What Happens to Your Tax Refund in Bankruptcy

If you’ve filed or are preparing to file bankruptcy, you may wonder if you’ll still receive a tax refund and, if so, whether or not you’ll get to keep it. This article covers how bankruptcy can affect your tax refund and what you can do to keep as much of your refund as possible.

Tax Refunds and Your Bankruptcy Estate

Tax refunds you receive after filing bankruptcy are usually part of your bankruptcy estate. To understand how tax refunds fit into your bankruptcy, it helps to have a quick reminder of what all goes into your bankruptcy estate. Everything you own at the moment you file bankruptcy makes up your bankruptcy estate. Your bankruptcy trustee oversees and administers this estate. Exemption laws protect some or all of the property in your estate from being sold by the trustee. 

In a Chapter 7 bankruptcy, the trustee can liquidate the assets in your estate and use the money to pay your debts. In theory, the total value of your bankruptcy estate, minus the total of all your claimed exemptions, is the amount your trustee can pay to your unsecured creditors. But most people who file Chapter 7 bankruptcy can claim everything in their bankruptcy estate as exempt (more about exemptions later).

So, why is your tax refund part of your bankruptcy estate if you don’t have it at the time you file your bankruptcy? Any money you have in checking or savings accounts when you file bankruptcy is part of your estate. From a legal standpoint, paying more taxes than necessary and then having the overpayment returned to you is similar to storing that extra money in a bank account. Except that account is with the IRS instead of a bank. Under bankruptcy law, you can’t hide money from the trustee by temporarily sending it to the IRS.

Which Tax Refunds Are Part of Your Bankruptcy Estate?

A refund for taxes on income you earned before you file bankruptcy is always part of your bankruptcy estate. Some examples:

• You file bankruptcy in March 2022. In May 2022, you receive a tax refund for tax year 2021. The refund is part of your estate.

• You file bankruptcy in June 2022. In July 2022, you file late tax returns for tax years 2019, 2020, and 2021. Any refunds you receive from those tax years are part of your estate.

Before or during your 341 meeting, your trustee will likely ask whether you expect a tax refund and, if so, how much. You should include your expected tax refund as an asset on your bankruptcy forms so that you can claim it as exempt, if possible. If you don’t include your potential refund on your bankruptcy forms, the trustee may require you to amend your paperwork.

Tax Refunds in Chapter 7 Bankruptcy

In a Chapter 7 bankruptcy, tax refunds based on income you earned after you filed bankruptcy aren’t part of your bankruptcy estate. For example, say you file Chapter 7 bankruptcy in July 2022. In April 2023, you receive a tax refund for tax year 2022. The part of the refund based on January through June 2022 is part of your bankruptcy estate, but not the part based on July through December. 

That said, the trustee can’t take your tax refund after your bankruptcy case has been closed. If you expect a tax refund for the part of the year before you filed bankruptcy, the trustee can hold your case open until you receive the refund. The trustee usually won’t do this unless the expected refund amount is large enough to be worth the effort.

Tax Refunds in Chapter 13 Bankruptcy

A Chapter 13 bankruptcy typically lasts from three to five years. In Chapter 13 bankruptcy, tax refunds based on income you earned before you filed bankruptcy are part of your estate, just like Chapter 7. But in Chapter 13, tax refunds based on income you earn while your bankruptcy is ongoing are also part of your bankruptcy estate. This means that your trustee can take these refunds and apply the money to your repayment plan.

Chapter 13 trustees have varying policies when it comes to taking debtors’ ongoing tax refunds. Some examples of these policies include:

• Automatically take all refunds.

• Take all refunds unless the debtor files a statement that they need the money for other expenses.

• Only take refunds that are over a certain amount. 

You can contact your Chapter 13 trustee’s office to find out their tax refund policy.

Is Your Tax Refund Protected by Exemptions?

Exemption laws allow filers to protect certain assets from liquidation. All states have their own exemption laws. There are also a set of federal bankruptcy exemptions. Some states allow you to choose either the federal exemptions or state exemptions. Other states have opted out of the federal exemptions. If you live in an “opt-out” state, you must use that state’s exemption laws. 

Some states have exemption laws that specifically protect certain types of tax refunds. For example, under Mississippi’s state exemptions, debtors can claim up to $5,000 of a federal tax refund, up to $5,000 of a state tax refund, and up to $5,000 of an Earned Income Tax Credit as exempt. Some states also have specific exemptions for the Child Care Tax Credit. 

The federal bankruptcy exemptions don’t include a specific provision for tax refunds, but they do include a wildcard exemption. This exemption can be used to protect a tax refund or any other assets that don’t fit within the other exemption categories. Some states also have a wildcard exemption. If the wildcard exemption isn’t enough to protect all your property and your tax refund, you may want to apply the exemption to your tax refund first. The trustee is more likely to take a liquid (cash) asset like a tax refund than other kinds of property that take time and money to convert to cash.

Other Ways To Protect Your Refund

If you receive your tax refund before you file bankruptcy, only the portion that’s still in your possession when you file bankruptcy becomes a part of your bankruptcy estate. In other words, if you spend your tax refund before you file bankruptcy, it won’t be available for the trustee to take. That said, don’t spend your tax refund on luxuries such as jewelry or vacations. Doing so can create problems for your bankruptcy case. 

But it’s fine to spend your tax refund on ordinary living expenses, such as:

• Rent or mortgage payments

• Necessary home or car repairs

• Groceries

• Utilities

• Insurance payments

• Medical and dental expenses

• Necessary clothes or shoes

Another way to avoid having your refund taken by the trustee is to not overpay your taxes in the first place. If you plan to file bankruptcy within the next year, you can adjust your income tax withholding so that you only pay what you owe. You’ll take home more money from each paycheck and likely won’t receive a tax refund the following year. If you go this route, though, you could end up owing taxes when you file your return.

What if Your Refund Isn’t Exempt?

If you receive a tax refund after you file for bankruptcy and it’s not covered by any exemptions, you’ll likely need to turn your refund over to your bankruptcy trustee. In this case, don’t spend any of the refund money. Spending this money could get you into trouble with the bankruptcy court. 

Let your trustee know that you’ve received (or are going to receive) a non-exempt tax refund and ask how to turn the funds over. If you don’t disclose your refund or don’t turn over a non-exempt refund, the bankruptcy court can deny your discharge or even revoke a discharge that’s already been granted. If you’re not sure whether your refund is exempt, consult with an experienced bankruptcy attorney in your area.

Let’s Summarize…

Income tax refunds that you receive after filing bankruptcy are usually part of your bankruptcy estate. Refunds for taxes you paid after you filed bankruptcy aren’t part of your estate in Chapter 7 bankruptcy. In Chapter 13 bankruptcy, though, your estate includes all the tax refunds you receive during your payment plan. If you receive your refund and spend it on necessary expenses before you file bankruptcy, it doesn’t become a part of your bankruptcy estate.

Your trustee can take a tax refund that’s part of your bankruptcy estate unless you can claim the refund as exempt. You can avoid turning future refunds over to your trustee by adjusting your tax withholding so you don’t overpay your income taxes.