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Bankruptcy and Tax Refunds: What Happens to Them?

Filing for bankruptcy is a big decision, and if you’re expecting a tax refund, you might wonder how it will be impacted.

Tax refunds can be a financial lifeline, especially if you’re facing mounting debts. But when bankruptcy enters the picture, those refunds might not be entirely yours to keep.

Understanding how bankruptcy affects your tax refund and how to time your filing strategically can make a huge difference in your financial outcome.

How Tax Refunds Are Treated in Bankruptcy

Tax refunds are considered assets in bankruptcy. This means the bankruptcy trustee—the person appointed to oversee your case—has the right to review your financial situation and determine whether your refund should be used to pay off your creditors.

The way your tax refund is treated depends on the type of bankruptcy you file (Chapter 7 or Chapter 13) and the timing of your filing.

Tax Refunds in Chapter 7 Bankruptcy

In Chapter 7 bankruptcy, the goal is to liquidate non-exempt assets to repay creditors. Once the trustee sells off those assets, your remaining eligible debts are discharged.

Because a tax refund is treated as an asset, it could be used to pay your creditors unless it qualifies for an exemption.

For example, if you file for bankruptcy before receiving your tax refund, the trustee may claim the refund—even if it’s for income earned before you filed.

This can feel unfair, but the law views tax refunds as part of your financial resources for the year, even if you haven’t yet received them.

Tax Refunds in Chapter 13 Bankruptcy

Chapter 13 bankruptcy works differently because it involves a repayment plan rather than liquidating assets.

If you file under Chapter 13, your tax refund may be included in your repayment plan to help pay off creditors. In many cases, the court requires you to contribute all disposable income, including tax refunds, toward your repayment obligations during the three to five years of your plan.

However, some courts allow exceptions for necessary expenses, such as medical bills, home repairs, or emergencies. Your bankruptcy attorney can help you request to keep all or part of your refund for such purposes.

Timing Your Filing to Protect Your Tax Refund

Timing can make all the difference when it comes to preserving your tax refund during bankruptcy. By understanding when refunds become vulnerable to the bankruptcy process, you can plan your filing in a way that minimizes the impact.

1. Before Filing:
   If you’re expecting a tax refund soon, consider waiting until you receive it and use it for necessary expenses before filing for bankruptcy. You might use the refund to cover rent, utilities, groceries, or other essential costs. However, it’s important to avoid using your refund to pay off unsecured creditors, such as credit card companies, as this can raise red flags and lead to complications in your case.
2. During the Tax Season:
   If you file for bankruptcy in the middle of tax season and you’ve already filed your return but haven’t yet received your refund, the trustee can claim the refund. Filing before completing your tax return may prevent the trustee from seizing the funds, but you’ll need to report your anticipated refund in your bankruptcy paperwork.
3. After Spending the Refund:
   Timing your bankruptcy filing to occur after you’ve received and responsibly spent your tax refund can help protect the funds. Courts generally don’t have an issue with debtors using their refunds to cover necessary living expenses before filing for bankruptcy.

The Role of Exemptions

Bankruptcy laws allow you to protect certain assets through exemptions, which vary by state. Tax refunds can sometimes be protected under exemptions, but this depends on the laws in your state and how the refund is used.

For example, if your refund includes earned income tax credit (EITC) or child tax credit (CTC), many states and federal bankruptcy laws allow you to exempt those portions of your refund. Additionally, some states allow you to apply a wildcard exemption, which can protect a portion of your refund if other exemptions don’t apply.

Your bankruptcy attorney can help you navigate the exemption rules in your state and maximize your protections.

Special Considerations for Future Refunds

When you file for bankruptcy, the court examines your financial situation at the time of filing, but it may also have an interest in refunds for the same tax year.

For example, if you file for bankruptcy in December, your trustee might claim part or all of the refund you receive the following spring, since it includes income earned before your filing date.

In Chapter 13 bankruptcy, this issue can extend for the duration of your repayment plan. Each year, your trustee may request copies of your tax returns to assess whether your refund should go toward your creditors.

Steps to Protect Your Refund

If you’re concerned about how your tax refund might be affected by bankruptcy, the best thing you can do is consult an experienced bankruptcy attorney. They can help you:

• Determine the right time to file: Your attorney will evaluate your financial situation and recommend whether to file before or after receiving your refund.
• Apply exemptions strategically: They’ll ensure you claim all available exemptions to protect as much of your refund as possible.
• Avoid costly mistakes: Your attorney can guide you on how to spend your refund responsibly before filing, ensuring that your actions don’t raise suspicion with the court.

Final Thoughts

Your tax refund can be an important financial resource, and understanding how bankruptcy affects it can help you make informed decisions. Filing for bankruptcy doesn’t mean giving up everything—it’s about creating a manageable path forward.

By working with a knowledgeable bankruptcy attorney, you can protect your refund and take the first step toward financial relief.

If you’re considering bankruptcy and worried about your tax refund, don’t wait to seek advice. An attorney can help you navigate the process, time your filing for maximum benefit, and ensure you keep as much of your hard-earned money as possible.

Hiring an Experienced Bankruptcy Lawyer

It’s important to hire an experienced bankruptcy attorney as one of the steps to take when you’re facing bankruptcy and you need solid guidance and representation.

This is because there are many different types of bankruptcy. Only an experienced lawyer will know which one would work best for your specific situation.

It might seem like it makes sense to do this yourself. But most people don’t have the time or patience to understand all of the intricate details involved in bankruptcy.

That means they make mistakes by not choosing the right type, or by not filling out paperwork correctly. Both things could lead to delays and ultimately hurt your chances of getting any debt relief at all.

This is not a journey to take lightly, but it is also not one to take alone. If you need to file for bankruptcy, reach out to us today to start your journey with us.

If you want to learn more about the options you have and the steps to take, call us for a free consultation.