Can I Keep My Tax Refund in Chapter 7 Bankruptcy?

If you are considering filing for Chapter 7 bankruptcy and you are expecting to receive or have received a tax refund, you probably want to know what happens to that refund. In general, whether you lose the refund or not depends on the timing of your bankruptcy and the receipt of your refund. But there are things you can do to make sure you keep your tax refund.

A Tax Refund Is Part of Your Bankruptcy Estate

When a debtor files for Chapter 7 bankruptcy, all of the person’s assets become part of the bankruptcy estate, which is administered (controlled) by the Chapter 7 bankruptcy trustee. The Bankruptcy Code defines assets very broadly. It includes more than money in the bank or property, such as a car. A tax refund is an asset that the trustee can use to pay unsecured creditors. It is very likely that the trustee will ask about a tax refund at your meeting of creditors.

In Chapter 7 bankruptcy, the trustee can use the assets you have when you file for bankruptcy to pay off your creditors. You can keep any assets you receive after filing for bankruptcy, however. A tax refund can be tricky because it often involves a process that begins before the bankruptcy filing date and continues afterwards.

What Happens to Your Tax Refund in Chapter 7 Bankruptcy

If you do not take any action, the trustee will handle a tax refund as follows:

Coordinating the Timing of Your Bankruptcy and Your Tax Refund

Whether you can keep your tax refund from income earned before you file bankruptcy depends on how you manage the timing of your bankruptcy and receipt of your tax refund. In most cases, if you plan ahead you’ll be able to keep your tax refund, or use the money for other expenses.

Depending on how far in advance you know you will be filing for bankruptcy, there are three things you can do to keep your tax refund from creditors:

• adjust your withholding to reduce your refund to a minimal amount
• spend the refund on necessary expenses, or
• include the refund in your bankruptcy exemptions.

What to Do If You Think You May File for Bankruptcy Within a Year

If you think that you are going to file for bankruptcy in the next year, you can avoid the refund issue by adjusting your tax withholding so that you only pay the tax you owe. You will get more money in each paycheck and your refund that will be too small to provide any meaningful payment to your creditors. The trustee may abandon the refund, meaning that you will be able to keep the money. It is important to make sure, however, that you continue to withhold a sufficient amount to cover the taxes you do owe.

What to Do if You Receive a Tax Refund Check Before Filing for Bankruptcy

If you have received your tax refund and have not yet filed for bankruptcy, you can keep the money out of your bankruptcy estate by spending it. The trustee cannot use money to pay your creditors that you no longer have.

If you spend your tax refund before you file for bankruptcy, make sure you spend it on necessary items. Approved expenses include:

• mortgage payment, rent, or home repair
• utilities
• food
• clothing
• medical care
• car payments, maintenance, or
• education.

Expenses that are not allowed include:

• luxury goods
• repayment to a friend or family member, or
• repayment of one credit card.

If you buy luxury goods, the trustee could seek to deny your discharge because of bad faith. If you pay back one of your creditors and ignore the others, the trustee may find that you have made a preferential payment. This means that you have favored one creditor over another. The trustee can force the person or company who received the money to return it to the estate. Therefore, if you spend your tax refund, make sure to spend it on necessary expenses. In addition, keep very good records of how you used the money.

(To learn more, see the articles in Prebankruptcy Planning.

What To Do if You Receive a Tax Refund Check After Filing for Bankruptcy

A tax refund you receive after the petition is filed will be part of your estate if it is based on income you earned before the bankruptcy. You may, however, be able to keep it.

In bankruptcy, every debtor is allow to keep (exempt) a certain amount of property regardless of how much the person owes to creditors. The amount a person can exempt depends upon the state where the bankruptcy petition will be filed. Some states have a generous amount for exemptions that could cover a tax refund. More information on exemptions can be found in Nolo’s Bankruptcy Exemptions topic area.