Tax refunds are the most likely item you will lose in bankruptcy. 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 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 the 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 filed in December would have to turnover 4650 dollars to the Trustee who would get paid over $1100 for paying creditors the remaining $3487. $5,000 tax refund – $350 exemption – $1162.50 Chapter 7 Trustee 25% fee $3487.50 for the benefit of creditors. File the bankruptcy instead in February after you get and spend the refund and 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 may 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 property which is not exempt creates other problems. You can often safely spend the refund on food, clothes, and furniture because the household goods exemption is so large that it is rare that you use up Kentucky’s $23,000 federal exemption for household goods. 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.
If you have any money in your bank account, you may need to draw it out or spend it before filing. Kentucky and many other states use the federal exemptions. The federal exemptions allow you keep about $25,000 in real property. One half of what you don’t use to keep real estate can be used to keep any other kind of property as a wild card exemption. There is also another specific $1225 wildcard exemption. Kentucky has a much larger wildcard exemption than Indiana. This makes it possible to keep over $12,000 + 1225 dollars if the $25,000 real estate exemption is not used to keep a home. The $25,000 exemption is meant to keep your personal home. The remainder not used for your personal home is reduced to half if you are using it to keep rental, business or vacation property.
Why do they take your income tax refund when you file Chapter 7 or 13 Bankruptcy
A person loses a tax refund in Chapter 13 because they are required to pay to the Chapter 13 trustee any funds which exceed their monthly budget. In other words, all their disposable income is required to be paid into the plan. Every year in our western district of Kentucky you are required to turn in a copy of your Income Tax return by May 15th. Western Kentucky allows you to keep the income tax deduction in the first year of your plan. During the first year, a tax refund is an asset you can exempt. In the later years, a tax refund is disposable income you are required to use repaying your creditors. 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 allowed for if they can be anticipated in your budget and Chapter 13 plan. But not all expenses can be anticipated and planned for. Generally, you want to increase your deductions, so you don’t get a refund in Chapter 13. You can’t lose what you never get. Planning your bankruptcy with an experienced attorney and timing is everything in discharging the maximum debt and keeping property.
Modifying a Chapter 13 plan so you can use the funds
100% plans do not have to lose their tax refunds. But a modification of the plan may be used to keep the refund. If you do have a refund, there may be unplanned upkeep expenses which you may be able to cover by filing a motion with the court to use the refund for a furnace, air conditioner or other expense. A good Chapter 13 attorney plans for such maintenance expenses. You may be able to 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 will require filing a motion for approval of using the refund.
It is also possible to propose in the plan you submit that you know in year two that the furnace will go out and need replacement. You can plan an expense to be covered by a tax refund, or you can have gradually increasing or decreasing plan payments which adjust to changing incomes and expenses. Changes may be made in steps. Sudden, unanticipated expenses may also require conversion to a Chapter 7, modifying the plan payments, how creditors are treated and even earmarking refunds.
How can I keep my income tax refund after filing Chapter 7 or 13 bankruptcy
In a Chapter 7 income tax refunds can only be kept if you can use an exemption. As soon as you transfer property out of your name you can’t use the exemption. So if you pay mom back the 750 dollars, she leant to you the exemption can’t be used. She has the 750. The transfer is a preferential or fraudulent transfer. Either way, the Trustee gets the money back by suing her to recover the money. Even if you could have kept the money by using an exemption, you and mom lost the money by transferring it to her. You may have been able to keep the money by using an exemption, or you may have been able to use the money for an expense. But by transferring assets, you lose the ability to keep assets.
It is easy to keep a tax refund in Chapter 7 simply get the refund and spend it before you file a Chapter 7 bankruptcy. After the refund has been spent it is no longer an asset. In Indiana, the trustee will look at next years refund as an asset if the bankruptcy is filed 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. This is a total of up to $13,750 that may be available in Kentucky to keep a tax refund in a Kentucky Chapter 7. Every year these exemptions increase.
Losing the tax refund may not be that bad.
In some plans losing the tax refund may mean finishing the bankruptcy sooner than you expected. Chapter 13 cases must pay back priority and secured debts in full and must pay back as much as a Chapter 7 would have. Losing the tax refunds may increase what is paid back, so it becomes feasible.