Without question, the biggest Chapter 7 bankruptcy trap at this time of year is losing part or all of a debtor’s income tax refund. The risk is fairly easy to describe: if you have received or are entitled to receive a tax refund, any amount not protected by legal exemptions is subject to turnover to the Chapter 7 trustee. Most bankruptcy trustees will keep your case open until you actually receive the tax refund. Every year there are Chapter 7 debtors who file bankruptcy before receiving their tax refund, and are surprised to receive more than expected after IRS adjustments to their tax returns.
The answer for many debtors is simply to postpone filing bankruptcy until after the tax refund is received and the money is safely spent. However, nothing in the bankruptcy process is simple or entirely safe. Even spending your tax refund before bankruptcy can cause you or others headaches. Spending tax money on luxury goods, repaying loans to friends or family, and even paying down creditors can create problems for you, the payee, or both!
The best advice is to spend your income tax refund under the supervision of your bankruptcy attorney. Your attorney may be able to exempt all or part of your tax refund, which will help you keep your finances under control after bankruptcy. Your attorney can also help guide you in spending the non-exempt portion of your refund. Below are three common ways income tax refunds are spent before bankruptcy:
Sadly, many debtors need their income tax refunds before they can “afford to go broke.” Paying your Chapter 7 attorney fees, mandatory credit counseling fee, and bankruptcy court filing fee are all expected before you file bankruptcy. However, be aware that some jurisdictions consider money in your bank account on the day you file your case as property of the bankruptcy estate, even if there is an outstanding check written that has not yet cleared.
Play Catch Up
Paying utility payments and rent/mortgage arrears is another common use for tax money. Avoid the urge to “pay ahead” as the trustee may claim that an advance payment is an asset of the bankruptcy estate.
Necessary living expenses such as food, clothing, medicines, or making needed repairs to your home or auto are often wise ways to spend your income tax refund before bankruptcy. If your family budget is already stretched, purchasing a set of tires for your car or replacing a failing appliance may save you financial grief in the future.