Are you expecting a tax refund?

Are you expecting a tax refund? As in life, timing is everything. If you're considering filing for bankruptcy in Chapter 7 to eliminate debts and you're expecting an income tax refund, you have some thinking to do.

If you file Chapter 7 before you receive the tax refund, that right to future income is an asset that becomes part of the bankruptcy estate under control of the bankruptcy trustee. In general, unless it qualifies as exempt under a "wildcard" type of exemption, the trustee can use it to pay off your creditors. That's probably not what you would want. So, it's often better to delay filing Chapter 7 until you receive your tax refund. That way you retain control over the refund and have an opportunity to use it in a way that benefits you. A few of those ways might be to spend it on normal living expenses and/or catch up on mortgage payments (of course before filing Chapter 7), or put it into an "exempt" place, like an ERISA-qualified plan within IRS limits.

When do you acquire that right to the tax refund, the right that the bankruptcy trustee wants for the benefit of creditors? The general rule is that the right to receive a tax refund accrues every day taxes are withheld from your paycheck. That right doesn't wait to exist until, for example, until you file a tax return. How might that play out in specific situations? Let's assume that you will get a refund for 2009 income taxes after the taxes are filed in 2010, and you want to file a Chapter 7 bankruptcy to discharge debts.

- If the bankruptcy is filed in 2009, the portion of the tax refund that becomes part of the bankruptcy estate is pro rated based upon the amount of income earned before bankruptcy filing compared to the total year's income. Of course, if you're still working, you might be able to reduce your withholding for the remainder of 2009 so there would either be no refund for the bankruptcy estate to get or a refund so small it wouldn't be worth the trustee's time to go after it.

- If the bankruptcy is filed in 2010 but before the tax refund is received, the entire amount of the refund would become part of the bankruptcy estate.

- If the bankruptcy is filed in 2010 but after the tax refund is received, the refund received becomes just another asset and may be used for normal living expenses or as described above prior to filing bankruptcy. Of course, if you will get a refund for 2010 taxes then the trustee can get the pro rated part of that, but there should be only very few months in 2010 before you file bankruptcy so that part of the refund should be small.

Delaying your bankruptcy filing may have other consequences, possibly worse than losing a part or all of a tax refund, especially if the refund is small. Because of these and other issues beyond this discussion, you should really consult a qualified bankruptcy attorney to discuss these issues as a part of your bankruptcy process.