How to Keep Your Tax Refund After Filing Chapter 7 or 13 Bankruptcy
Understanding Tax Refunds in Bankruptcy
Can You Keep Your Tax Refund After Filing Chapter 7 or 13? Almost always for a Kentucky tax refund in Chapter 7. Rarely for a Kentucky tax refund in Chapter 13 unless you have a 100% plan. The penalty for not handing the federal tax refund in Chapter 13 to the trustee is having the case dismissed. See Local Rule 6070-1 (e)
What is a Bankruptcy Estate?
A bankruptcy estate refers to the collection of assets, including property and income, that a debtor owns at the time of filing for bankruptcy. This estate is administered by the bankruptcy trustee, who is responsible for overseeing and managing the assets to pay off creditors.
In the context of tax refunds, the bankruptcy estate includes any tax refunds that the debtor is entitled to receive, which may be used to repay creditors. When you file for bankruptcy, your tax refunds become part of this estate, and the trustee will determine how they are used to satisfy your debts. However, exemptions can sometimes be used to protect certain assets, including tax refunds, from being included in the bankruptcy estate.
Which Tax Refunds Are Part of the Bankruptcy Estate?
In a bankruptcy case, tax refunds can be a valuable asset for creditors. However, not all tax refunds are part of the bankruptcy estate. To determine which tax refunds are included, it’s essential to understand the timing of the refund and the type of bankruptcy filed. The Chapter 13 trustee is concerned with tax refunds you acquire after the bankruptcy is filed.
Tax refunds for income earned before filing for bankruptcy are typically part of the Chapter 7 bankruptcy estate. This means that if you are entitled to a tax refund for income earned prior to your bankruptcy filing, that refund will likely be used to repay creditors. On the other hand, tax refunds for income earned after filing for bankruptcy can only be taken in Chapter 13.
In Chapter 13 bankruptcy, the situation is different. Tax refunds for income earned both before and after filing may be part of the estate, as the repayment plan is based on the debtor’s disposable income. This means that your tax refunds could be considered disposable income and used to fund your repayment plan.
Understanding which parts of your tax refund is part of the bankruptcy estate can help you plan accordingly and take steps to protect your refund funds.
How the Bankruptcy Trustee Affects Your Tax Refund
The bankruptcy Trustee determines what happens to your tax refund in bankruptcy. The Trustee is responsible for identifying and collecting all non-exempt assets, including tax refunds, to distribute to creditors. If you receive a tax refund while in bankruptcy, the trustee may claim it as part of the bankruptcy estate and use it to repay creditors. However, there are ways to protect your tax refund, such as adjusting your tax withholding or using exemptions. By understanding the trustee’s role and planning accordingly, you can take steps to safeguard your tax refund funds.
The tax refund problem in Chapter 13
In Chapter 13, your annual refund money is disposable income that should be paid to a Chapter 13 trustee to repay creditors. Bankruptcy allows you to keep income for reasonable and necessary expenses, but a tax refund is a windfall. Money over and above your budget. In the Western District of Kentucky, the Debtor is required to file an annual budget and to turn over the tax refund. You can keep the earned income portion of the refund and the cost to prepare the tax refund. But you cannot keep the childcare credit.
You want to plan the timing of when you file and your tax exemptions so you never get a tax refund which can be lost. The failure to turn over this refund means your case may be dismissed. You are sent notices at the start of your Chapter 13 case about your duty to turn in the budget and tax refund annually.
You don’t lose the tax refund or have to file a budget if your plan pays 100%. In Chapter 13, retaining your tax refund is about planning your budget and decreasing your tax withholdings.
Filing a Motion to Keep the Refund
In some circumstances, you can petition the bankruptcy court to keep the refund for payment of necessary medical expenses or other unusual events and there is a severe need for the refund. Reasonable and necessary expenses are allowable in your budget. But you must anticipate all your future expenses when you file your budget and Chapter 13 plan. It is not always possible to anticipate or plan for every expense.
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. You are better off owning the IRS slightly than getting a refund in a Chapter 13 bankruptcy. Planning your taxes and tax deductions are just part of proper Chapter 13 bankruptcy planning.
Modifying your Chapter 13 Repayment Plan to Keep the Refund
100% plans do not lose their bankruptcy estate tax refunds. However, if you owe taxes it can complicate the process and may require additional planning. A plan modification might allow you to keep the refund in a real emergency such as a needed medical operation. The court uses a balancing approach to your need for money and the need to pay disposable income into the plan. A broken transmission probably won’t qualify. The Court may allow you to keep a tax refund for a maintenance expense such as an unexpected furnace or air conditioner replacement. But the penalty for not turning over the tax refund is dismissing the Chapter 13 case.
