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Tax Season: The Benefits of Filing a Chapter 7 Case Before the Recording of a Tax Lien

Chapter 7 can prevent a tax lien. Here’s what happens with and without that recorded tax lien.


Our last blog post was about the benefits of stopping the recording of a tax lien by filing bankruptcy before that happens. We described how the prior recording of a tax lien could be a very expensive event for you. Specifically we showed the huge detrimental effect if you have a tax debt that could otherwise have been discharged (legally written off) in bankruptcy.

Today’s blog post will make this clearer by showing how a Chapter 7 “straight bankruptcy” would treat a dischargeable tax debt WITHOUT a recorded tax lien, and then how it would treat that same tax debt WITH a prior recorded tax lien.

Dischargeable Taxes in Chapter 7 WITHOUT a tax lien

Under Chapter 7, if you have a tax debt that is old enough and otherwise meets the conditions of discharge, and no tax lien has been recorded on it, that tax is simply discharged. The IRS or state tax authority is legally forbidden from attempting to collect on the tax in the same way that any creditor is forbidden from collecting on a debt that’s discharged in bankruptcy. This usually happens quite quickly, only about 3 or 4 months after your case is filed. It doesn’t matter if that tax is for $10 or $10,000; it’s simply gone.

(To meet the conditions for discharging an income tax debt, its tax return must have been due more than 3 years before the Chapter 7 filing (adding in any extensions to file the return) and the tax return must have been actually filed 2 years before. There are other possible conditions, but they don’t apply to most income tax debts.)

The filing of your Chapter 7 case also stops the IRS/state from being able to record a tax lien as of the moment of that filing, and through the course of the case. Then once the tax debt is discharged a few months later the IRS/state can never record a tax lien on that tax ever again.

The modest exception on such a dischargeable tax not being paid anything is if you have an “asset” Chapter 7 case. That’s the small minority of cases in which some of your assets are NOT covered by the available property exemptions. This means that some asset(s) must be surrendered to the bankruptcy trustee, who then liquidates it (them), and uses the proceeds to pay the creditors. But even then that tax would be paid only a pro-rated portion of whatever amount is being distributed among the creditors. The dischargeable tax—no matter how small or large—would have no effect on what assets the trustee can take and liquidate.

Furthermore, even in an “asset” Chapter 7 case, the dischargeable tax debt may well be paid nothing through the trustee’s distribution if you have any “priority” debts—more recent tax debts, or back child or spousal support, for example. That’s because “priority” debts are paid in full before anything goes to the other creditors, and so could well exhaust the available money.  Regardless whether the older dischargeable tax is paid anything through the trustee’s distribution, any unpaid portion of it is discharged, just like in a “no-asset” Chapter 7 case.

Dischargeable Taxes in Chapter 7 WITH a recorded tax lien

However, if the IRS/state recorded a tax lien at any time before your bankruptcy is filed—even just a few days or a few minutes beforehand—that recording creates a lien, in the amount of the tax, on everything the recording covers under state law.

In most states there’s a different procedure for recording a lien on real estate than on personal property. So if you think that a tax lien has been recorded against you, talk with your attorney to determine if that’s true, and about the effect of that tax lien.

The prior recording of a tax lien creates problems because most liens are not affected by a Chapter 7 bankruptcy. For example, if you have a vehicle loan, with the lender as a lienholder on the vehicle’s title, you may well be able to discharge the debt on the loan through bankruptcy, but that does not take the lender off the title. The lien survives. So if you want to keep the vehicle you have to pay the debt.

In the same way, the lien on your property created by a recorded tax lien is not affected by bankruptcy. So if you have a recorded tax lien on a tax that would otherwise be discharged in your Chapter 7 case, the IRS/state would continue to have a lien on either your personal or real property, or both. After the completion of your bankruptcy case you—or your attorney—would have to negotiate with the IRS/state about how much you would have to pay to get it to release the lien. How much to pay would depend on the amount of the tax that is secured by the lien and the value of whatever the lien is attached to. If you truly owe extremely little, some taxing authorities may release the tax lien with little or no payment, but that is unusual.

The Bottom Line

If you owe any income taxes eligible for discharge (see above), by the very nature of the conditions for discharge those taxes are relatively old. So if the IRS/state has not recorded a tax lien yet, it may well do so soon. Since there’s likely such a huge detrimental impact if that were to happen before you filed a Chapter 7 bankruptcy, you would be wise to look into this option right away. 


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