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Bankruptcy by Example: How Chapter 13 Resolves an Income Tax Lien on Your Home-Part 2

Oct. 3, 2014

Last week we covered how Chapter 13 attacks a tax lien on a tax could be written off. Today, the effect of a lien on a tax that can’t be written off.

Income Tax Liens on Tax Debts that Can Be Discharged

Please look at our last blog post. It explains what happens with a tax lien on your home in situations where the tax related to that lien meets the conditions for “discharge”—legal write-off in bankruptcy.

The key takeaway was that the recording of a tax lien turns a tax that could have been completely discharged without paying a penny into one that may have to be paid in full, plus interest. Filing bankruptcy BEFORE the IRS or the Oregon Department of Revenue happens to record a tax lien can make all the difference. So it’s crucial to look into the bankruptcy options if you owe any substantial income tax debt. Doing so may save you a substantial amount of money.

The Huge Procedural Benefit of Chapter 13

We ran out of time and space last week to emphasize one very important practical help that Chapter 13 provides in situations where a tax lien HAS been recorded before filing bankruptcy. If the tax lien attaches to some equity in your home, determining the amount of equity is crucial because that largely determines how much you will have to pay on that tax.

Using the example we provided last week about a person named James, we showed that he had to pay $10,000 of a $15,000 tax debt that, but for the recorded tax lien, he could have discharged without paying anything. That $10,000 amount was based on how much equity was in his $300,000 house that the IRS and ODR tax liens attached to. The $15,000 tax owed was a partially secured debt, to the extent of that $10,000 of equity.

But if that home had been determined to be worth $10,000 less, there would have been no equity in the home for the tax liens to attach to. As a result the tax debt would no longer be secured at all. In a Chapter 13 case it would only be paid to the same extent that other “general unsecured” debts were being paid, which is often little or nothing.

So you can see that coming up with the right value of a home is critical in these situations. It determines how much you would have to pay on an otherwise dischargeable tax debt, often a difference of thousands or even tens of thousands of dollars.

Chapter 13 provides you two major advantages in this:

  • Through the formal payment plan that you and your attorney propose, you get to present how much equity you believe your home has, and therefore how much you will have to pay. That proposal stands and is part of the court-approved plan unless the IRS and/or ODR object. They don’t tend to object as long as the proposal is within the range of reasonableness. This opportunity to be the one putting the proposal on the table can, if done carefully, translate into a few thousand dollars in your favor.

  • If the IRS and/or the ODR do object to your proposed home value and thus the amount of equity secured by the tax lien, the bankruptcy court is a convenient, relatively inexpensive, friendly, and fair forum to get any such objections resolved quickly.

Income Tax Liens on Tax Debts that Can NOT Be Discharged

Recall that an income tax debt CAN be discharged—legally written off in bankruptcy—if it’s old enough and meets a few other conditions. If it doesn’t meet those conditions and cannot simply be discharged, it must be paid. But paying it within a Chapter 13 case can be much better than doing so on your own, for a bunch of reasons but in general because your payment terms can be much more flexible and you are protected from the IRS and ODR in the process.

As for the impact of a tax lien recorded on a tax that CAN’T be discharged, the possible bad impact of that tax lien is usually nowhere near as big as with debts that CAN be discharged. That’s because with debts that can’t be discharged you’re not faced with the possible difference between not having to pay the tax at all if there is no tax lien vs. having to pay it in full if there is a tax lien.

So what is the impact of a tax lien on a tax that can’t be discharged anyway? Just as with a dischargeable tax, a tax lien potentially turns an unsecured debt into either a fully secured or partially secured one. And the extent to which a tax is secured turns on whether there is any equity in your home that the tax lien can attach to, and how much equity there is. If there is no equity in your home available for the tax lien, then the tax at issue does not become a secured debt at all. If there is enough equity to cover the full amount of that tax, then it is fully secured. If there is only enough equity to cover a portion of the tax, then the tax is secured to that extent.

And what difference does a debt being secured make, when that debt can’t be discharged anyway? Two things: you will have to pay ongoing interest on the secured portion, and you may have to pay a penalty in full instead of in part or not at all.

Paying Ongoing Interest

In most Chapter 13 cases you do not have to pay ongoing interest—from the time your case is filed until its completion. That is one of the advantages within Chapter 13 of paying income taxes that cannot be discharged. But debts that are secured, including tax debts, are entitled to interest. So to the extent a tax is secured by equity in your home, you must pay interest on that tax. The practical result is that it will take that much more money to satisfy that tax debt within your Chapter 13 plan than if there was no tax lien, or no equity in your home for that lien to attach to.

Pay a Pre-Bankruptcy Penalty

Even with taxes that don’t qualify for discharge, the tax penalty that had accrued up to the date your case is filed is usually treated quite favorably. It is not a “priority” debt that must be paid in full but rather is a “general unsecured” one. So it only needs to be paid as much as you can afford, which is often little or even nothing.

However, a recorded tax lien covers both the tax itself and any related penalties. So if the lien attaches to equity in your house sufficient to cover both the tax and the penalty owing at the time your Chapter 13 case is filed, you will have to pay the penalty along with the tax in full.

Our Example

To make sense of this consider Janet, who owes $7,000 to the IRS and $2,000 to the ODR for 2011 income taxes, and $3,000 to the IRS and $1,000 to the ODR for 2012 taxes. In addition, she owes a total of $2,000 to the IRS and $1,000 to the ODR in penalties. All of those taxes and penalties, totaling $16,000, are too young to discharge.

Both the IRS and the ODR recently recorded tax liens on these two years of taxes, doing so in part because of Janet’s earlier tax debts, which she just succeeded in paying off. The tax liens were recorded in Multnomah County, thus they all attach to her home. She has $20,000 of equity in her home that the tax liens attached to. (That’s without taking the homestead exemption into account, because exemptions do not apply to and so provides no protection from tax liens.)

In Janet’s Chapter 13 case, had there been no tax liens, she would only have had to pay $13,000 to the IRS and ODR, representing the two years of taxes without the penalties. She would NOT have had to pay any ongoing interest during the four years that she paid off that $13,000 in her Chapter 13 plan. And because all her monthly “disposable income”—about $350, all that she had available in her budget—would be going to pay those taxes, she had a “0% plan,” meaning she did not have to pay her “general unsecured” debts anything. As a result, she would not have had to pay anything on the $3,000 in tax penalties.

But because of the tax liens having been recorded before Janet saw an attorney and filed her Chapter 13 case, she has to pay significantly more. The taxes, and penalties as well, are fully secured against the equity in her home. That’s because the amount of equity, $20,000, more than covers the amount of the taxes plus penalties, $16,000.

So in her Chapter 13 plan Janet must pay $16,000 (instead of $13,000), and has to pay interest on $15,000 of that amount. The IRS charges interest on both taxes AND penalties while the ODR only on the tax itself, not on penalties.

Although the interest rate is not terribly high—currently 3% to the IRS and 4% to the ODR—it add up. Roughly, about $1,200 of interest would accrue during Janet’s Chapter 13 case.

In having to pay the pre-bankruptcy penalties of $3,000 and the interest of about $1,200, Janet has to pay an extra $4,200. At $350 per month, Janet’s Chapter 13 case would take a year longer, 5 years instead of 4.

If Janet had filed his case before the IRS and ODR recorded their tax liens, she could have saved about $4,200 and finished her Chapter 13 , and become debt-free, a year earlier.