Chapter 7 and Chapter 13–Income Tax Lien Partly Secured by Equity in Your Home
Oct. 20, 2015
If you don’t have much equity in your home, so that a tax lien eats up all that equity and then some, how can you get rid of that tax lien?
Our last 2 blog posts discussed your options if the IRS or state records a tax lien against your home. We first got into what happens if your home has no equity so that the tax lien does not attach to anything of value. And second we looked at your options if your home has plenty of equity so that there is more than enough to cover the entire amount of the tax lien.
But what if you have some equity in the home but less than the amount of the tax lien? How do you minimize what you have to pay of that tax before getting that tax lien released from your home?
A Tax Lien on a Dischargeable Tax
As in the last couple of blog posts, assume that the tax debt in question meets the conditions for legal write-off in bankruptcy. Because those conditions mostly involve how old the tax is, and because it usually takes some time before a tax lien is recorded, tax liens are mostly put on taxes that would otherwise qualify for discharge.
Som how best to deal with a tax lien only partially secured by your home, where the underlying income tax could have been discharged but for the recording of the tax lien?
The Special Problems of a Partially Secured Tax Debt
As explained in our last few blog posts a recorded tax lien gives the IRS/state huge leverage against you. The IRS/state tries to exploit that leverage to get paid as much as possible even when the home equity that the lien attaches to is smaller than the tax owed.
An example shows how this works. Assume you have a home with not much equity—say, about $5,000. Let’s say the income tax owed is $20,000, and a tax lien has been recorded on that tax debt against the home. The IRS/state wants the $20,000 tax paid, and won’t want to release its tax lien without being paid in full. Or at least it will use the tax lien to make you pay as much of the $20,000 as fast as you can even though that lien is only secured by $5,000 in home equity.
So for instance, if you tried to sell or refinance the home the IRS/state could challenge and perhaps disrupt the sale or refinance on grounds that it is not getting paid enough money on its lien. It is not required to release its lien unless it is paid in full, even if there’s not enough value in the home to pay off that lien.
A Partially Secured Tax Debt in a Chapter 7 Case
A Chapter 7 “straight bankruptcy” works very well against a tax debt that meets the conditions for discharge. Within about 4 months after the Chapter 7 case is filed, the debt is discharged along with the rest of your debts, and you’re done, that tax debt is gone forever.
But once a tax lien is recorded, Chapter 7often does not help you much in overcoming the leverage of a tax lien. That’s true even if the underlying tax debt otherwise meets the conditions for being discharged. That’s because the tax lien against your home survives a Chapter 7 bankruptcy. As a result the IRS/state will use that tax lien as its leverage to make you pay as much of the tax as possible. It will likely drive a hard bargain, trying to get more than the value of the home equity that the lien attaches to.
In the above example, the tax authority would try to make you pay more than $5,000 to get a release of the lien on your home, even if that’s the amount of equity in your home. The IRS/state knows that the property’s value may well increase over time, potentially giving it more money then. So time is mostly on its side.
The IRS/state also recognizes that you probably have intangible reasons for getting a release of the tax lien —such as the desire to improve your credit record, or to sell or refinance the home, or the most common motivation—to turn off the tax collection pressure. All these drive you to be willing to pay a premium to get rid of the tax lien.
The problem is that Chapter 7 does NOT provide a procedure of determining the amount of the home equity that a tax lien attaches to when that equity is less than the amount of the tax owed. So the IRS/state can often exploit this to get more money from you after the Chapter 7 is finished in return for releasing the tax lien.
A Partially Secured Tax Debt in a Chapter 13 Case
In contrast, the Chapter 13 “adjustment of debts” DOES have a procedure for determining the amount of the home equity that a tax lien attaches to. Then that amount—for example the $5,000 in the above example—and no more, can be paid over time through the Chapter 13 payment plan. That is considered to be the secured portion of the tax debt. Being able to determine and pay that amount takes away much of the leverage of the IRS/state’s tax lien.
The rest of the tax beyond the secured portion is treated as a “general unsecured” debt—in our example the remaining $15,000. That amount only has to be paid to the extent that you have money left over after paying the secured $5,000 plus any other legally more important debts in full. Indeed usually you don’t have to pay any more into your Chapter 13 plan payments because of that $15,000 because most of the time you pay a set amount to all of your “general unsecured” debts. So adding the $15,000 unsecured portion tax debt to that pool of “general unsecured” debts just means that the rest of the pool will be paid less.
To finish the example, the secured portion—$5,000—would be paid over the length of the 3-to-5-year payment plan, under very flexible payment terms, and while under protection from the IRS/state. The remaining $15,000 would not have to be paid except to the extent that there would be money to spare for that. Then at the end of the Chapter 13 case the remaining unpaid portion of the tax would be discharged and the tax lien would be released.