What will happen to my tax refund in bankrutpcy?

It's that time of year; W-2's are being mailed out, and people the nation over are rushing to their favored tax preparer (self, Internet, or brick-and-mortar) to have their taxes done in hopes of getting their tax refund and using the (interest-free loaned) money to catch up on bills, get that needed repair done to a car or house, or fund the family vacation.

But what if you have filed, or are considering filing, a bankruptcy?

Let's start with a few basic ideas. First, your right to receive an income tax refund is generally considered an asset of your bankruptcy estate, and is thus available to be taken by a Chapter 7 Trustee. In a Chapter 13 case, the courts consider a tax refund income, and thus it may need to be paid into your Chapter 13 plan, either in whole or in part.

DISCLAIMER: The preceding and following are general statements, and cannot be universally applied in all districts. I can only vouch for the Western District of Missouri and the District of Kansas (Kansas City Division), and I wouldn't even make blanket statements about those either. In other words, your mileage may vary.

So, Chicken Little, is the sky falling? Not necessarily. You may lose only some of the refund, or even get to keep it in whole. Let's begin with those who have already filed. In an existing Chapter 7 case (at least as it's done around here), how much of your refund the Trustee gets to take depends on when your case was filed, and what exemptions you may be able to apply to it. If your case was filed last year (2009 in this case), the percentage of the refund subject to the bankruptcy estate is the same percentage of 2009 that has passed. Thus a case filed 75% of the way through the year can claim 75% of the tax refund. If your case was filed this year before you received the refund, 100% is part of the estate. On top of that, if your state allows the use of a "wildcard" exemption, it can be applied to a tax refund, thus further reducing the amount that has to be turned over.

In an existing Chapter 13 case, I am afraid you will have to consult the local rule and practice. In my districts the rules have changed (evolved) over the years, and hopefully your attorney will know what is up. You may be allowed to keep a portion of the refund, or ask the court for permission to use it in specific ways. According to this, however, Chapter 13 Trustees wont be able to intercept your refund (insert much legal track-covering here, since I don't and you likely don't live in Michigan).

For those who haven't yet filed, my advice is fairly simple: Delay filing until you have received and spent the refund. How you spend the refund is somewhat limited, however. A couple of do's and dont's:

• Don't repay debts owed to family, or pay more than $600 to an unsecured creditor;
• Do use them on reasonable and necessary living expenses;
• Do track how you spend it, with receipts if possible;
• Don't "hide" it by shoving it into an IRA, another person's name, or a coffee can in the backyard; and
  
• Do consult with a licensed, experienced local bankruptcy attorney before spending the refund.

If you can't wait, then use this perspective: That refund is the payoff for all of your debts; that is a $2,000 tax refund pays off $35,000 in credit cards. Not such a bad deal, eh?

One more note - if you have a relatively steady income, you can plan your withholdings to approximately cover your expected tax liability. That way, you get the money each pay period, which I think most of us could use these days.