A tax lien may attach to assets worth more than the amount of the underlying tax, making it a secured tax debt. That could make either a small or a huge difference.
A Potentially Secured Tax Debt
The recording of an income tax lien potentially turns an unsecured tax debt into one secured by some of your property and possessions. Whether that tax debt actually becomes secured or not turns on whether that lien attaches to anything of value, and whether the amount of that value covers the amount of the tax at issue.
Assume, for example, that you owed income taxes on a particular tax year in the amount of $7,500, and the IRS recorded a tax lien for that tax in the county recorder’s office of the county in which your home was located. Also assume that you had no equity in that home at the time that tax lien was recorded, i.e., that the combined total owed on your property taxes, mortgage(s), and any judgment liens and any other liens on the title exceeded the value of your home. In this situation of no equity, that tax lien would have nothing to which it could attach. The income tax debt for which that tax lien was recorded would still be unsecured. (We discussed this situation thoroughly in our last blog post.)
On the other hand, if the home had $7,500 or more in equity, the tax lien would attach to that equity and the underlying tax debt would be fully secured.
The Difference When a Tax Debt is Fully Secured
The effect that fully securing a tax debt through a tax lien turns on whether or not that tax debt can be “discharged”—legally discharged in bankruptcy. (See our blog post a week and a half ago about the treatment of older tax debts and the conditions under which income taxes can be discharged.)
If the underlying tax debt couldn’t be discharged, it would have to be paid regardless of the tax lien. The lien does give the IRS/state a significant amount of extra leverage against you and your home or whatever asset(s) its lien attaches to. But again the tax would have to be paid either way.
However, if the underlying tax could be discharged in bankruptcy, then the tax lien makes a huge difference. The lien turns a debt that would not have to pay at all into one that you would likely have to pay in full to avoid the IRS/state taking the asset(s) against which the lien attaches.
Specifically, if the tax lien is against your home, the IRS/state would have to be paid in full if you refinanced or sold you home. Or even if you didn’t refinance or sell, under certain circumstances the IRS/state may be able to foreclose on its tax lien to get its tax paid.
A Fully Secured Income Tax Debt under Chapter 7
If you had a tax debt that could be discharged but for a tax lien that made it fully secured, a Chapter 7 bankruptcy filing would discharge that tax so that you legally no longer owed it. However, because the tax lien survives the Chapter 7 discharge, you still risk losing those assets after the Chapter 7 case is filed. It may sound strange that your assets would be taken from you to pay a debt that you no longer owe. But that is similar to a vehicle loan that is discharged in bankruptcy, resulting in the creditor’s right to repossess the vehicle. If you want to keep the vehicle you have to pay for it. If you want to keep whatever the IRS/state has a lien on, you need to pay the tax debt you would not have had to had there been no recorded lien.
So, if you have a fully secured tax that would otherwise have been discharged, contact the IRS/state immediately after getting the discharge in the Chapter 7 case in order to make payment arrangements.
A Fully Secured Income Tax Debt under Chapter 13
The situation is similar under a Chapter 13 “adjustment of debts” case, but arguably safer. A fully secured income tax debt must be paid in full to avoid losing the assets to which the tax lien attaches. To protect those assets, you and your attorney would propose a Chapter 13 plan providing for payment in full of the tax at issue, with interest.
That’s safer than just making payment arrangements directly with the IRS/state immediately after the end of a Chapter 7 case. That’s because at that point you are under no further protection of the “automatic stay”—the law that prevents virtually all creditor collection action against you or your assets during an active bankruptcy case. You have that protection in most cases throughout a 3-to-5-year Chapter 13 case, instead of being without any such protection as soon as a Chapter 7 case is closed about 3 months after it is filed.