When someone decides to file for Chapter 7 bankruptcy, they may be curious to know whether they can retain the tax refund or if the expected refund will be diverted during bankruptcy to pay your creditors. Unfortunately, there is no single correct answer. In reality, the answer will depend on your unique circumstances.
How Tax Refunds Work
Before delving into the interplay between tax refunds and bankruptcy, it is important to have a baseline understanding of how tax refunds work. Generally, someone is eligible for a tax refund when an individual winds up paying more taxes during a particular year than they actually owe because too much money was withheld from their paycheck each week. According to Internal Revenue Service data from 2018, the average federal tax refund for an individual was approximately $1,865.
Tax Refunds May Be Part of Your Bankruptcy Estate
Now that you have a general understanding of how tax refunds work, let’s explore how tax refunds are viewed and managed in the context of a bankruptcy proceeding.
When you file for bankruptcy, most likely Chapter 7 bankruptcy, the process will include creating a “bankruptcy estate.” This estate is comprised of your assets commencing the date of your bankruptcy filing. The bankruptcy trustee can utilize the assets in the bankruptcy estate to repay your creditors, with the notable exception of assets that are exempt and thereby not part of the bankruptcy estate.
This leads to the obvious question – “are tax refunds exempt or do they fall into the bankruptcy estate?” The answer is – it depends on when you file for bankruptcy. If you earned all or a portion of your tax refund for work you did prior to filing for bankruptcy, that portion of your refund is part of your bankruptcy estate. This means that portion of the refund will be diverted to the bankruptcy estate and accessible by the trustee.
Here is an example of how it works – Person X decides to file for Chapter 7 bankruptcy on January 1, 2019. Two months later, Person X files their tax return for the previous year and receives a $2,000 tax refund. Because Person X earned 100 percent of their tax refund for their work before filing for bankruptcy, the entire tax refund is part of Person X’s bankruptcy estate. Unless Person X, are a skilled bankruptcy attorney retained by Person X, can protect the refund via an exemption, the bankruptcy trustee will be entitled to use the $2,000 refund to back creditors.
Protecting a Tax Refund with an Exemption
It may be possible to protect a tax refund that is part of a bankruptcy estate if the refund is protected by an exemption. For example, if you are able to claim the federal bankruptcy exemptions, then you may be able to use a wildcard exemption to protect any property. In addition to the federal wildcard bankruptcy exemption, some states offer a wildcard exemption as well. As a result, it is fairly common for bankruptcy filers to utilize the wildcard exemption to protect their tax refund.
As mentioned, if you are unable to use the federal bankruptcy exemption to protect your refund, many states offer a lower value wildcard exemption. Though, the wildcard exemptions offered at the state level typically provide less protection for a tax refund. Nevertheless, some states have also codified special exemptions that specifically protect tax refunds attributed to a filer who was eligible for the Earned Income Tax Credit or Child Care Tax Credit.
Spend Your Tax Refund Before Filing
If it looks like your tax refund will not be exempt, you may want to delay your bankruptcy filing. Often the best way to avoid losing your tax refund in bankruptcy is to spend your refund before you file for bankruptcy. Spending your tax refund on luxury items like jewelry will create problems in your bankruptcy case. But you can use your refund on many ordinary expenses, including rent, mortgage payments, home repairs, food, utilities, clothing, educational expenses, car repairs, medical and dental expenses, and insurance. And if you have spent your tax refund on ordinary expenses before you file for bankruptcy, there is no tax refund to protect in your bankruptcy case.
Change Your Tax Withholding
If you plan to file for Chapter 7 in the next year, you can also avoid receiving a refund at all by adjusting your tax withholding so that you only pay the tax you owe. By doing this, you’ll receive more money each month and you can avoid getting a tax refund. But you need to make sure you have savings to pay any tax bill when it comes due.
Importance of Amending a Petition and Listing Your Tax Refund
Tax refunds are valuable assets that need to be listed on your bankruptcy forms. If you forgot to list your tax refund on your bankruptcy forms and your 341 meeting has yet to take place, it is important to file an amendment to your bankruptcy forms to clearly list the refund, whether or not it qualifies for an exemption.
If your 341 meeting has already occurred and the bankruptcy trustee determines you have a “no-asset” case, then there is likely no need to file an amendment because you would have otherwise been protected by an exemption. Though, it is important to check your respective state exemptions to confirm. In some instances, a bankruptcy trustee may indicate that they will check back after your tax return has been filed to confirm whether you receive a tax refund.
If you receive a notice asking your creditors to file a “proof of claim” or your trustee states your tax refund will be seized, you have the option to file an amendment to protect what you can using available state or federal exemptions.
How Much of a Tax Refund Can Be Protected?
The amount of your tax refund that can be protected by an exemption will likely depend on whether other assets are being protected with the federal wildcard exemption and whether your state has specific exemptions for one or more tax credits.
What To Do If You Received a Tax Refund Check When the Funds are Not Exempt
If you already filed for bankruptcy and your tax refund was not deemed exempt, there is a chance you may still wind up receiving a refund check or direct deposit. If you find yourself in this situation, make sure not to spend the tax refund check. If you go ahead and use those funds, it is going to create serious issues with your bankruptcy proceedings. Instead, you need to contact the bankruptcy trustee and ask how to turn over the non-exempt refund funds. Failing to turn over your non-exempt tax refund can lead to you being denied a bankruptcy discharge.
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If you are feeling weighed down by a mountain of debt, filing for bankruptcy may be a worthwhile option to consider. When you go through the bankruptcy process, it provides an opportunity to achieve financial freedom and set you on a promising path forward. To get started, fill out a free, confidential evaluation form on this page.