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Will Your Bankruptcy Affect Your Tax Refund?

Tax Refund Check with W-2 and 1040 U.S. Individual Income Tax Return Forms - John A. Steinberger & Associates

It’s tax season, and that means many Michigan families are looking forward to receiving and spending their tax refund. Michigan taxpayers often rely on these annual refunds to pay for everything from past-due credit card debt to new glasses. But what happens to that plan when there is a bankruptcy involved? Will your bankruptcy affect your tax refund?

This blog post will discuss how a Chapter 7 or Chapter 13 bankruptcy will affect your tax refund. It will explain how those funds will be used in each type of bankruptcy, and whether you can look forward to any extra spending money this tax season.

Chapter 7 Bankruptcy’s Effect on Tax Refunds is All About Timing

If you are considering filing a Chapter 7 bankruptcy around tax time, it is a good idea to talk to both a bankruptcy attorney and an accountant before heading to the courthouse. A Chapter 7 bankruptcy can affect your tax refund and even cause you to lose it entirely, but that effect will depend on the timing of when you receive your tax refund and when you file your bankruptcy petition.

A Chapter 7 bankruptcy works as a snapshot picture of your financial circumstances on the day the petition is filed. At that moment, everything you have, from homes to bank accounts, becomes part of your bankruptcy estate. You and your bankruptcy attorney can carve out several exemptions, including your home up to a certain value, the family car, and a certain value of personal property items. Then everything else is sold and the proceeds are used to pay off your creditors.

Your tax refund can count as part of your bankruptcy estate depending on when you earn the money that goes into the tax refund and when you receive it compared to the date you file for bankruptcy:

  • If you receive your tax refund first, any amount not spent on allowable expenses will be affected by your bankruptcy and become part of the bankruptcy estate to pay off creditors
  • If you receive your tax refund for income earned in the year before your bankruptcy after the petition is filed, the trustee will take the tax refund to pay off creditors
  • If the tax refund you receive includes income earned after you file for bankruptcy, that portion belongs to you and cannot be used to pay your creditors.

Because your Chapter 7 bankruptcy affects your tax refund you will want to discuss the timing of your filing both the tax return and the bankruptcy petition so you can avoid giving the bankruptcy more of your money to pay off your creditors.

Chapter 13 Bankruptcy Uses Tax Refunds to Finish Payment Plans Faster

If a Chapter 7 bankruptcy is a snapshot, then a Chapter 13 bankruptcy is a 3- to 5-year movie. In preparing to file a Chapter 13 bankruptcy, you and your bankruptcy attorney will create a payment plan that includes a budget for your regular living expenses and makes all the rest of your income available to pay down your debts.

That includes your tax refund. Because your tax refund is unpredictable (especially for 2018 because of changes in the tax code), your bankruptcy attorney will usually not include your tax refund as part of your budget. Instead, it becomes a source of additional income your bankruptcy trustee can use to pay your debts ahead of schedule and finish your payment plans faster. Because a Chapter 13 bankruptcy is a process, it will inevitably include at least a few years’ tax returns. You should talk to your bankruptcy attorney to create a strategy that works best for you and your family: minimize your tax refunds and keep more of your money, or use larger tax refunds to help finish your payment plan ahead of schedule.

How to Avoid Giving Your Tax Refund to the Bankruptcy Trustee

For anyone filing a Chapter 7 bankruptcy, and many going through a Chapter 13 payment plan, giving your tax refund to the bankruptcy trustee may simply mean you have less money available to support yourself and your family. The good news is that through careful planning and use of the bankruptcy code, you can often avoid putting your tax refund into your bankruptcy estate, and use it for yourself instead. Depending on your circumstances, this could include plans to:

Spend Your Tax Refund Before You File for Bankruptcy

One of the best ways to keep your bankruptcy from affecting your tax refund is to file your tax return, receive the refund, and spend it before filing your petition. As long as you use the money for permissible expenses, you won’t be required to repay that amount to the bankruptcy trustee. If you are preparing to file for bankruptcy, you should use your tax refund on things like:

  • Housing expenses (mortgage, rent, repairs, and utilities)
  • Food
  • Clothing
  • Medical care or equipment (including prescriptions and eye-glasses)
  • Car payments, maintenance, and repair
  • Education tuition, books, or expenses

You should avoid spending your tax return on unapproved expenses like:

  • Repaying any one credit card
  • Payments to family members

If your tax refund goes to these unapproved expenses, it could be up to you to repay those amounts back to the trustee after the bankruptcy begins. The best way to avoid this is to discuss how you plan to spend your tax refund with your bankruptcy attorney beforehand and give him or her copies of your receipts once the money is spent.

Modifying Your Payment Plan to Pay for Unexpected Expense

If you have a Chapter 13 bankruptcy payment plan, sometimes things come up that you do not expect. Your household budget should include a certain amount for regular maintenance and discretionary expenses, but that may not be enough to handle emergency repairs. In these cases, you may be able to file a plan modification that will allow you to keep your tax refund and use it to pay for:

  • House repairs caused by natural disasters
  • Repairing or replacing household appliances
  • Car repairs following an accident
  • Unexpected medical costs for you or your spouse or children
  • Funeral costs

In these cases, you should expect to disclose the amount of the tax refund, the specific reason you need it, and the receipts showing you spent the refund the way you said you would.

Adjusting Your Withholdings to Minimize Tax Refunds

One of the best strategies to avoid turning over your tax refunds to a bankruptcy trustee is not to receive them in the first place. Receiving a tax refund means that you have pre-paid more to the IRS than you owe in taxes. By adjusting how much you want withheld from your paycheck each month, you can increase your income throughout the year and use it to support your family, rather than waiting until April 15, and getting a refund back.

Work with your bankruptcy attorney and an accountant to determine how much you need to withhold to pay just enough to cover your taxes without overpaying. You want to avoid creating a new tax debt that could threaten your Chapter 13 bankruptcy, but you also don’t want to withhold too much just to hand that tax refund over to the trustee.

There is a lot of strategy that goes into controlling how your bankruptcy will affect your tax return. That is why you should start talking to a bankruptcy attorney early, sometimes several months before you actually file the petition. That will give you and your attorney time to make a plan to make the best use of your tax return, and keep you from giving the trustee more than he or she needs to pay off your creditors.

At John A. Steinberger & Associates, P.C., we are a full-service bankruptcy law firm in Southeast MI. We serve debtors and families in Southfield, throughout Metro Detroit, and in the surrounding communities. We will help you review your options and choose the bankruptcy strategy that is right for you. Call us toll-free at (866) 690-2140 or contact us online to schedule a free initial consultation.

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