A good Chapter 13 bankruptcy attorney or experienced law firm plans for such maintenance expenses in the budget setting back money for appliance replacement and repair. You might use the refund to pay for an emergency expense but then increase your plan payment to make up for the immediate use of the funds. This requires filing a motion for approval of using the refund. It puts the Chapter 13 attorney through a lot of work which he generally is not paid for.
Putting known future expenses into the plan
In the plan submitted by your lawyer, it is also possible to propose that the furnace will go out in a year or two. A step plan allows you to lower the plan payment initially and increase it later. You can cover an expense by having a step plan that lets you pay for a roof at the start of a case. Then you have gradually increasing plan payments which adjust to changing incomes and expenses. If you spent the refund modify the plan to keep the case from being dismissed by making up for it by increasing the remaining payments.
Sudden expenses or a loss in income might require you to convert a Chapter 7 bankruptcy. You can modify the plan payments, lower the plan percentage, suspend plan payments, and you might even earmark tax refunds for emergency repairs by planning your Chapter 13.
What happens if I owe the IRS?
Taxes over three years old can normally be discharged in bankruptcy just as easily as credit card and medical debt. But if you owe the IRS and you have a tax refund they will keep the refund even if you are in bankruptcy. This is called a set off. They are not taking your refund. They already have it in their possession.
It is hard to perfectly plan your deductions to not give you a refund or owe a penny. But you do not want an IRS refund during your Chapter 13 case. It is just lost income.
The tax refund problem in Chapter 7
If you are in Chapter 13 it is still important to know this Chapter 7 section because it explains exemptions. I use Indiana as an example because tax refunds and bank accounts are more of a problem there. We have larger exemptions here in Kentucky, but you still need to know how exemptions work.
The trustee sells or distributes any property over the amount of equity and exemptions you are allowed to keep. In a Chapter 7 bankruptcy, keeping your income tax refund is all about what you own when you file the case and the allowed exemptions. If you have spent the tax refund before you file there is no asset for the Trustee. Technically, the tax refund is a property just like any other property you own. It is an unpaid debt to you that the government uses interest-free for a year. You own that refund long before you get it. You just forget it is an asset.
Indiana has a special problem with tax refunds
In Indiana, the exemption for a tax refund was only 350 dollars in 2024. Money in a bank account or a tax refund is intangible property. You can not hold in your hand money owed to you.
With a tax refund of 5,000 dollars, a Chapter 7 bankruptcy filing in December must turn over 4,650 dollars to the trustee, who gets over $1,100 for paying creditors the remaining $3,487, if you have filed bankruptcy. For example: $5,000 tax refund – $350 exemption – $1162.50 trustee 25% fee = $3,487.50 for creditors. You get 350 (Your Exemption) The trustee earns an 1162 commission, and the creditors get 3487.
Instead, if you file bankruptcy in February after you receive and spend the refund. Then, you keep $5,000 instead of $350. The $350 exemption is for all 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. But she will also look for the dividends you are paid from any stock you have and for other property that is not fully exempted.
Kentucky uses Federal exemptions which makes this not a problem
Spending the tax refund to repay relatives or purchase property that is not exempt creates problems. In Kentucky, you also have a 15,000 dollar exemption for household goods. You can usually safely spend a refund on food, clothes, and furniture because Kentucky uses federal exemptions for household goods. The federal exemptions are so large that most people rarely exceed them. 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.
Kentucky and many other states use federal exemptions. In 2022 the federal exemptions allow you to keep about $28,900 in real property. Half of what you don’t use to keep your home residence can be used to keep any other kind of property as a wild card exception.
In 2025 the federal exemptions have a second specific $1,450 wildcard exemption. Kentucky has a much larger wildcard exemption than Indiana. This makes it possible to keep over $14,450 + $1,450 if you don’t use the $28,900 real estate exemption to keep a home. Please note that the full amount of the $28,900 exemption is meant to keep your home. However, the remainder of what you don’t use for your home is reduced to half if you use it to keep other property.
Role of the Bankruptcy Trustee
You might lose a tax refund in Chapter 13 because of the requirement to pay to the trustee funds that exceed your monthly budget, including refunds from different tax years. In other words, it is a requirement that all your disposable income is paid into the plan.
In the western district of Kentucky, you must turn in a copy of your yearly income tax return by May 15th. Western Kentucky allows you to keep the income tax deduction in the first year of your plan. Also, a tax refund is an asset you exempt during the first year.
In the later years, a tax refund is a disposable income you must use to repay 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 must surrender the child credit.
What Do You Need to Do to Keep Your Refund After You File a Chapter 7 or 13 Bankruptcy?
