In Chapter 7 bankruptcy, any accrued tax refunds on income you earned prior to filing your case are considered property of your bankruptcy estate whether or not you have filed a tax return. This means that unless you can exempt your tax refund, a Chapter 7 bankruptcy trustee may be able to seize it for the benefit of your creditors.
In general, whether you can keep your tax refund in Chapter 7 bankruptcy depends on:
- the amount of your anticipated refund
- the timing of your bankruptcy, and
- whether you can exempt your refund.
To learn more about how different assets are treated in Chapter 7 bankruptcy, see our topic area on Your Property in Chapter 7 Bankruptcy.
What Happens to Tax Refunds in Chapter 7 Bankruptcy?
Tax refunds you are entitled to receive are considered property in bankruptcy just like money in your bank account. You must disclose any anticipated tax refunds as an asset on your bankruptcy schedules. This means that if you want to keep your refund, you must be able to exempt it.
In general, bankruptcy trustees are most interested in tax refunds during tax season when debtors are preparing their tax returns and receiving their refunds. But any tax refunds owed to you on income you earned prior to filing your case are technically part of your bankruptcy estate.
Is My Tax Refund Exempt?
If you can exempt your tax refund in Chapter 7 bankruptcy, you can keep it. But in most states, there is no specific exemption designed to protect tax refunds. This means that you will typically have to rely on a wildcard exemption (if your state has one or allows you to use the federal bankruptcy exemptions) to protect your expected refund.
Bankruptcy exemptions differ greatly from state to state. As a result, review the exemption laws of your state carefully or talk to a knowledgeable bankruptcy attorney to learn whether you will be able to protect your entire tax refund. If you can’t exempt your tax refund, it may be in your best interest to delay your case until you receive your refund and spend it before filing your case (discussed below).
For more information on both federal and state exemption systems, see our Bankruptcy Exemptions topic area.
Delay Your Bankruptcy If You Can’t Exempt Your Refund
If you can’t exempt your tax refund, consider delaying your case until you receive your refund and spend it. Once you receive your refund, you can use it to pay for necessary expenses prior to filing your case. In general, you can spend your refund on necessary living expenses such as rent, food, clothing, utilities, gas, car repairs, and medical expenses.
However, don’t use your refund to purchase luxury goods (which may not be exempt and can lead to bad faith arguments from the trustee) or pay off debts from family members or other preferred creditors prior to filing your case. If you pay off preferred creditors with your refund, the trustee may be able to get the money back to distribute it among all of your creditors. This is commonly referred to as a bankruptcy clawback. (To learn more about when the trustee can claw back payments to creditors, see The Clawback Provision and Preferential Transfers.)