Can I Keep My Tax Refund in Chapter 7 Bankruptcy?

If you file for Chapter 7 bankruptcy around tax time, Chapter 7 trustees will check for tax refunds. Bankruptcy trustees know that protecting money in bankruptcy is challenging, and tax refunds are an easy source of funds for creditors. Keep reading for strategies to help you keep your tax refund in Chapter 7 bankruptcy.

Are You Entitled to a Tax Refund When You File for Chapter 7?

The Chapter 7 trustee will want to know whether the IRS owes you a tax refund, and will likely ask about it at the meeting of creditors. If you received your tax refund before filing and aren't owed anything further, your answer will be "No." But you'll need to protect all your cash and money in a bank account with a bankruptcy exemption (more below).

If you're owed a tax refund, whether you've filed or not, your answer to the trustee's question will be "Yes." You'll need to protect the unreceived funds with a bankruptcy exemption. Any refund that results from income earned after filing for bankruptcy is yours to keep.

The chart explains when you might need to turn over tax refund funds in Chapter 7.

How Do You Keep a Tax Refund in Chapter 7 Bankruptcy?

If you do nothing to protect your tax exemption, there's a good chance you'll lose it. But in many instances, preventing a tax refund loss is possible by doing the following:

• eliminating a tax refund by adjusting your tax withholding
• protecting it by spending it on necessary items,
• exempting it with a bankruptcy exemption.

Here's how these successful strategies work.

Avoid a Tax Refund By Adjusting Withholdings

Lowering your exemptions and paying only the tax you owe is a good strategy when you have time to plan before bankruptcy. The other benefit? You'll get more money in each paycheck. Just be sure to withhold enough to cover the taxes you will owe.

Spend Tax Refund Funds on Necessary Items

Most people live paycheck to paycheck, and all funds already go toward basic needs, so spending the money on things needed to work and live shouldn't be problematic. So if you haven't yet filed for bankruptcy, consider spending your tax refund on necessary items, such as:

• a currently-due mortgage, rent, or utility payment
• needed home repairs
• food, clothing, or medical care
• car payments and maintenance, and
• education costs.

However, you'll want to avoid certain pitfalls. For instance, avoid paying monthly expenses in advance, such as multiple rent payments. Such tactics could appear as an attempt to avoid paying creditors and hide assets, which could constitute bankruptcy fraud. Similarly, avoiding using your tax refund to pay for luxury goods is a good idea. Otherwise, the trustee could seek to deny your discharge because of bad faith.

This might surprise you, but you won't want to pay debts owed to friends, family members, or other preferred creditors with your tax refund before filing for Chapter 7. Such payments would fall into the category of preferential payment, which occurs when you repay a favorite creditor in full and ignore others. In many instances, the trustee can force the return of the preferential payment and disperse it to bankruptcy creditors according to payment priority laws—and your best friend, cousin, or business partner wouldn't be happy to receive a demand to return the $500 you repaid them.

For additional protection, keep records of how you used the money to prevent any problems with the bankruptcy trustee. Because some districts might have different practices, a local bankruptcy lawyer is best positioned to explain allowed practices in your area.

Exempt the Tax Refund in Chapter 7

You might be able to keep your tax refund by claiming it as exempt property that the trustee can't take. Here's how it works.

When you file for Chapter 7 bankruptcy, your assets become part of the bankruptcy estate administered (controlled) by the bankruptcy trustee. The trustee can use the assets to pay creditors. You can "exempt" or keep the property your state decides you'll need to work and live. You'll find your state's bankruptcy exemptions here. Look for an exemption that protects cash, money in a bank account, or a tax credit. You might be able to use a wildcard exemption as well.

Learn more about preparing for bankruptcy and what to do with bank accounts, automatic payments, and utility deposits.

Need More Bankruptcy Help?

Did you know Nolo has made the law accessible for over fifty years? It's true, and we wholeheartedly encourage research and learning. You can find many more helpful bankruptcy articles on Nolo's bankruptcy homepage. For instance, Nolo articles will explain what bankruptcy can do, what you'll want to avoid before filing for bankruptcy, and more. Information needed to complete the official downloadable bankruptcy forms is on the Department of Justice U.S. Trustee Program website.

However, online articles and resources can't address all bankruptcy issues and aren't written with the facts of your particular case in mind. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.