Tax Refunds in Bankruptcy

My editor shall double-take at the San Diego bankruptcy attorney's for-once straightforward and  not-cutesy title.*  Well, it's good to try something new.

We dread our tax-return filings, though more often than not a rewarding refund awaits.  While I'm not an accountant, I peruse bankruptcy debtors' tax returns on a daily basis.  They range from a single page to a hundred.  I prefer the former.

The tax return informs the bankruptcy petition preparation on many levels.  Yet, invariably my eyes turn first to the refund line (we'll address the liability line another day).  Tax refunds can be pretty hefty; and when it comes to money, something hefty warrants pause.

The Tax Refund in Bankruptcy: Can I Keep It?

Can you protect your tax refund in bankruptcy?  The right to preserve one's tax refund is not inalienable both inside and outside of bankruptcy.  In the latter realm, an otherwise due refund may be set off against other government debts.  Inside bankruptcy it is both: 1) an asset to be protected; and 2) a source of disposable income.

The Tax Refund in Bankruptcy: What an Asset

In chapter 7 bankruptcy, a deposited, cashed, or pending tax refund must fall within the accepted allowances for what you get to keep or exempt.  California debtors are usually** eligible for a "wildcard" and unused homestead-exemption allowance totaling (presently) $23,250.  Generally, the tax refund fits within that exemption allowance.  We must protect the last tax-period's refund (if not already received and exhausted--for normal living expenses--prior to the bankruptcy filing) as well as a prorated amount of the present tax-period's refund (that will be payable the following year).  For example, as of July 1, 2012, you've "earned" half of your 2012 tax refund, which you'll receive when you file 2012's taxes in 2013.  Hence, if you file bankruptcy July 1, 2012, then you must exempt half of that year's forthcoming tax refund.  An asset in bankruptcy is both the bird in your hand and the birds in the bush, if you're entitled to pluck them from the bush some time in the future. 

The Tax Refund in Bankruptcy: Deferred Income, Yet Income Just the Same

Besides asset protection in chapter 7 bankruptcy, your bankruptcy attorney considers your tax refund in the context of ascertaining your disposable income-- or lack thereof.  Disposable income is what your budget has available for repayment of debt; it is a function of one's income (whether it's taxable or not, though Social Security income is sanctified as something not strictly allocatable to debt repayment) less reasonable and necessary expenses (meaning what you "should" be spending if budgeting modestly).  A tax refund is a sort-of hidden income that must be factored into your prorated monthly income.  If it is not offset by reasonable and necessary expenses, then it yields disposable income that might either 1) disqualify you from chapter 7 bankruptcy; or 2) increase your chapter 13 bankruptcy payments.

Example: Jack, a chapter 7 bankruptcy filer lives paycheck to paycheck.  In his bankruptcy papers, he must schedule his monthly income on Schedule I ("I" apparently stands for Income), and schedule his monthly expenses on Schedule J ("J" apparently stands for-- I don't know... Jexpenses?).   Jack's Schedule-I total less his Schedule-J total equals -$1 (negative one-dollar).  He is in the red.  Yet, Jack routinely receives a $6,000 tax refund, which amounts to an additional (6000/12) $500 in prorated monthly "income." Unless Jack's Schedule J (listing of expenses) is modest to a fault and begs revision, then he objectively has ability to repay $500 in debt monthly.

If he has a spare $500, Jack would not qualify for chapter 7 bankruptcy; yet he might benefit from a chapter 13.  A chapter 13 bankruptcy could permit him to pay off his debt in full for pennies on the dollar.  This is because in chapter 13, one most often commits only the extent of one's monthly disposable income--which for Jack is $500--and any unpaid balance of dischargeable*** debt is forgiven.


The Tax Refund: Where Should it Go

For the unprepared bankruptcy debtor it may need to go to debt repayment.  That is not a bad thing in the grand scheme; yet it's bad for the bankruptcy debtor if the money's needed to pay property taxes, utility bills, and all the things our kids demand, yet don't thank us for (till they have kids of their own). 

San Diego Bankruptcy Attorney, Asaph Abrams
Offering free, no-obligation chapter 7 bankruptcy and chapter 13 bankruptcy consultations in San Diego. Visit us at http://www.bankonitsd.com/ or call 858-344-0500. E-mail admin@abramslawsd.com to set an appointment. Also representing Imperial County residents.

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*No, I don't really have an editor.
**Note all qualifying language, such as "usually," "generally," "mostly," and the like: it's not random.  After all, you're reading a bankruptcy attorney blog.  (For some reason.)  Reading a bankruptcy attorney blog implies that exceptions apply.  For example, not all California debtors are eligible for the "wildcard" allowance.  Consult your local counsel (or me if you're in San Diego or Imperial Counties) for specifics on your case.  
***I.e. debt that can be discharged or forgiven.  E.g., credit card debt is generally dischargeable (see that word again: "generally?"); student loan debt is generally not dischargeable.