When tax season comes, many individuals filing for bankruptcy expect to receive a tax refund. But can you keep that refund? Generally speaking, any portion of the tax refurn you earned for work you did before filing bankruptcy will be part of your bankruptcy estate and belong to your trustee. That is, unless it's protected by an exemption. This article will explain more.
Written by Kristin Turner, Harvard Law Grad.
Updated November 18, 2021
When you pay more taxes during the year than you actually owe, you'll probably qualify for a tax refund when you file your taxes. Tax refunds are a predictable annual source of funds for many Americans. According to IRS data from 2004, 77% of tax returns result in a refund check. And in 2018, the average federal tax refund was $1,865.
So that raises a question: When you’re filing for Chapter 7 bankruptcy, can you keep the tax refund that you’re expecting to receive? The answer, unsurprisingly, is “it depends.” In this article, we explain how to protect your tax refund in bankruptcy as fully as possible.
Tax Refunds Are Property of the Estate
Your bankruptcy estate is the pool of your assets on the date of your bankruptcy filing. Unless these assets are protected by an exemption, your bankruptcy trustee can distribute them to your creditors to help repay your debts. Tax refunds are tricky because they're often part of your bankruptcy estate even though you may not receive the refund until months after your bankruptcy filing.
Here’s the rule: If you earned all or part of a tax refund for work you did before filing for bankruptcy, that portion of your tax refund is part of your bankruptcy estate. So that portion of the refund belongs to your trustee unless the refund is protected by an exemption.
Example 1: David files for Chapter 7 bankruptcy on January 1, 2019. Two months later, David files his tax return for the previous year, and he receives a $2,000 tax refund. Because David earned 100% of the tax refund for his work before filing for bankruptcy, the entire tax refund is part of David’s bankruptcy estate. Unless David can protect the refund with an exemption, the bankruptcy trustee can take the $2,000 refund and use it to pay some of David's debt.
Example 2: Sarah files for bankruptcy on June 30, 2019, and is employed for all of 2019. In the spring of 2020, Sarah receives a $2,000 tax refund from her 2019 tax return. Because Sarah earned half of that tax refund before filing for bankruptcy, half of the tax refund, or $1,000, becomes part of her bankruptcy estate. Unless Sarah can protect the entire refund with an exemption, the bankruptcy trustee can take $1,000 from Sarah's refund.
Example 3: Jason files for bankruptcy on January 1, 2019, having failed to file tax returns for the past three years. Shortly after filing, Jason files late tax returns for 2016, 2017, and 2018. The tax refunds that he receives from those three years are part of his bankruptcy estate because those refunds resulted from work that he performed before filing for bankruptcy. Unless Jason can protect the refunds for all three years with an exemption, he will lose them to the bankruptcy trustee.
Protecting Your Refund With Exemptions
The good news is you can protect a tax refund that’s part of your bankruptcy estate if the refund is protected by an exemption. If you’re entitled to claim the federal bankruptcy exemptions you have the ability to use a wildcard exemption to protect any property. Some states have wildcard exemptions as well. Especially with respect to the federal exemptions, that wildcard will often be enough to protect your tax refund.
Of course, you may also need some or all of the wildcard to protect other types of personal property like personal electronics or a vehicle. But, in most cases, filers use the wildcard to protect their tax refund first. That’s because non-cash assets are far less attractive for trustees to take than tax refunds.
If you can’t use the federal bankruptcy exemptions, most states have a lower value wildcard exemption that offers less protection for your tax refund. On the other hand, certain states do have special exemptions to protect tax refunds attributed to the Earned Income Tax Credit or the Child Care Tax Credit. So, you need to carefully check your exemption scheme to know how much of your tax refund you can protect.
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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. But be careful what you spend it on.
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 for the trustee to take as part of 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.
Amending Your Petition To List a Tax Refund
Tax refunds are valuable assets in your bankruptcy that must be listed on your bankruptcy forms. If you forgot to list your tax refund on your bankruptcy forms and your 341 Meeting has not yet taken place, you must file an amendment to your bankruptcy forms listing the refund, whether it's exempt or non-exempt.
If your 341 Meeting has already occurred and the trustee has determined your case is a no-asset case, adding an amendment to address your tax refund may not be necessary because it would have otherwise been protected by an exemption. You can check your state exemptions to confirm. In some cases, a trustee may indicate that they will check back after your tax return has been filed to see if you get 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 can file an amendment to protect what you can using available exemptions. The amount that can be protected by an exemption may depend on whether other assets are being protected with the wildcard exemption and/or whether your state has specific exemptions for one or more tax credits.
If you’re an Upsolve user and need instructions on how to use our free web app to prepare your amendment, please visit my.upsolve.org and use the "Ask Upsolve Team" feature to post a private message to the team.
Turnover of Tax Refund
Finally, if you’ve already filed for bankruptcy and your tax refund is not exempt, make sure not to spend the refund check. That will get you into trouble. Instead, you must contact your trustee asking how to turn over the funds from your non-exempt refund. If you fail to turn over your non-exempt tax refund, your bankruptcy discharge can be denied or even revoked.
When you’re filing for bankruptcy, it’s important to pay attention to your tax refund so you don’t lose it. Hopefully, your refund can be protected by an exemption. But if not, the best solution is to spend your refund on essential expenses before filing so it doesn’t need to be protected in your bankruptcy.