We are continuing our discussion of tax refunds and Chapter 7 bankruptcy. As we said in our last post, a debtor in Chapter 7 bankruptcy liquidates all assets that do not qualify for state or federal exemptions, and those assets become part of the debtor's bankruptcy estate. The trustee then pays creditors from that estate.
With Chapter 7, the filing date is the bright line for figuring out what happens to a tax refund. If a refund is for activity that occurred before the filing date, it is part of the bankruptcy estate -- even if it is received after the filing date. If the refund is for activity after that date, it is not part of the estate.
Naturally, there are exceptions to the general rule. There are times when a debtor has spent the refund before the filing date. Does that take it out of the estate?
As much as we hate to say it -- because it seems to be our stock answer for so many questions -- it depends. It depends on what you buy.
If you spend the money on a Caribbean cruise or indulge in some luxury retail therapy along Chicago's Magnificent Mile, that refund may, indeed, be part of the bankruptcy estate. Likewise, paying back a personal loan from a friend or relative or making a payment to one credit card could be a sign of bad faith to the trustee: You favored one creditor over others.
A finding of bad faith would put your discharge in jeopardy. Remember, the trustee has the power to deny the discharge, putting you back on the hook for all of those debts. The trustee also has the power to demand that the creditor return the money to the estate.
If, however, you spend the money on necessities -- clothing, shelter, food, medical care, car payments, education or utilities -- the refund is not part of the estate. Remember, bankruptcy is your chance at a fresh start, not a return to old, bad spending habits or permission to buy whatever you could not afford before.
As you can see, timing is important when you're filing for bankruptcy. An experienced bankruptcy attorney can help you determine how to avoid surprises and how to maximize the benefits of a Chapter 7 (or Chapter 13) filing.
Sources: Nolo.com, "A Tax Refund Is Part of Your Bankruptcy Estate," accessed April 3, 2015