Tax refund what happens to it in bankruptcy?

Recently on our bankruptcy forum a user asked, “I am considering filing for Chapter 7 bankruptcy. I usually get a pretty sizeable tax refund. I am wondering if I am legally required to notify my trustee about the refund, and if so, is he allowed to take the money and liquidate it?”

What is Chapter 7 bankruptcy?

Filing Chapter 7 bankruptcy allows debtors the opportunity to discharge certain unsecured debts. It also, however, allows a bankruptcy trustee to gather nonexempt assets, or assets which are not protected from the bankruptcy, and sell these assets to repay the debtor’s creditors.

The Bankruptcy Code defines what is and is not an asset and what assets can be considered part of the debtor’s bankruptcy estate. For example, assets can include property, motor vehicles, and other funds in the bank.

Now, whether or not a tax refund is considered part of the bankruptcy estate can be difficult to determine and may depend on when the refund was received and whether or not you take certain actions to protect your refund. Let’s look at some of your options to protect your refund.

Protecting your tax refund

If you receive your tax refund before you file for bankruptcy protection this money is treated like any other cash or money you have in the bank. If you know you are going to file for bankruptcy protection, however, you can take certain steps to protect your refund.

First, if you know you might get a refund, one option is to adjust the amount of taxes which will be withheld each pay period to reduce your potential refund. Although it’s important to make sure that you withhold enough money to pay your taxes, if your refund is small enough the trustee may simply abandon the refund, allowing you to keep it.

Next, if you receive the refund before you file for bankruptcy protection you may be able to keep the refund if you spend it on items that the court deems “necessary.” Items that the court will consider as necessary can include medical care, educational expenses, car maintenance, utilities, mortgage payments, home repair, and clothing.

Failure to spend your tax refund on items which are deemed necessary or repaying certain creditors (and not others) may allow the trustee to deny your bankruptcy discharge. For example, buying “luxury” items, making payments to friends (which can be considered “preferential” payments) or only paying one unsecured creditor (i.e., one credit card payment) may not be allowed.

Protecting your refund by claiming it as an exemption

Finally, one of the best ways to protect your tax refund if you receive it after you file for bankruptcy is to designate the monies as an exemption under federal or state law. Although you will need to disclose your tax refund, if you claim it as an exemption (generally under the “wildcard” exemption) you may be able to protect the refund up to a certain dollar amount.

Note: the amount protected varies by state. Some states have a generous wildcard exemption which can be used to protect a generous tax refund; other states do not.

Bottom Line:

Trying to hide assets or a tax refund can be considered fraud. If the trustee finds out that you committed any type of fraud the bankruptcy can be denied or revoked. If you properly disclose and plan for the tax refund, however, you may be allowed to keep it.

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Beth

Beth L. is a content writer for Better Bankruptcy. Good content and information is one of many methods we utilize to bring you the answers you need.