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Can I Keep My Income Tax Refund If I File a Chapter 13 Case?

A Chapter 13 case gives you greater flexibility about what you can do with your current income tax refund than a straight Chapter 7 one does.

As we said in our last blog, if you file a Chapter 7 bankruptcy after the beginning of the year when you’re due a tax refund, and before you receive and appropriately spend it, your trustee is going to be very interested in that refund. It’s your money that the government is simply holding for you until you claim it. That’s true even if you haven’t yet filed your tax return, and don’t know even know the amount of the refund. Whatever the amount, it’s still your money—you just haven’t yet claimed it or calculated the amount by filing the tax return. So unless that refund fits within an exemption, or is small enough to not be worth the trustee’s bother, the trustee is going to get that refund.

Chapter 13 Is Usually Not So Rigid

In a Chapter 7 case, assets that are not exempt—including the non-exempt portion of any tax refund—simply go to the trustee to be distributed to creditors (after the trustee is paid a fee out of it) according to a very rigid formula. In Chapter 13 in contrast, you may be able to use that refund in two very beneficial ways.

First, you may be able to get permission to use the refund, or a part of it, for a necessary, one-time expense. A common example is to pay for a vehicle repair so that you can commute to work. The proposed expense usually needs to be an extraordinary one, a necessity over and beyond your standard monthly budget. And it helps if the expense is mission-critical—you can’t pay your Chapter 13 plan payments without a job and a vehicle that will get you there reliably.

Second, if you are required to pay all or part of the refund to the trustee, in a Chapter 13 case you usually have greater control over where that money will go. We may be able to specifically designate, through some direct language in your Chapter 13 plan, where some or all of that refund would go. Or in other situations, we may well be able to nudge that money in a particular direction that may be more favorable to you, within the latitude provided by Chapter 13 law. For example, a vehicle that you need to keep could be paid off faster than otherwise. Or a child support obligation may be caught up more quickly, perhaps buying peace with your ex-spouse sooner.

But there is a potential downside to Chapter 13 when it comes to tax refunds—future refunds. While Chapter 7 fixates on what assets you have in your possession or have a right to as of the moment your case is filed, Chapter 13 by its very nature is also interested in your future income during the three to five years that you are expecting to be in the case. And for most purposes future tax refunds are considered future income. So, most of the time that means that you must turn over your tax refunds to the trustee while you are the case, to be paid out according to the terms of your plan.

But that may not be a bad thing:

  • If you usually get large tax refunds, your withholdings very likely need to be adjusted so that you can put that money to use during the year for your regular living expenses. This can be especially helpful if your budget is tight. This would reduce the size of the refunds going to the trustee, minimizing this problem. However, if you’ve relied on this method of “forced savings” to pay for certain larger expenses, changing this will take some adjustment.

  • Sometimes a year or two into a Chapter 13 case you may need to get permission to use that year’s tax refund for a new special expense, such as, again, for a necessary vehicle repair that costs more than your budget provides.

  • Even if your refunds simply go to the trustee during the course of your case, sometimes that extra money flowing in is very helpful, or even crucial. Depending on your circumstances, this extra money may:

    • finish your case faster;

    • pay important creditors more quickly, foiling their efforts to repossess your vehicle or other collateral; or

    • prevent your case being thrown out by enabling you to pay it off within the mandatory maximum 5-year period.

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