Can I Keep My Tax Refund in Chapter 7 Bankruptcy?

Learn about your tax refund options if you file for Chapter 7 bankruptcy.

If you're considering filing for Chapter 7 bankruptcy and you're expecting to receive (or have received) a tax refund, you probably want to know what will happen to that refund. The answer will depend on several factors, including when you receive it, the timing of your bankruptcy, and whether you can protect the funds with a bankruptcy exemption. In this article, you'll learn more about keeping your tax refund in bankruptcy.

To learn more, see Bankruptcy Filing Considerations.

When Did You Earn the Tax Refund?

When figuring out whether you can keep your tax return, the first step is determining whether your tax refund came from income earned before or after filing bankruptcy.

Any return that results from income earned after filing for bankruptcy is yours to keep. A tax refund that's based on the income you earned before filing will be part of the bankruptcy estate no matter if you receive it before or after the filing date.

Tax Year

Tax Refund

Year before bankruptcy

Tax refunds go to the estate. It's treated like cash or money in a bank account. (See Can I Keep Cash in Chapter 7?)

Year of bankruptcy

A tax refund based on the income you earned before you file for bankruptcy goes to the estate (but not any part of the refund that's based on income earned after the filing date.

Tax year after bankruptcy

You keep the full refund

Get step-by-step instructions on filing Chapter 7 bankruptcy in Nolo's How to File for Chapter 7 Bankruptcy.

How to Keep a Tax Refund in Chapter 7 Bankruptcy

If you worried that you'd lose a refund in bankruptcy, there are things you can do to protect it. In most cases, you'll be able to keep your tax refund if you:

  • have enough time to adjust your withholding to reduce the refund to a minimal amount
  • spend the refund on necessary expenses, or
  • protect (exempt) the refund with a bankruptcy exemption.

Adjust Your Tax Withholding

If you think that you're 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'll get more money in each paycheck that you can use to pay for necessary expenses. It's important to make sure, however, that you continue to withhold a sufficient amount to cover the taxes you do owe.

Spend the Refund on Necessary Items

If you've received your tax refund and haven't yet filed for bankruptcy, you can spend it on necessary items that you currently need, such as:

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

Expenses that aren't allowed include:

  • luxury goods
  • repayment to a friend or family member
  • expenses paid in advance (for instance, you can't make multiple rent payments), 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 that favors 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, you'll likely want to do so on necessary expenses that you need currently. Also, you'll want to keep good records of how you used the money. However, be aware, that some districts might have different practices. A local bankruptcy lawyer can tell you what you can expect in your area.

Use an Exemption to Protect the Refund

You might be able to keep your tax return by claiming it as exempt property that the trustee isn't entitled to use. Here's how it works.

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. In Chapter 7 bankruptcy, the trustee can use the assets you have when you file for bankruptcy to pay your unsecured creditors (those creditors holding debt that isn't secured by property).

That doesn't mean that you'll lose everything that you own. You're entitled to keep (exempt) the property that your state believes you'll need to work and live.

Most states don't let you protect much cash or money in a bank account. However, some state exemption systems have generous wildcard exemptions that cover any property of your choice that you could use to cover a tax refund.

Learn more about the cost of bankruptcy in Average Attorney Fees in Chapter 7 Bankruptcy.

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