You can only keep Chapter 7 income tax refunds if you use an exemption, but you may still receive tax refunds during the bankruptcy process. But, if you transfer property out of your name, you can’t use the exemption. For instance, the exemption is not usable if you pay back $750 to your mom for a loan before filing Chapter 7. This is because it is a preferential or fraudulent transfer. You can only exempt property you own and need to start over on. Either way, the trustee sues your mom to recover the money. Instead, by using an exemption in Chapter 7, or an expense using it for an expense in Chapter 13, you might be able to keep the money and repay her after filing. 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 for a Chapter 7 bankruptcy. Then, after you spend the tax refund, it is no longer an asset. In Indiana, the trustee looks at next year’s tax season refund as an asset if you file bankruptcy after September in Chapter 7. In Indiana, the exemption is minimal, and the trustee will pro-rate any refund check.
Exemptions in Indiana and Kentucky
The exemption is only $350 in Indiana, which can significantly impact your tax refund depending on the tax year. But, in Kentucky, you have a $1450 wild card exemption plus one-half of the unused real estate exemption. If you rent or have no home, this is about an additional $14,450 in 2022. Up to $15,800 might be available to keep a tax refund or tax withholding in a Kentucky Chapter 7. Also, these exemptions increase every year.
Adjusting Your Tax Withholding
Adjusting your tax withholding is one way to minimize the impact of bankruptcy on your tax refund. By reducing your tax withholding, you can avoid overpaying your income taxes and reduce the amount of your tax refund. This can help you keep more of your disposable income and avoid having to turn over your tax refund to the bankruptcy trustee. However, it’s essential to ensure that you’re not under-withholding, as this can result in penalties and interest. Properly managing your tax withholding can be a strategic move to retain more of your income during the bankruptcy process.
Instances When Losing the Tax Refund is Better
In some plans, losing the tax refund might mean finishing the bankruptcy sooner than expected, especially if you receive tax refunds regularly. A Chapter 13 bankruptcy case must pay back both priority debts in full and make the secured debts up to date. Chapter 13 also must pay back the same amount as Chapter 7. Losing the tax refund may help you repay the required priority expenses back quicker, making a plan more feasible or affordable with lower payments.
Chapter 7 and tax refunds you have not gotten yet
Both a tax refund and money in a bank account are intangible property. You have to empty the bank account as well or pay utilities to zero the account just before filing a Chapter 7 in Indiana. If a tax refund is coming on February 25th cash the check, spend it, and file on February 30th. In Kentucky. your wild card exemption is over 15,000 dollars. You have enough exemptions in Kentucky to cover just about any tax refund check you will get in Kentucky.
The problem comes with a tax refund you have not gotten yet. If you file bankruptcy in Indiana in November 2024 your tax refund for 2024 has not been paid to you yet but you still have a right to that refund. So the trustee has 11/12ths of your tax refund you will get next year minus any exemption you use (350). Maybe it would be best to wait to file till March after you get that refund to file.
Using Your Tax Refund Wisely
If you receive a tax refund while in bankruptcy, it’s essential to use it wisely. You can spend your tax refund on necessary expenses, such as rent or mortgage payments, utilities, groceries, and medical expenses. However, you should avoid using your tax refund to pay for luxury items, pay back loans or credit cards, or make preferential payments to creditors.
The bankruptcy court may deny your discharge if you’re found to have made bad-faith payments or purchases. By understanding how tax refunds work in bankruptcy and taking steps to protect your refund, you can minimize the impact of bankruptcy on your finances and ensure a smoother recovery.
Filing Taxes After Filing for Bankruptcy
Filing taxes after filing for bankruptcy requires careful consideration of the bankruptcy estate and the debtor’s tax obligations. Here are some key points to keep in mind:
The Bankruptcy Code requires debtors to file an individual tax return or request an extension, just like anyone else. However, the process can be more complex due to the involvement of the bankruptcy trustee. The trustee is responsible for filing a tax return for the bankruptcy estate, which may include income from assets sold or other sources. This means that there could be two separate tax returns: one for the individual debtor and one for the bankruptcy estate.
Debtors should not file their tax return as they normally would, as the bankruptcy filing may affect their tax obligations. It’s crucial to work with a tax professional or attorney to ensure compliance with tax laws and bankruptcy regulations. They can help you navigate the complexities of filing taxes during bankruptcy and ensure that you meet all necessary requirements.
By understanding the requirements for filing taxes after filing for bankruptcy, you can avoid potential pitfalls and ensure that you remain in compliance with both tax laws and bankruptcy regulations.
Resources for Bankruptcy
Annual Budgets and Tax Refunds in Bankruptcy
Chapter 13 and IRS Tax Returns and Refunds in Bankruptcy
Your Fresh Start on a New Budget with Bankruptcy
If you are considering filing bankruptcy, don’t delay because timing is crucial. I am here to help you. So, contact my office immediately to start the conversation—Nick C. Thompson, Bankruptcy Lawyer: 502-625-0905.
