Keep Your Tax Refund in Chapter 7 Bankruptcy

Many clients tell me they have “overpay” their taxes by using a higher withholding amount throughout the year because they like the idea of getting a larger refund at tax time to help pay household bills, get caught up on bills or utilities, or catch up on their rent or mortgage.  However, tax refunds are assets which are considered part of the bankruptcy estate just like your other property and if not properly protected using exemptions, can be taken by the trustee.  However, with a bit of pre-bankruptcy planning you may be able to keep most, if not all of your tax refund.  Here are some strategies to keep in mind.

Use Your “Wildcard” Exemption

Massachusetts does not provide an exemption specifically for tax refunds, however it has a fairly generous “wildcard” exemption.  In bankruptcy, certain kinds of property, up to a specific value is exempted automatically.  So, what is the “wildcard” exemption?  Well, it allows debtors to exempt property  – any type of property – over what the rest of Massachusetts bankruptcy laws allow for. The “wildcard” allowance can be as high as $6,000.  This means that if you have $6,000 remaining of your wildcard exemption & you anticipate a tax refund of $4,000, you can use $4,000 of wildcard exemption and keep your tax refund and apply the remaining $2,000 towards some other personal property you wish to keep. But remember, in order to use the wildcard exemption, you must first disclose that you are expecting a tax refund.

Delay Filing Chapter 7 Bankruptcy

The Chapter 7 bankruptcy trustee can only take that nonexempt property which you are entitled to as of the day you file. If you have already received and spent your tax refund, it is no longer an asset that needs to be disclosed in your bankruptcy.  Remember, however, that if you decide to delay your bankruptcy filing so that you can spend your tax refund you should be able to show that you spent it on necessities such as food, rent, living expenses or attorneys fees to file bankruptcy.  Don’t use it to pay off a credit card or other unsecured debt which you will be able to deal with in bankruptcy. Finally, if you use your refund to buy other personal property which is not a necessity, you will have to disclose them in bankruptcy and risk losing them.

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The Dangers of Debt Settlement

One of my favorite questions potential clients ask when they first meet me is “what about debt settlement companies?”  I immediately cringe because people want to believe those slick TV and radio ads and let’s face it, no one really wants to file bankruptcy.  However, I have yet to find a settlement company who actually has helped make a client’s financial life better, not worse.

Catchy Ads

We have all seen those ads on TV late at night.  Those ads are strategically placed to hit the audience when you are up worrying about how you are going to pay your bills, keep a roof over your head, and feed your kids.  The ads claim to be a better alternative to bankruptcy by saying: “get out of debt in less than 6 months!” or “Reduce your debt by up to 50%”.

How Debt Settlement Works

Debt settlement companies promise to reduce your debt by negotiating with your creditors to lower your interest rate or get your creditors to forgive a portion of your debt.  The the settlement company will consolidate your debt into a newer, lower monthly payment.  You then stop paying your individual creditors and the settlement company will pay them for you.  This sounds like a fine idea – everyone gets paid and you move on with your life.  Unfortunately, they rarely fully explain to you what will happen to your credit score or how they calculate your monthly payment.

Effect on Credit and Taxes

One of the biggest problems with debt settlement companies is that they encourage customers to default on their debts.  Often, creditors will not negotiate with anyone, whether it is the client or a debt-settlement program until the client is delinquent on their payments for approximately three months.  Meanwhile, late payments have already been reported to the credit bureaus, your credit score drops and you start receiving harassing collections calls.  These late payments will remain on your credit reports for seven years, the same amount of time that a bankruptcy will be on your credit report.  What the debt-settlement program doesn’t tell you is that they cannot guarantee they can get your creditors to work with you and even if they do, the delinquent information is not erased from your credit.  In fact, often the creditor reports the debt to the credit bureau as having been “charged off”.

The debt-settlement programs also almost never tell you the truth about taxes.  Frequently, if a creditor agrees to reduce or settle debts, they will issue you a 1099 tax form.  The Internal Revenue Service (IRS) treats forgiven debts as income, which means that the IRS expects you to pay taxes on the forgiven debt.

The Cold Hard Truth

Promises to nuke your debt is often a pipe dream.  In fact, only about one in 10 consumers participating in debt-settlement programs actually ends up debt-free in the promised period of time, according to a consumer alert issued recently by the nonprofit National Association of Consumer Bankruptcy Attorneys.  Debt-settlement companies prey on vulnerable consumers who usually end up getting sued, stuck with outrageous fees, more deeply in debt, and far worse off in terms of their credit score.  The sad truth is that the fees associated with these debt-settlement programs can be as suffocating as the interest you are already paying to your creditor.

My advice:  Beware of promises that seem to be too go to be true, try to negotiate with your creditors yourself and, if you’re still thinking about debt settlement, go to www.ftc.gov and search for “Debt Relief Services.” Read the advisory by the consumer bankruptcy association at www.nacba.org and read the fine print.