For many people filing their federal income tax return is followed by the anticipation of receiving a refund check from the government. This annual refund becomes part of an individual’s yearly budget. When filing a bankruptcy the question arises of what becomes of that expected yearly bonus.
The first thing to understand is, when you file a bankruptcy, your federal tax refund is part of the bankruptcy estate. The bankruptcy estate is simply a person’s legal property that is available to pay his or her creditors. This property must be turned over to the trustee administering the bankruptcy case. The trustee will then sell any property to provide funds to pay your creditors. Tax refunds can be used by the trustee to help satisfy any existing debt.
Potential debtors want to know how they can hold onto, and maximize, their tax refunds. This question needs to be addressed prior to filing a bankruptcy. Timing is important. When filing a bankruptcy you will be required to provide copies of your most recent federal tax returns. These returns will show the amount of money you have received, or are entitled to receive, as a refund.
How can You Use Your Tax Refund?
If you have received your refund before filing for bankruptcy you can spend those funds. It is important to keep a record of how you spent the money should the trustee question how the refund was disbursed. The money should only be used for necessities such as mortgage payments, car payments or maintenance, medical expenses, groceries, utility bills or home repairs. Using the money to pay for vacations, luxury items or to pay back friends or families members who have loaned you money may result in the trustee objecting to those payments and requiring those funds to be turnover to the trustee. It does not matter that you already paid the money. It is important to discuss any use of the refund with your bankruptcy attorney.
What Exemptions are Available in California?
If you are waiting on a refund at the time of filing your bankruptcy the trustee is entitled to that refund unless you are able to protect it. The bankruptcy code, as well as state law, provides ways to protect some, or all, of your property. These protections are called exemptions.
There are exemptions on both the Federal level and through State laws. Many states allow you to pick either the Federal or State exemptions depending on which set benefits you the most. California is not one of those states and an individual filing bankruptcy must use the California State exemptions.
703 and 704 Exemptions
California law provides two systems of exemptions in a bankruptcy case known as either 703 or 704 exemptions. While the full scope of each system of exemptions is too complex a topic to cover within this article a number of key points must be explained in order to understand to what extent, if any, you can protect your tax refund.
The two exemptions to consider are the Homestead exemption and the Wildcard exemption. The important factor in determining which exemption system is best for you is the amount of equity in your primary residence, or in simpler terms, how much is your home worth once the balance of your mortgage and any liens are paid off.
If you have a considerable amount of equity in your home then the 704 exemptions are more beneficial. Under the 704 Homestead exemption you can protect the equity in your principal residence from $75,000 to $175,000 depending on your particular circumstances.
The 703 exemptions provide protections in a different manner. Under the 703 Homestead exemption you can protect up to $29,275 for real property used as your principal residence or an interest in a burial plot. This amount is substantially less than the 704 exemption and should only be used if there is little to no equity in your principal residence.
The 703 Homestead exemptions also provide a Wildcard exemption of $1,550 that may be used to protect any property in which the debtor has and interest. This includes any tax refund. Additionally, any unused portion of the Homestead exemption that is not utilized for either the principal residence or for an interest in a burial plot may be added to the Wildcard exemption potentially allowing for $30,825 (as of April 2019) in exemptions that may be applied towards any property the debtor wants to protect.
So the 704 exemptions provide a significant protection for your home they provide no protection whatsoever for a tax refund of any proportion. The 703 exemptions provide significantly less protection for your home but can provide substantial protection for a large tax refund. If you have a considerable amount of equity in your home you will not be able to protect your tax refund.
The above covers your tax refund at the time of filing a bankruptcy but a chapter 13 bankruptcy can last up to five years. What about the tax refunds over the next few years? Those refunds are part of the bankruptcy estate and are available to the trustee to pay creditors. Depending on the potential size of the refund the trustee may require copies of your tax returns and for you to turnover any refunds that you may receive.
The easiest solution is to adjust your W-2 withholdings so you receive a very small or no refund keeping more money in you weekly paycheck. Most retirement accounts are exempt from the bankruptcy estate so, if possible, you can increase your contribution to those accounts. Again, it is important to speak with your bankruptcy attorney to determine which accounts are applicable.
An Experienced Bankruptcy Attorney can Help You Understand Your Options
It is important to remember that if you file a bankruptcy your tax refund may have to be turned over to the trustee. However, with careful planning with your bankruptcy attorney, there are ways to mitigate that risk as well as make informed decisions in the planning stages prior to filing a bankruptcy. Contact the Bankruptcy Group for a Free consultation.