer as of the day after the end of the tax year, which for almost everybody is the first day of January of the immediately following year. So in Chapter 7 cases filed early in the year, any tax refund owed from the prior year not yet received and spent is property of the bankruptcy estate, and potentially subject to collection by the Chapter 7 trustee.
But if a taxpayer doesn’t prepare tax returns until the extended October 15 deadline, or has not filed a few years of tax returns on time, or any other circumstance, whenever tax refunds are owed to the taxpayer as of the date he or she files a Chapter 7 case will be property of the bankruptcy estate.
None of this has anything to do with whether the person has actually filed an income tax return, whether the person knows the amount of the anticipated refund(s), or whether the person is even aware that he or she is owed a refund. If there is found to be any tax refund due to the taxpayer at the time of the bankruptcy filing, that refund is property of the bankruptcy estate and potentially belongs to the Chapter 7 trustee for payment to the taxpayer’s creditors.
Protecting Tax Refunds through an Exemption
As stated above, if an anticipated refund is owed to the taxpayer at the time of the Chapter 7 filing and is therefore property of the bankruptcy estate, it can still be kept by the taxpayer and not surrendered to the bankruptcy trustee if the refund is covered by an exemption.
Often, the applicable exemption is more than large enough to protect the tax refund. For example, in the many states that allow a person filing bankruptcy to choose between either that state’s set of exemptions or the federal set of them, the federal exemption for tax refunds can be quite large, depending on the circumstances. The federal “wildcard” exemption is not terribly large of itself–$1,225, or $2,450 in a jointly filed case by both spouses. But it allows for a potentially very helpful spillover effect in that any unused portion of the homestead exemption –as much as $22,975, or $45,950 in a jointly filed case—gets added to the “wildcard” exemption amount. So in a Chapter 7 case in which the homestead exemption is not used at all—because the person filing doesn’t own a home or owns one but it has no equity, and is not using the exemption for any other purpose—he or she can exempt up to $24,200 ($1,225 + $22,975) in tax refunds, or $48,400 ($2,450 + $45,950) in a jointly filed case).
Again, This Is NEVER As Simple As It Might Seem
In summary, a person can avoid a tax refund being property of his or her Chapter 7 estate by waiting until receiving and spending the refund before filing the case. Or he or she may not need to wait to file bankruptcy if the tax refunds are fully protected by an exemption.
But this is usually much more complicated than it may seem. This blog post has only presented the broad principles at play. There can be many factors in weighing the advantages and disadvantages of filing a bankruptcy case earlier vs. later, and the various potential risks of all those factors. In balancing all of these, you truly need the expertise and advice of a careful bankruptcy attorney.