A recorded income tax lien against your home hurts even if the home has no equity. But, a Chapter 13 bankruptcy can often get rid of such tax liens.
The Adverse Effect of a Recorded Tax Lien
In our last blog post we explained why the recording of a tax lien by the IRS or state tax authority can be so bad for you. We emphasized the advantage of filing a bankruptcy case before a tax lien is recorded in order to prevent its recording and the bad consequences that flow from it.
But what if the tax lien has already been recorded? Can bankruptcy get rid of a tax lien once it’s been recorded? Yes, but only under the right circumstances, and using the right tool to do so.
Liens Are Generally Protected in Bankruptcy
A lien is a creditor’s property right, the type of creditor’s right that is generally respected and preserved in bankruptcy, not so easily gotten rid of. For example, if you owe a vehicle loan and want to keep the vehicle, the lender’s lien on your vehicle continues regardless of your bankruptcy filing. As common sense would tell you, you can’t just write off (“discharge”) the debt and keep the vehicle, because the lienholder stays on the title. You have to pay it off before the lender will release the lien.
This is true in principle with recorded income tax liens as well. Whatever property of yours that a tax lien attaches to effectively secures that tax debt. So even if you could discharge the tax debt, the lien in the amount of that tax debt would still attach to your property, very much like the lienholder on the vehicle above.
Or to use another real estate example, let’s say you owed the IRS $10,000 in income taxes, and the IRS recorded a tax lien in the country recorder’s office of the county where you owned your home. Then that tax lien would attach to the title of your home. Even if you could discharge that $10,000 tax debt because it met the conditions for discharge (see our recent blog post about discharging older income taxes), the lien would survive and continue being on your home’s title.
When CAN a Tax Lien Be Released through Bankruptcy?
In the right circumstances bankruptcy can force the release of a recorded tax lien. Two conditions must exist:
- The income tax upon which the tax lien was recorded must be able to be discharged. That is, the tax must meet the conditions for discharge (again, see our recent blog post about those conditions).
- The lien must attach to nothing of value. For example, if the tax lien is on a house, there can be no equity in the house (beyond the debts that are ahead of the tax lien on the title, such as property taxes, the mortgage(s), prior judgment liens, etc.).
If the underlying tax can’t be discharged, that tax debt keeps giving the tax lien its purpose. If the tax lien has equity in the home to attach to, the lien is a property right with value untouched by bankruptcy. Only if the bankruptcy can discharge the underlying tax debt, and the lien attaches to nothing of value, can the lien be forced into being released.
HOW Does a Tax Lien Get Released through Bankruptcy?
Even under these circumstances, a Chapter 7 “straight bankruptcy” case does not necessarily achieve the release of a tax lien. Arguably the IRS and state tax agencies are under no affirmative duty to release a tax lien after the completion of a Chapter 7 case which discharges the underlying tax debt.
In the example of a tax lien on a home with no equity, after the Chapter 7 is completed the tax lien could just sit on the property until perhaps the value of the property would go up enough and/or the prior liens would get paid down enough so that at some point before the legal expiration of the tax lien it would attach to some equity. At that point, the IRS/state could demand to be paid, at least in part, in return for the release of the tax lien. This would usually happen at the time that the homeowner was refinancing or selling the home, giving the IRS/state the opportunity to extract payment in return for release of its tax lien.
Indeed, even if there was no equity and the homeowner wanted to sell or refinance, the IRS/state could demand some compensation—usually a relatively modest “nuisance” value because in such circumstances it has comparatively little leverage.
In contrast to Chapter 7, the Chapter 13 “adjustment of debts” has a valuable legal mechanism that affirmatively forces the IRS/state to release tax liens which do not attach to any value or equity in property. At the heart of Chapter 13 is the procedure through which you and your attorney propose a formal payment plan, the trustee and creditors have the opportunity to object to its terms, any objections are negotiated (or resolved by the bankruptcy judge), and then the plan is approved (“confirmed”) by the judge. Within that procedure all debts are determined to be either secured against your property or possessions, or are not (they’re unsecured). (Some debts may be partly secured and partly unsecured—we’ll cover that situation in our next blog post.)
Determining whether the debts are secured or unsecured also applies to income tax debts. So if there is no equity against which a tax lien can attach to in a home, the judge effectively orders that tax debt to be considered unsecured. And if that tax debt can be discharged (because it meets the legal conditions for discharge), then that tax debt is treated like all the other “general unsecured” debts.
That is, that tax debt is paid only as much as the debtor can afford to pay during the life of the Chapter 13 case, AFTER paying other legally more important debts, such as secured ones like home mortgage arrears and “priority” ones like more recent income taxes that can’t be discharged. As a result the dischargeable tax debt is often paid, along the rest of the “general unsecured” debts, very little or even sometimes nothing at all. Then at the end of the Chapter 13 case, the lien having been satisfied, the IRS/state must release the tax lien. The tax debt is discharged, and the tax lien is released.