What Happens To Your Tax Refund In A Chapter 7 Bankruptcy?

by
Richard Fonfrias, J.D.
Chicago’s Financial Rescue & Bankruptcy Lawyer
Fonfrias Law Group, LLC

If you’re expecting an income tax refund, you may be able to keep it even if you have filed for Chapter 7 Bankruptcy. It all depends on the amount of your refund, when you file for bankruptcy, and when you receive your refund check.

Your Bankruptcy Estate
When you file for Chapter 7 Bankruptcy (liquidation), your assets are lumped together and called your bankruptcy estate. Your entire bankruptcy estate is under the control of the bankruptcy trustee until your bankruptcy ends.

Take These Steps

Here is what you can do to keep your tax refund from your creditors.
1. Make your tax refund as small as possible by changing the amount of money your employer withholds from your paycheck.
2. Spend your tax refund on high-priority expenses, such as your house payment and utilities.
3. Protect your refund by including it in your bankruptcy’s exemptions.

If You Think That You Might File For Bankruptcy Within The Next Year…
…you can avoid getting a refund by having your employer change the amount of your tax withholding so it covers only the actual tax you owe. As a result, you will receive more money in each paycheck and your refund will be very small, so it won’t make much impact on what you owe to creditors. Seeing this, the bankruptcy trustee may simply let you keep the money.

If You Receive Your Tax Refund Before You File For Bankruptcy…
…you can spend the money so it does not become part of your bankruptcy estate. After all, if you don’t have the money, the bankruptcy trustee cannot use it to pay your creditors.

Make sure you spend your tax refund on court-approved expenses, such as
1. Your house payment or rent
2. Repairs to your home.
3. Utilities, such as electricity, natural gas and propane
4. Car payments and repair
5. Medical care.
6. Food and clothing.
7. Education.

The court will not allow you to spend your tax refund on
1. Luxury goods you don’t need.
2. Repaying a loan to a family member or friend.
3. Paying on one of your credit cards.

Here’s why: If you buy items you don’t need, the bankruptcy trustee could accuse you of “bad faith” and ask the court to dismiss your bankruptcy.

If you pay one creditor and no others, you may be guilty of making a “preferential payment,” which means you placed a higher priority on one creditor than others. The bankruptcy trustee could force your friend or creditor to return the money to your bankruptcy estate.

This is why it’s important that you spend your tax refund on needed expenses. Also, make sure you keep detailed records of how you spent the money.

If You Receive Your Tax Refund After You File for Bankruptcy…

…it will become part of your bankruptcy estate if the refund results from income you earned before you filed for bankruptcy. Even so, you may be able to keep it as part of your exemptions.

Exemptions are assets that the law allows you to keep. They cannot be sold by the trustee to pay your creditors. The amount and nature of exemptions varies from state to state, so make sure you speak with a bankruptcy lawyer to learn what your state allows.