Will I Lose My Tax Refund By Filing Chapter 7 Bankruptcy in Arizona?

This is a common question that comes up with increased frequency between October and April, when tax season is just around the corner. So what do I say when a client sits down and asks me “Will I lose my tax refund by filing chapter 7 bankruptcy in Arizona?” The short answer: You Betcha. But, as with any legal question, it is not that simple. So let me elaborate.

When you file for chapter 7 bankruptcy protection, a trustee will be assigned to liquidate the non-exempt portion of your estate and pay your creditors in partial fulfillment of your total debt. The remaining dischargeable debt is then discharged. Unfortunately, any tax refund owed to you at the time of filing is considered part of your estate.

Furthermore, Bankruptcy Code provides that under certain circumstances money received by the debtor within the six month period following discharge belongs to the bankruptcy estate and can be seized by the trustee. This means that in specific situations, for example when losses applied to previous filings result in an additional refund shortly after discharge, the trustee may attempt to seize that refund as part of the bankruptcy estate.

I should also note that you may, sometime down the line, receive a prorated portion of that refund returned to you. However, I’m of the opinion that money in pocket today is worth more than money 6 months down the road. Furthermore, with increased chapter 7 filings in Arizona resulting in backlogged trustees, I wouldn’t be surprised if this got lost in the shuffle.

So, what can you do to prevent losing your tax refund in a chapter 7 bankruptcy? The best option is likely to postpone filing bankruptcy until you have already received your current tax refund. You can then apply that money towards food, fuel and provisions for 6 months, which is exempt in Arizona.

I am the first to admit that hiring a bankruptcy attorney can be expensive, so this is another option. If you postpone bankruptcy until after you receive your tax return, you can then use that money to pay legal fees associated with preparing and filing your bankruptcy petition. This is a great option if you are struggling with attorney’s fees.

If you are facing an emergency situation, waiting to file may not be an option for you. In that case, the necessity of filing may just outweigh the possible loss of your tax refund. However if your refund is comparatively small, say less than $500.00, you may get lucky. Sometimes, a trustee won’t deem it worth their while to seize that small amount into the bankruptcy estate. This is solely up to the discretion of the trustee and is not something I would count on.

Some people employ techniques to decrease the amount owed to them on their tax returns. If you are expecting to receive a significant amount of money from the Earned Income Tax Credit, consider applying to receive that credit as part of their regular pay. Talk to your tax accountant about completing Form W-5, Earned Income Credit Advance Payment Certificate (available here or through your employer). Another option that individuals have employed is to withhold any applicable losses until the bankruptcy has been discharged, and then file an amended return. Whether or not these techniques are effective is variable, and of course I never advocate any sort of deception when filing bankruptcy as it puts your entire discharge in jeopardy.

In my opinion, the best option is to simply postpone bankruptcy filing until you have received all refunds owed to you at that time, and have applied that money towards exempt expenses.