Chapter 7 vs. Chapter 13–Income Tax Lien Fully Secured by Home Equity

Wasson and ThornhillIncome Taxes

If you have a recorded income tax lien fully secured by home equity, to keep your home you must pay the tax. Here’s how bankruptcy helps.

 

Our last blog post laid out the options if a tax lien was recorded againt your home but there WASN’T equity in the home to cover that tax lien. Today’s blog post is about dealing with an income tax lien recorded against a home which DOES have enough equity to cover the full amount of the income tax owed on that lien.

Let’s make this clearer with an example. Assume your home is worth about $20,000 more than you owe against on your mortgage(s). Imagine that you owe $6,000 in income taxes to the IRS for the 2011 tax year that you’d been struggling to pay when the IRS recorded a tax lien on your home a few months ago on that tax. The equity in your home is larger than the amount of that tax lien, so the entire $6,000 tax is now secured by your home.

What are your options for dealing with this tax?

Dischargeable Tax or Not?

In our last blog post we explained how there are two big considerations for determining your options here. First, whether there’s equity to cover the tax lien, and second, whether the underlying income tax is one that can be discharged—legally written off—in bankruptcy.

Today let’s again look at the scenario in which the income tax meets the conditions for discharge. So continuing with the above example of the $6,000 tax owed for 2011, assume that you filed the tax return for that tax by the usual April 2012 deadline. This means the $6,000 tax would very likely now be dischargeable in bankruptcy. That’s because it meets the two main necessary conditions: more than 3 years have passed since that tax return was due (April 2012) and more than 2 years since that tax return was actually filed (the same date).

Without the recorded tax lien, this $6,000 tax could be discharged in either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts.” Under Chapter 7 you’d likely not have to pay ANYTHING on that tax before it would be discharged forever. Under Chapter 13 you’d likely not have to pay ANYTHING MORE than you’d pay otherwise to all of your creditors if you hadn’t owed the tax.

But the recorded tax lien, securing that debt with the equity in your home, changes everything.

Without Any Bankruptcy

A recorded tax lien gives tremendous leverage to the IRS or state taxing authority. It makes your tax debt a matter of public record. It directly and seriously hurts your credit record. A tax lien requires you to pay the underlying tax—plus interest, penalties, and costs—in full if you sell or refinance your home. And the lien can even jeopardize your ability to sell or refinance your home at all. Under some circumstances the IRS/state may even foreclose on its tax lien.

So a tax lien gives you a much incentive to pay off the IRS/state lien. But most likely you can’t. You’ve wanted to take care of that tax debt but just haven’t had the money to do so. You may even entered into a payment plan with the IRS/state and not been able to keep it up. Or you simply have not had the money to begin making payments to them. Either way you need help.

How Chapter 7 Can Help

“Straight bankruptcy” can help in two ways.

First, the main benefit of filing a Chapter 7 case is that it can discharge all or most of your other debts—perhaps even some other years’ income taxes—so that you can focus your financial attention on the income tax debt with the lien on your home.

The IRS and state taxing authorities will often agree to take no further action on a tax lien if you enter into and comply with a monthly payment plan with them. So your Chapter 7 case could take away most of your other financial pressures so that you could focus on taking care of the tax debt and lien in a feasible way.

Second, if you decided to sell your home or walk away from it, Chapter 7 would help by discharging the income tax with the tax lien on it, so you’d not owe anything more on that tax. If you sold your home but it didn’t sell for enough to pay off the tax, or if you surrendered the home and the IRS/state got nothing from the mortgage holder’s foreclosure of the home, outside of bankruptcy you’d owe whatever tax debt would remain. But assuming that the tax qualified for discharge (as in the $6,000 example we’ve been using), you would not owe any of that tax after the Chapter 7 case was completed and the home was gone

How Chapter 13 Can Help More

But assuming you want to keep your home, entering into a payment plan with the IRS/state to satisfy the tax lien after completing a Chapter 7 case doesn’t always work.

Even after discharging your debts through Chapter 7, you may not qualify for or be able to afford to pay what the IRS/state requires in a payment plan.

You may have other crucial debts to pay that Chapter 7 does not help with, debts that would compete with what you’d otherwise be able to pay to satisfy the tax lien. If you want to keep the home, you may need to catch up on its property taxes, mortgage(s), or a homeowner’s association assessment. To keep your vehicle, you may need to catch up on its payments. Or you may need to quickly catch up on your child or spousal support to stop paycheck garnishments or the suspension of your driver’s license.

You may need the benefits that only Chapter 13 provides. These include “stripping” a second or third mortgage so that you could avoid making those payments and get closer to having equity on your home. Or you may need to catch up on child or spousal support and protect yourself and your income and assets from your ex-spouse or the support enforcement people while you do so. You may need to save money on your vehicle loan through a “cramdown,” reducing both monthly payments and on your total vehicle debt. Or you may need to discharge non-support obligations to your ex-spouse, or to keep student loan payments on hold for a few years.

How Chapter 13 Helps with the Tax Lien

Besides giving you unique tools such as the mortgage “strip,” stopping collection of support arrearage, vehicle loan cramdown, and others that Chapter 7 can’t provide, Chapter 13 deals with and protects you from the tax lien itself.

First, it stops the IRS/state from enforcing the tax lien through foreclosure of the lien or any other heavy-handed collection tactics. When you enter into a payment plan with the IRS/state after a Chapter 7 is over, you have no further bankruptcy protection. In contrast, that protection continues throughout the 3-to-5-year Chapter 13 payment plan.

Second, your payments on the underlying tax can be delayed or reduced while you pay other even more time-pressing debts, such as support arrearage or home mortgage or vehicle arrearage. The IRS/state doesn’t have grounds for objection as long as the tax secured by the tax lien is being paid before your case is finished.

Third, if your financial circumstances change, you can usually adjust your Chapter 13 plan payments and the payments being paid to the IRS/state on the income tax debt to account for those changes. Instead of being at the mercy of the IRS/state and their largely arbitrary rules, you would likely have more flexibility and protection within the bankruptcy procedures.

Finally, if your personal circumstances change or the value of your home increases or decreases so that instead of staying in your home you decide instead to sell or surrender it, you can usually change your Chapter 13 plan to incorporate those changes in dealing with the tax and tax lien in a way most favorable to you. You also have an almost universal right at any point to either dismiss (get out of) your Chapter 13 case altogether or to convert it into a Chapter 7 one.

Assuming that you wanted to keep your home, and you completed your Chapter 13 plan either as originally approved or as amended later, at its completion the tax debt with the tax lien would be paid in full and the IRS/state would release the tax lien.