A Fresh Start for Your Home Equity Encumbered by a Tax Lien
Feb. 10, 2016
A tax lien encumbering the equity in your home is dangerous. Chapter 13 takes away the danger.
If the IRS or your state tax collector records an income tax lien against your home, and you want to keep the home, sometimes through bankruptcy you don’t have to pay the tax. If there’s no equity at all in the home to cover the tax lien, and if the tax meets the conditions for being “discharged” –written off, mostly by being old enough—you may not have to pay most of that tax. You might even not have to pay any of it. And that’s in spite of the recorded tax lien, which would be removed from your home’s title. See our last blog post about how this can happen.
But it’s a different story if there’s equity in your home to cover the tax lien.
You Have to Pay the Tax
If your home is worth enough so that it has equity to cover the entire amount of the tax lien, you’re going to have to pay the tax. Even in bankruptcy. That’s as long as you want to keep the home.
That’s true even if that tax would otherwise qualify for being legally discharged—completely written off.
That’s right. If the tax return for the tax you owe was due to be filed with the IRS/state more than 3 years ago, and was actually filed more than 2 years ago, you would likely not have to pay that tax debt at all in a Chapter 7 “straight bankruptcy.” And under Chapter 13 “adjustment of debts” you would likely not have to pay most of it, and maybe none at all.
But the moment a tax lien is recorded on a home with equity to cover that lien, it’s a completely different story. The tax has to be paid in full.
This clearly means that whenever possible you should look into filing bankruptcy BEFORE a tax lien is recorded.
The Homestead Exemption Doesn’t Count with Tax Liens
When we say that you have to pay a tax debt that you could otherwise discharge if your home has equity to cover the tax lien, let’s be clear what that means.
When determining whether the home has equity of the tax lien, the homestead exemption is irrelevant. With certain kinds of liens—particularly judgment liens—the homestead exemption is effectively stronger than the lien. But not with income tax liens. You don’t get to factor in the homestead exemption.
Let’s make this clearer with a simple example. If you owned a home worth $200,000 with a mortgage of $170,000 and a recorded tax lien of $20,000, the home would have equity of $30,000 ($200,000 minus $170,000) for the tax lien to attach to. Assume that in your state you would be entitled to a homestead exemption of $40,000. If you didn’t have the tax lien, all that $30,000 in home equity would be protected in bankruptcy by the homestead exemption. And if the income tax debt met the time-based conditions for being written off, you would likely not have to pay any of it.
But once the tax lien is recorded, it attaches to the equity in your home. As long as you want to keep the home you have to pay the tax in order to get rid of the tax lien.
Chapter 7’s Limited Help
“Straight bankruptcy” can help by discharging (again, permanently writing off) all or most of your other debts so that you can focus on paying the income tax debt with the lien on your home.
If you also owe another income tax debt that has no recorded lien and also qualifies for discharge, you could reduce your tax load by discharging that other tax debt through Chapter 7.
Then after the Chapter 7 case is over and you concentrate on paying the tax with the recorded lien, you may be able to get the IRS/state to agree to take no further action on a tax lien if you enter into and comply with a monthly payment plan.
So your Chapter 7 case could leave you in a decent place, taking care of the tax debt and lien in a feasible way.
Often Chapter 7 Doesn’t Help Enough
Unfortunately the scenario we just describe often simply doesn’t work.
That’s because even after discharging your debts through Chapter 7, you may not qualify for or be able to afford to pay what the IRS/state requires in a monthly installment tax payoff plan.
First, you may have other crucial debts to pay that Chapter 7 does not discharge. These debts—such as unpaid child or spousal support, or student loans—would still need to be paid, making it hard to pay off the income tax secured by the tax lien.
Second, you may be behind on other obligations on your home–property taxes, the mortgage(s), or a homeowner’s association assessment—that need to be caught up.
Third, you may need to use the legal tools that only Chapter 13 provides. For example, you may need to save money on your vehicle loan through a “cramdown,” reducing both the monthly payments and your total vehicle debt. Or you may need to discharge non-support obligations to your ex-spouse, or to keep student loan payments on hold for a few years.
How Chapter 13 Can Be Much Better
Besides giving you some tools that Chapter 7 can’t provide, Chapter 13 deals with and protects you from the tax lien itself in the following ways:
1. It stops the IRS/state from enforcing the tax lien through foreclosure of the lien. It also stops all collection of all the income tax debts. In contrast, when you enter into a payment plan with the IRS/state after a Chapter 7 is over, you have no further bankruptcy protection. In Chapter 13 that protection continues throughout the 3-to-5-year payment plan.
2. Your payments on the underlying tax can be delayed or reduced while you pay other even more time-pressing debts, such as support arrearage or home mortgage or vehicle arrearage. The IRS/state doesn’t have grounds for objection as long as the tax secured by the tax lien gets paid off before your case is finished.
3. If your financial circumstances change during the 3-to-5-year Chapter 13 court-approved payment plan, you can usually adjust your plan payments, along with the payments being paid to the IRS/state on the income tax debt. Instead of being at the mercy of the IRS/state after the completion of a Chapter 7 case, you would likely have more flexibility and protection within Chapter 13.
So, if you have a recorded income tax lien on a home you very much want to keep, and your home has equity to cover that tax lien, look into whether getting rid of your other debts through Chapter 7 would free up enough of your cash flow to be able to enter into a reasonable monthly payment plan with the IRS/state.
If not, and/or if you need the other benefits that Chapter 13 provides, that is often the best way to go.