In Bankruptcy, it is most likely that you will lose your tax refunds. In fact, debtors often lose tax refunds in Chapter 7 because the refund is so large it exceeds the amount of any wild card exemption. You are allowed to keep property which does not exceed the exemptions. Any property over the equity and exemptions you are allowed to keep the trustee sells or distributes to creditors. In Chapter 7 keeping your income tax refund is all about what you own at the moment you file the case and the allowed exemptions.
In Chapter 13, retaining your tax refund is about planning your budget and increasing your tax deductions. You are required to turn in a copy of your prior two years of tax returns whenever you file a Chapter 7 or Chapter 13 bankruptcy. In Chapter 7, the trustee looks through this tax return to find property or transfers of property. The refund is a property just like any other property you own. It is an unpaid debt to you which the government uses interest-free for a year. But in Chapter 13, it is also disposable income which should be paid to a Chapter 13 trustee for the benefit of creditors. In Chapter 7 or 13, you want to plan the timing and your exemptions so you never get a refund which can be lost.
If you are getting a refund, you may want to spend it before you file any Chapter 7. The government owes you a refund all year long every month you pay into it. You don’t collect it until after you file the income tax return. That is why in Indiana in Chapter 7 they pro-rate the refund and ask for a portion of the refund. It is an asset the Chapter 7 Trustee often recovers because the exemption to keep it is so small. The Debtor is always due some part of that refund.
An Indiana Example
In Indiana, the exemption for a refund was only $300 dollars in 2018. With a refund of $5,000 dollars, a Chapter 7 filing in December must turn over $4,650 dollars to the trustee who gets over $1,100 for paying creditors the remaining $3,487. For example: $5,000 tax refund – $350 exemption – $1162.50 trustee 25% fee = $3,487.50 for creditors.
Instead, file the bankruptcy in February after you receive and spend the refund. Then, you keep $5,000 instead of $350. The $350 exemption is for all of your money in a bank account or a tax refund. So, if you have money in the bank, you might have nothing left to exempt the refund. Since it is common to get a $5,000 dollar refund the trustee often profits from bankruptcy cases in Indiana.
Spending the tax refund to repay relatives, or to purchase a property which is not exempt creates other problems. You can usually safely spend the refund on food, clothes, and furniture because the Kentucky federal exemption for household goods exemption is so large that most rarely use it up. Car or home maintenance is often another safe way to spend the refund because maintenance does not create an asset or increase your equity in the property.
Next, if you have any money in your bank account, you might need to draw it out or spend it before filing. Kentucky and many other states use the federal exemptions. The federal exemptions allow you to keep about $25,000 in real property. One half of what you don’t use to keep real estate is then useable to keep any other kind of property as a wild card exemption.
There is also another specific $1,225 wildcard exemption. Kentucky has a much larger wildcard exemption than Indiana. This makes it possible to keep over $12,000 + $1,225 dollars if you don’t use the $25,000 real estate exemption to keep a home. Please note that the $25,000 exemption is meant to keep your personal home. However, the remainder you don’t use for your personal home reduces to half if you use it to keep rental, business, or vacation property.
You Income Tax Takes Your Income Tax Refund
You might lose a tax refund in Chapter 13 because of the requirement to pay to the trustee funds that exceed the monthly budget. In other words, it is a requirement that all your disposable income pays into the plan.
In the western district of Kentucky, your requirement is to turn in a copy of your yearly income tax return by May 15th. Western Kentucky also allows you to keep the income tax deduction in the first year of your plan. Also, during the first year, a tax refund is an asset you exempt. In the later years, a tax refund is a disposable income you must use to repay your creditors. However, you lose the tax refund in the second through fifth year of the plan. You may keep the earned income credit portion of the refund, but you have to surrender the child credit.
In some circumstances, you can petition the court to keep the refund for payment of necessary medical expenses or other unusual events and serious needs for the refund. Expenses like that should be allowable if you anticipate them in your budget and Chapter 13 plan. But, it is not always possible to anticipate nor plan for these expenses. Generally, you want to increase your deductions, so you don’t get a refund in Chapter 13 because you can’t lose what you never get. So, plan your bankruptcy with an attorney with experience because timing is everything in discharging the maximum debt and keeping the property.
Modifying Chapter 13 to Keep the Refund
100% of plans do not lose their tax refunds. Interestingly, a modification of the plan might allow you to keep the refund. If you do have a refund, there might be possible maintenance expenses that you cover by filing a motion with the court to use it for a furnace, air conditioner, or other expense. In fact, a good Chapter 13 attorney plans for such maintenance expenses. You might use the refund to pay for an emergency expense but increase your plan payments to make up for the immediate use of the funds. This requires filing a motion for approval of using the refund.
In the plan you submit, it is also possible to propose that in year two that the furnace will go out and need replacement. There are also steps to cover an expense by a tax refund or get gradually increasing or decreasing plan payments which adjust to changing incomes and expenses. Sudden expenses might also require conversion to Chapter 7. This modifies the plan payments, how much creditors get, and might even earmark refunds.
How to Keep the Refund after Filing Chapter 7 or 13
You can only keep Chapter 7 income tax refunds if you use an exemption. But, if you transfer property out of your name you can’t use the exemption. For instance, the exemption is not useable if you pay back mom a $750 loan. This is because it is a preferential or fraudulent transfer. Either way, the trustee sues your mom to recover the money. Instead, by using an exemption, or an expense, you might be able to keep the money. However, by transferring assets, you lose the ability to keep assets.
It is easy to keep a tax refund in Chapter 7 by spending a refund before you file Chapter 7. Then, after you spend the refund it is no longer an asset. In Indiana, the trustee looks at next year’s refund as an asset if the bankruptcy files after September. In Indiana, the exemption is very small and the trustee will pro-rate any refund check.
The exemption is only $350 dollars in Indiana. But, in Kentucky, you have a $1250 wild card exemption plus one half of the unused real estate exemption. If you rent or have no home, this is about an additional $12,500 dollars in 2018. In fact, up to $13,750 might be available to keep a tax refund in a Kentucky Chapter 7. Also, these exemptions increase every year.
Instances When Losing the Tax Refund is Better
In some plans, losing the tax refund might mean finishing the bankruptcy sooner than you expect. Chapter 13 cases must pay back both priority and secured debts in full. They also must pay back the same amount as Chapter 7. Losing the tax refunds might increase what you pay back, making it feasible.