If you owe a bunch of income taxes, and have a tax lien on your home, it’s tempting to try to fix everything by selling your home.
This series of blog posts is about how to make better decisions about selling your home when under pressure from your creditors. Some of the biggest pressure can come from the IRS and the state taxing authorities. There are some persistent misconceptions are about how bankruptcy can and can’t help with income taxes and income tax liens.
If You Have Income Tax Debt
If you owe back income taxes, especially if you owe for a number of tax years or owe a large amount, or both, you may feel like you’re in a vicious cycle. You keep hoping that you’ll get on top of the problem but it seems to get worse. Maybe you’ve put off filing tax returns, hoping to fly under the radar of the IRS and state. Or you’ve entered into a monthly payment plan for a prior year or two of taxes but know you’ll owe more with your next tax return and that will break your payment plan. You may have already had a tax lien recorded against your home or are afraid that will happen any day. And the interest and tax penalties keep on piling on.
Misconceptions about Income Taxes and Bankruptcy and Your Home
The law about income taxes is notoriously complicated. What bankruptcy can do about tax debts can be confusing and so people have many misassumptions. Add in issues about tax liens on real estate and understandably it’s difficult to know which end is up.
The “Discharge” (Legal Write-off) of Income Taxes
Bankruptcy can discharge tax debts just like most other debts, as long as the tax fits certain conditions. Those conditions mostly involve how old the tax is and whether and when you’ve filed the tax return for the tax.
Basically, if the tax return for the tax was due more than 3 years ago and you filed the tax return more than 2 years ago you can discharge the tax by filing a bankruptcy case. That could be either a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts.
In a Chapter 7 case the tax would usually just be discharged within a matter of 3 or 4 months without paying anything at all on that tax debt (just like a medical bill or credit card debt).
In a Chapter 13 case you may have to pay a portion of the tax debt over the course of your 3 to 5 year payment plan, but often it’s only a small portion or sometimes nothing. Chapter 13 can also give you great advantages with more recent taxes that can’t be discharged, with tax liens, and with your home mortgage and other home-related debts.
Dealing with Tax Debts that Can’t Be Discharged
If you owe income taxes that don’t meet the 2 year/3 year condition stated above so that they can’t be discharged in bankruptcy, both Chapter 7 and Chapter 13 may still be able to help a lot.
Chapter 7 can discharge all or most of your other debts so that you may be able to afford to enter into a reasonable payment plan with the IRS/state for the payoff of the income taxes. That may be particularly true if some of the taxes you owe ARE old enough to discharge and some are not, so that you only need to arrange to pay for those taxes that survive bankruptcy. Your attorney can often help you determine a game plan to maximize how much taxes you can discharge and minimize how much you have to pay.
Same thing under Chapter 13. But with Chapter 13 you also have the benefit of usually not needing to pay any further ongoing interest and penalties on any taxes that can’t be discharged during the 3 to 5 years of your payment plan. In addition you have great flexibility about when and how fast you pay off those taxes, with your budget dictating the terms instead of the IRS/state doing so. You can often pay other even more important debts—such as back child support, your home mortgage arrearage, and even vehicle loan payment—ahead of the taxes.
The Danger of Tax Liens
When the IRS or state record a tax lien against your home, it’s both a serious bad mark on your credit standing and very dangerous for your home. That tax lien hurts your ability to sell or finance your home. The IRS/state could foreclose on the tax lien to force payment in full. And if a tax lien has not been recorded against your home yet, there’s a degree of arbitrariness about whether and when that would happens so understandably you’re always on edge afraid of that happening.
The Benefit of Bankruptcy with Tax Liens
If you do owe taxes and own a home but no tax lien has been recorded, and you file a Chapter 7 case and discharge that tax debt, you will never owe that tax again and no tax lien can ever be recorded against it. If you file a Chapter 7 case and a tax is not discharged but you enter into a payment plan for that tax often no lien will be recorded as long as you stick by the terms of the payment plan and the tax owed is below a certain amount.
If you file a Chapter 13 case and comply with the payment plan that you and your attorney put together, the IRS/state cannot record a tax lien throughout the 3 to 5 year case. You don’t have to worry about your home being exposed to those dangers. So if you owe income taxes and have not yet had a tax lien recorded, that’s a huge benefit to Chapter 13. That’s also still true if you’ve had a tax lien recorded as to SOME of your tax debts but NOT as to some other (usually more recent) tax debts.
Where Chapter 13 really shines is with tax liens that have already been recorded. Usually the taxes owed that are secured through a tax lien on your home have to be paid in full before the lien will be released off your home’s title. That’s true almost no matter how old the tax is.
But under Chapter 13 if the tax is old enough to that it can be discharged, and there is no equity in your home to cover the tax lien, then the bankruptcy court can in effect declare that the tax be treated as if there is no tax lien. The tax debt would be throw in with the rest of your general unsecured debts, with all of them paid no more than what your budget allows, which is often not much given what other debts do have to be paid (such as more recent income taxes and/or mortgage arrears). Then at the end of the case the part of that income tax debt that was not paid would be discharged (along with all your other general unsecured debts) and the tax lien would be released from your home.
If the tax is old enough to be discharged but there is some equity in your home to cover only SOME of the tax amount, under Chapter 13 ONLY that portion would have to be paid—the IRS/state would not be able to pressure you to pay the full tax as would happen outside of bankruptcy.
And if the tax with the tax lien against it is not old enough to be discharged in bankruptcy, under Chapter 13 you would pay that tax in full—and even with interest if there is equity in your home at least as much as the amount of the tax. You would not pay any interest (or penalties) if there was no equity covering the amount of the tax. But what’s crucial here is that throughout the payment process the IRS/state would not be able to enforce that tax lien. They could not pressure you to pay the tax faster by threatening to foreclose on your home.
Selling Your Home
It may or may not be in your best interest to sell your home when you owe income taxes. If the tax debt is your primary motivation to sell, there’s a good chance you either don’t need to sell or you could sell months or years later when that sale would better fit into your personal or family circumstances.
It may be wiser to sell after you’ve discharged most of your debts through a Chapter 7 case, including some or perhaps all of your income taxes. That could prevent a tax lien from being recorded against your home, resulting in more money for you out of the proceeds of sale.
It may be wiser to sell after filing a Chapter 13 case, again preventing a tax lien from being recorded, or after getting previously recorded tax lien released from your home’s title.
It is surely wiser to understand all the many ways that either type of bankruptcy can help you and your home before rushing to sell your home to pay tax debts that you either don’t have to pay or can deal with in a much better way.