If you’re planning to file for bankruptcy, you’re likely short on cash and want to keep any refund you might be owed. Your ability to keep your tax refund in bankruptcy will depend on:
In this article, you’ll learn whether you can expect to retain your return or whether you’ll turn it over to the Chapter 7 bankruptcy trustee assigned to your case. More useful tips are available in Prebankruptcy Planning.
You’ll have to turn over tax returns to the bankruptcy trustee fairly early in your case. How many you provide will depend on the chapter you file:
If you’re owed a refund, you’ll have to be able to protect it with a bankruptcy exemption— the laws that set forth the property you can keep in bankruptcy (more below). If you can’t, what will happen to it will depend on the chapter type filed.
Every state (and the federal system) has a different set of bankruptcy exemptions debtors can use to protect their property. Your state decides the exemption amounts and the types of property you can protect and whether you can use the federal bankruptcy exemptions instead. Because exemptions vary significantly from state to state, you’ll want to review your state’s exemption laws carefully or talk to a knowledgeable bankruptcy attorney prior to filing your case.
Generally, most states don’t have an exemption that will allow you to protect a tax return or cash, and when one exists, it’s fairly minimal—a few hundred dollars or so.
However, many states have a wildcard exemption you can use to protect any property of your choosing. Not all do, though. If that’s the case, you would want to plan your filing to give you enough time to use your return for things you need, such as rent, food, and utilities. Otherwise, you risk losing your tax refund.
To learn more about how exemptions help you keep your property in bankruptcy, see Bankruptcy Exemptions.
If you can’t exempt your tax refund and you’re not in a hurry to file your case, the simplest option is to delay your bankruptcy until you receive your refund and spend it. This process is known as converting bankruptcy assets, and there is a right way to do it, and a wrong way.
You’re always allowed to use your assets to pay for necessary expenses, such as your mortgage payment or rent, needed clothing, and car repairs. Using a tax refund for such items is no different. As an extra precaution, it’s a good idea to keep careful records of your purchases in case you’re questioned by the bankruptcy trustee later.
If you don’t use the funds for necessary items, keep in mind that you’ll have to exempt that asset as well. But this can be risky if the return is large. Many courts frown on converting a nonexempt asset—the tax return—into an exempt asset. Finally, you never want to hide or conceal assets in bankruptcy. Getting your case dismissed or facing criminal charges isn’t worth the risk.
Find more information in What Happens to Tax Refunds in Bankruptcy?