Despite what you might have heard, A Chapter 7 bankruptcy can wipe out your income tax debts. Although some types of tax debt, such as property tax and employment tax, do survive a bankruptcy, income taxes are fair game. That’s not all. A Chapter 7 bankruptcy can also put a stop, albeit temporarily, to all creditors and bill collectors, including the IRS.
Unfortunately, Chapter 7 bankruptcies cannot remove existing tax liens. Bankruptcy only removes your personal obligation to pay the tax. Tax liens recorded before you filed for bankruptcy remain as long as there is equity in the pre-bankruptcy property. If you are starting to get a headache, hang in there. By the time you finish this article, you will understand the basics of tax liens and how you can use the bankruptcy code to fight the IRS.
Disclaimer: If you are considering filing for bankruptcy to resolve tax debt, you need a tax attorney. It is easy to make a serious mistake that could be construed as tax evasion or trigger a tax audit. Although bankruptcy can be an excellent tax relief tool, it will have devastating effects on your credit and reputation. A licensed tax professional can help you determine what is the best tax relief options for you.
What is a Federal tax lien?
A federal tax lien is a claim the IRS makes on all your current and future property. It is the first step toward a tax levy, which occurs when the IRS actually seizes your property. You can compare tax liens to when a bank lends you money and takes the title of your home as collateral. If you don’t pay your mortgage, the bank sells the property to cover the debt. In the case of the tax liens, your tax debt is the loan, the IRS is the lender, and all your worldly possessions become collateral.
What happens to tax liens in a Chapter 7 bankruptcy
Automatic Stay: Chapter 7 bankruptcies triggers an automatic stay that bars creditors, including the IRS, from trying to collect debts. This can provide you with valuable time to put your financial affairs in order and get straight with the IRS.
Stops Post-bankruptcy Tax Liens: A Chapter 7 bankruptcy can also bar the IRS from attaching new tax liens on pre-bankruptcy tax debts that have been discharged. This creates a clean slate or “fresh start” that limits the property the IRS can attach to a lien. The IRS may be able to levy property you owned before the bankruptcy, but the new property you acquire after the bankruptcy is in the clear. This is huge.
With the right timing, it is possible to use bankruptcy to block the IRS from filing a tax lien in the first place. Remember, though, that not all income taxes are discharged in bankruptcy. For instance, you cannot discharge income taxes linked to a tax return you filed less than three years ago.
Once the bankruptcy is over, the IRS can seize (levy) many of the assets you owned when you filed for bankruptcy. In most cases, this is not an issue because taxpayers don’t tend to have many assets lying around after a bankruptcy. Unless you owned real estate or retirement funds, the old tax lien won’t affect you all that much. Another point to remember is that bankruptcy law gives debtors exemptions when liquidating their assets in a Chapter 7 bankruptcy.
Exemptions vary by state. In California, for instance, debtors receive a:
- $100,000 homestead exemption on the equity of your principal residence
- $2,900 exemption on the equity of your vehicle
- $7,625 exemption on jewelry and works of art
- And a $1,283,025 exemption on IRAs and Roth IRAs.
Dischargeable vs nondischargeable taxes
When it comes to bankruptcy, not all taxes are created equal. As mentioned above, income taxes can be discharged (removed) in bankruptcy. However, other taxes, such as property tax and employment tax cannot be discharged.
So, what happens to tax liens on taxes that aren’t discharged in a Chapter 7 bankruptcy? In such cases, existing tax liens will include property owned before the bankruptcy and also property obtained after the bankruptcy. Ouch. The take-home lesson here is to pay your property and employment taxes first.
How to deal with tax liens after a Chapter 7 bankruptcy
This is where things get really tricky. Here are your main options:
- Pay the entire tax debt and apply for a tax lien release. This would make sense for taxpayers who come out of bankruptcy with assets that exceed the value of their tax liability.
- Negotiate an installment agreement or offer in compromise. A good option for people who want to keep certain assets attached to a lien but their value is not enough to pay the tax debt in full.
- Redeem specific items on the tax lien. Taxpayers can pay the IRS the value of a specific asset, such as a car or home, as assessed by the bankruptcy court. In exchange, the IRS removes it from the tax lien.
- File a Chapter 20. This is what passes for humor among tax attorneys and CPAs. Chapter 20 refers to when debtors file Chapter 7 and then file a Chapter 13 bankruptcy to pay over time the debts they weren’t able to discharge in the first bankruptcy.
- Wait it out. In other words, do nothing. This may be a smart move if your tax obligation was discharged and the value of the property attached to the tax lien is nominal. It also may be the right move when the statute of limitations on a tax debt (10 years) is nearly over. Remember that certain actions, such as filing for bankruptcy and negotiating an offer in compromise, extend the statute of limitations.
Talk to a tax attorney or CPA before making a decision. Filing for bankruptcy and removing a tax lien are two things you do not want to do by yourself. Click here to receive a free, no-strings-attached consultation with an experienced tax professional.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.