How Does Filing for Chapter 7 Bankruptcy Affect My Tax Return?

Aside from the question—“If I file for Chapter 7 bankruptcy, and then win a lottery, can I keep the money?”—the second most asked question is: “Can I keep my tax refund under the same circumstance?” It’s a good and valid, question and one that depends upon certain conditions pertaining to the timing of the actual filing of bankruptcy.

Surprisingly, it is both permissible and legal to factor the question of the status of your tax refund into consideration when filing for bankruptcy. We’ll go over the various conditions related to timing, however, it might be a good idea to first gain an understanding of how the Chapter 7 bankruptcy process works.

Understanding Chapter 7 Bankruptcy

Filing for Chapter 7 bankruptcy is also known as a straight or liquidation bankruptcy, partly because it is the simplest form of bankruptcy. Unlike other forms, including Chapter 13 bankruptcy, filing under Chapter 7 does not involve coming up with a repayment plan for repaying the debt you owe to creditors.

Instead, a trustee is appointed by the bankruptcy court to oversee your petition and to take any of your assets that are not deemed exempt, sell them, and distribute the proceeds to your creditors. Not all your assets can be sold off. Some are exempted in accordance with the state laws governing your bankruptcy.

In general, these are the steps of the legal process a typical Chapter 7 bankruptcy goes through.

  1. Case preparation.
  2. This involves filling out many forms that help you to better understand the state of your finances in terms of what you earn, what you spend, what you owe in debt and what you are no longer able to pay back. It is also the basis for your petition for a discharge of your debts.

  3. Pass a state means test.
  4. If it is deemed that you are able to pay back a substantial portion of the debt you own based upon the mean income in your state, you may not be able to file under Chapter 7.

  5. Undergo approved credit counseling.
  6. This typically involves reading or listening to provided counseling on how to manage debt from a state-approved credit counselor. Often, a petitioner is required to speak with a credit counselor after reviewing the material to gauge the petitioners understanding.

  7. Attend a meeting of creditors.
  8. The trustee sends out a notice of a creditors meeting at which you may be asked questions related to your debt by said creditors. While the meeting is open to any and all of your creditors, generally speaking, it is only those for whom you are going to continue making monthly payments to, such as the continued financing of a vehicle you are trying to retain as a necessity. (Incidentally, you may be asked about any recent or impending tax returns during this meeting.)

  9. Surrender of assets to trustee.
  10. Those of your assets that will be sold by the trustee for the benefit of paying your creditors a portion of the debt you owe them usually takes place at the meeting of creditors prior to discharge of your debt.

  11. Your debt is formally discharged.
  12. The trustee at this point can discharge the listed debt in your filing as long as there is no objection from any of your creditors. It can take up to 60 days for the is discharge to be officially in effect.

“Can I Keep My Tax Return?”

Now that you have a better understanding of how Chapter 7 bankruptcy works, let’s return to the question of tax returns and how they are impacted by filing for bankruptcy. As mentioned earlier, timing is everything when it comes to determining the status of your refund. Basically, there are three conditions related to the timing of tax returns. Let’s review them now.

“I Received a Tax Refund Prior to Filing”

In general, any unspent money from a tax refund is considered part of your estate and subject to surrender to the trustee for payment to creditors. You can legally keep all of this money, instead, as long as you spend it all before filing for bankruptcy. The only condition is that you spend it on expenses that are approved, such as payments on your home, food and clothing, your vehicle payment, and medical and educational expenses. Unapproved expenditures include paying off just one of your debtors, purchasing luxury items or paying back personal debt from friends or family.

“I Intend to File for Bankruptcy Sometime Later This Year”

As in the first example, any refund amount would be deemed as part of your estate under this scenario. However, you can avoid losing the money by, instead, adjusting the amount of money deducted from your paycheck for income taxes so that you’ll only be covering the actual tax you’ll eventually owe. This way you’ll increase the amount of money you have to spend each paycheck.

“I Received a Tax Refund After My Bankruptcy”

Your bankruptcy was based upon the income you made prior to filling, and you are entitled to certain exemptions from having to use this money to pay creditors. You may be able to keep a portion of your refund in this situation. This is one example in which the state you reside in is important as some states allow for more generous exemptions that do others.

We understand this process is complex and that is why we are here to help. Contact one of our Ohio offices to learn more today!

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