If you are thinking about filing bankruptcy, you may be wondering what happens with a tax refund. It depends on your situation. There are three basic factors that impact whether you will keep or lose your tax refund in a Chapter 7 bankruptcy: the applicable exemptions, the timing of the filing, and the administration of the estate.
Upon filing a Chapter 7 bankruptcy petition, the amount of a tax refund earned as of the petition date becomes property of the bankruptcy estate. For example, if you file Chapter 7 on July 1, 2020, and have not yet received and spent your 2019 tax refund, then your entire 2019 refund is property of the estate. This is because as of July 1, 2020, you would be entitled to the full 2019 refund upon filing your income tax return. Be prepared for a Chapter 7 bankruptcy trustee to require you to turn over the refund unless it is protected by an exemption. Additionally, half of your 2020 refund is property of the bankruptcy estate, representing the portion earned between the months of January and June.
If the Arizona exemptions apply to your case, a tax refund is not exempt. This makes the timing of the bankruptcy filing pivotal in terms of keeping a tax refund. For the purpose of avoiding the loss of a tax refund, the best strategy is to file your tax return for the previous year as early as possible in the new year, appropriately spend the refund, and then file Chapter 7 before you’ve earned much of the refund for the new year. For example, file the return the first week of February, spend the entire refund on living expenses by the end of February, and file the bankruptcy in March. That way, you receive the benefit of the previous year’s refund, and have minimized the amount of the refund earned for the year in which the bankruptcy is filed.
In a case where the Arizona exemptions do not apply, you may have the luxury of filing the Chapter 7 whenever you are ready to do so, and without having to worry about losing a tax refund. This is possible through something called a “wildcard exemption”. The set of federal exemptions, as well as some state exemptions, include a wildcard exemption that can be used to protect any asset up to a specified dollar limitation.
Even when there is no exemption to protect a refund, a bankruptcy trustee may allow you to keep it. The trustee decides whether there is enough value to make it worthwhile to administer the estate. If your tax refund is $500, and there are no other non-exempt assets, the trustee will likely decide against requiring you to turn over the refund because the distribution to unsecured creditors would be nominal.
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