When you file for Chapter 7 bankruptcy, all of your non-exempt assets transfer to the court-appointed trustee overseeing your case. These can include checking and savings accounts, investments, vehicles, privately-owned capital goods and real property. Most states provide for “exemptions” of durable goods, property and personal funds up to a certain dollar value. You have considerable discretion over the assets on which you may choose to claim an exemption.
Your bankruptcy judge will treat your incoming tax refund as regular cash income. As such, you may claim it as a property exemption. If its value is less than your state’s maximum exemption amount, you’ll be able to shield the full amount of your refund from your creditors. If its value exceeds your state’s maximum exemption amount, you’ll necessarily lose a portion of it to your creditors.
Before using your property exemption privileges to protect your tax refund, consider whether you have other assets worth keeping. For instance, you may wish to keep a personal vehicle or retain some equity in your home.
If you don’t have assets like these, you may choose to use your tax refund to purchase other forms of exempt property to build an asset base that you can definitively keep from your creditors. Then again, cash is king: If you have a serious cash flow problem and anticipate using your incoming refund for everyday purchases, it may be your most important asset.
If you don’t use your state’s property exemption to shield your tax refund, it will become part of your trustee-controlled asset pool and may disappear into the hands of your creditors. However, there may be mitigating circumstances that permit you to retain a portion of the funds.
One is the Earned Income Tax Credit. With few exceptions, your creditors can’t touch the portion of your refund that can be directly attributed to the EITC. If your entire refund is EITC-derived and your debts are unsecured, you’ll likely be able to keep all of it. However, the EITC does not protect your return from garnishment by student lenders and government agencies collecting back taxes, alimony or child support payments.
Another is a joint filing. If you and your spouse filed a joint return, your spouse’s portion of the incoming refund is legally protected from seizure. In this case, you can take solace in the fact that your family will have some cash to burn during the bankruptcy process.