How to Protect Income Tax Refunds in Chapter 7

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Income Tax Refunds in Chapter 7

How to Protect Your Income Tax Refunds in Chapter 7

You can usually keep your income tax refund and file Chapter 7 bankruptcy, IF you get the right advice about doing so.

You may have heard that if you file bankruptcy you risk losing your tax refund. Here’s why that won’t happen if you plan it right.

Why Tax Refunds Can Be at Risk

Tax refunds are more troublesome than other kinds of assets mostly because of a timing consideration based on where you have lived leading up to the filing.

Chapter 7 fixates on what you own at the moment your case is filed. But you legally own not just what is in your hands at that moment but also money owed to but not yet delivered to you. Your 2014 tax refund is considered fully owed to you as soon as 2014 is over—immediately after December 31, 2014, and partially owed to you before that. But of course you can’t get that refund into your hands for at least a few weeks, and sometimes for several months. If you file a Chapter 7 case in the meantime–before receiving and appropriately spending the refund money—that money is your asset and could be taken from you by the bankruptcy trustee when the refund check arrives, if it is not exempt.

You Can Keep Income Tax Refund If It’s Exempt

What’s the maximum amount of a pending tax refund that would be exempt—protected from seizure by your Chapter 7 trustee?

That is a surprisingly complicated question, the answer to which depends on the exemption law applicable to the state where your bankruptcy case is filed (or the state where you lived in earlier if you’ve moved from another state recently). There is a federal system of exemptions (which we can use in Kentucky) and each state has its own system (for Indiana clients, we have to use the Indiana state exemptions). Each state also gets to decide whether its system of exemptions must be used for bankruptcies filed there or whether people can choose between its exemptions or the federal one.

After determining which system of exemptions to apply, the next step is to determine which category of exemptions the tax refund would fit into, the dollar amount of that exemption, and whether that exemption category needs to be also used to protect something else you own (thus reducing what is available for the tax refund).

To give an idea how this works in practice, let’s look at the federal system of exemptions. Like most state exemption systems, it does not provide an exemption specifically for tax refunds but rather a “wildcard” exemption for anything not covered by other exemptions. The federal “wildcard” exemption is $1,225.

But it has a twist in that you can add as much as $11,500 to the basic “wildcard” amount IF you don’t use a “homestead exemption” to protect the equity in your home. So if you are renting or your home has no equity to protect, you have as much as $1,225 + $11,500, or $12,725 total “wildcard” exemption for protecting a pending tax refund. That $12,725 amount would be reduced by whatever else you owned that also had to be protected by this “wildcard” exemption.

If the Refund Is Not Exempt, Wait to File Chapter 7 Case Until After Getting and Spending the Refund

This is generally our advice to clients using Indiana exemptions, which do not include a “wildcard” and currently only allow you to have $350 in monetary assets when filing (including all the money in the bank, and the expected tax refund, etc.).

When you cannot protect your refund, a better tactic often is to wait to file your Chapter 7 case until after you have received the tax refund AND have spent it in an appropriate way, so that it is no longer your asset. We emphasize “appropriate” because there are a number of ways you can spend money right before filing bankruptcy which would be counterproductive or even dangerous vs. other uses of your money that would be beneficial and safe. Because each person’s situation is different, be sure to talk with your bankruptcy attorney about whether you should wait, and if so how you should spend the refund money when you get it.

It is extremely important to get your attorneys advice on this before you do anything.  There are certain ways of spending that refund where a trustee could wind up forcing you to still turn the money over.

Conclusion

Your pending tax refund can usually be protected one way or the other when you are filing a Chapter 7 bankruptcy case, depending on how much it is and where you file. Often it is fully exempt and simply yours to keep. If not exempt, you can usually avoid the risk of the trustee taking all or part of the refund by holding off on filing the bankruptcy case until after you have received and spent the refund. At that point the tax refund is no longer your asset for bankruptcy purposes.  The main thing is to talk to an attorney before you do anything.