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Why It’s Crucial to File Bankruptcy BEFORE an IRS Tax Lien or Oregon Distraint Warrant is Recorded

Jan. 17, 2014

Waiting too long to file bankruptcy can make the difference between having to pay an income tax debt in full and not paying anything.

It’s human nature to try to avoid what you think is going to be unpleasant. And what can be more unpleasant than dealing with income taxes?! That’s especially so when you are far behind on your taxes and see no hope of ever paying them off.

The Good News

Bankruptcy can permanently write off (“discharge”) some income taxes, generally ones that are older. And even if the tax you owe can’t be discharged, bankruptcy can be incredibly helpful in resolving your tax debt headaches. In countless tax debt situations, bankruptcy—either Chapter 7 “straight bankruptcy” or Chapter 13 “adjustment of debts”—is your best option.

Don’t Turn the Good News into Bad

But you have the power to either hugely help or hurt how well bankruptcy can solve your tax problem. That’s because timing is critical. As stated above, if you wait until the IRS has recorded a tax lien or the Oregon Department of Revenue has recorded a distraint warrant, the tax debt at issue could instantly transform from one that could be completely discharged into one that can’t be discharged at all, or only in part.

Today’s blog post explains how this works in a Chapter 7 “straight bankruptcy” case; the next blog post will show how it works in a Chapter 13 “adjustment of debts.”

The Crucial Difference between “Unsecured” and “Secured” Debts

Income tax debts usually have no collateral attached to them. They are “unsecured.” This means that if the debt can be discharged in bankruptcy, the IRS or Department of Revenue would not have any right to any of your possessions as collateral on the tax debt.

But once the IRS or state record a tax lien or distraint warrant in the county in which you own real estate, doing so creates a lien on that real estate. It turns your real estate into collateral on the tax debt for which the tax lien or distraint warrant was recorded. Similarly, once a tax lien or distraint warrant is recorded with the Oregon Secretary of State, doing so creates a lien on all your personal possessions in the state. It turns all your personal possessions into collateral on that tax debt. The previously “unsecured” tax debt turns into one “secured” by whatever you own.

Bankruptcy can discharge debts, including most older income tax debts, but it does NOT wipe out a creditor’s legal right to collateral. To cite a more conventional example, you can discharge the debt you owe on your vehicle loan, but that doesn’t mean you can keep the vehicle without paying for it because the lender has a right to your title. In the same way you can discharge your debt on a home mortgage, but that doesn’t give you your home free and clear of the mortgage, because the mortgage is a lien on the home’s title.

The Difference that a Tax Lien/Distraint Warrant Makes

In the income tax situation, before a tax lien or distraint warrant is recorded, the IRS or state has no right to any collateral. If the tax meets the conditions for being discharged in bankruptcy, it will be discharged without any risk to your home or other property.

However, after the recording of a tax lien or distraint warrant, even if the tax meets the conditions for being discharged the IRS or state will continue to have a lien on your house and/or other possessions after your bankruptcy is finished. Assuming that you have a home with some equity or other possessions that are worth something, those liens will continue to attach to that home and/or possessions. So you will have to pay the tax, or at least a portion of it, to avoid the IRS or state foreclosing its lien on your house or levying on your possessions to satisfy the lien.

Again, the difference could be a tax debt that you do not have to pay at all vs. one that you have to pay in full or in part, just because you did not file bankruptcy until after the recording of the tax lien or distraint warrant.

Tax Debts That Can Be Discharged

An income tax debt qualifies for being discharged in Chapter 7—again, meaning written off without ever having to pay it—if it meets a series of conditions. But in most cases these conditions can be boiled down to the following two:

  1. the tax return for the income tax at issue must have been due more than 3 years before the Chapter 7 case is filed, including any extra time for extensions;

  2. the tax return must have been actually sent in to the IRS or Department of Revenue more than 2 years before the Chapter 7 case is filed.

If an income tax debt you owe meets these conditions, the entire debt would very likely be discharged in its entirety if you filed a Chapter 7 case.

For example, if you owed $5,000 to the IRS and $2,500 to the Oregon Department of Revenue from the 2009 tax year, you would not owe any of that $7,500 at the completion of your bankruptcy case. The fact that you owned a $3,000 vehicle or had $40,000 of equity in your home—both of which would be protected from the creditors in your Chapter 7 case by the applicable Oregon property exemptions—would not affect your ability to completely write off those tax debts.

Practical Effect of Tax Lien/Distraint Warrant

But using that same example, if you didn’t file the Chapter 7 case until after the IRS had recorded a tax lien and the Oregon Department of Revenue had recorded a distraint warrant on the 2009 tax debts, the result would be completely different. The resulting liens on your home and on your possessions, including your vehicle, would survive your filing of bankruptcy. The property exemptions that protected you in a Chapter 7 case from the rest of your creditors would not protect you from federal and state tax liens. Both tax entities could force the sale of your home and vehicle to pay off the liens. They would use that as leverage to make you pay the amount of the liens. Sooner or later you would be required to pay the $7,500.

The Obvious Lesson

If you owe any significant amount of income tax debts, see a competent bankruptcy attorney as soon as possible. You need a game plan that will give you all the advantages that the law provides. And that prevents you from making a simple mistake that can cost you many thousands of dollars.