If you're looking forward to your income tax refund, filing for bankruptcy may mean you're in for a disappointment. Bankruptcy will wipe out many of your debts, but the bankruptcy court will make you pay as much to your creditors as possible first; if you receive or file for your tax refund before filing for bankruptcy, you may wind up paying it all to reduce your debts.
Most individuals will file bankruptcy using either Chapter 7 or Chapter 13 of the bankruptcy code. In Chapter 7, the court can take your money and sell off your possessions and assets to pay your creditors, after which your debts are discharged, or wiped out; in Chapter 13, you devote your disposable income for three or five years to paying off your debts, then wipe out the rest. Some debts, however, such as alimony and child support, cannot be discharged in either chapter.
If you file Chapter 7 after you deposit your tax refund, the Fears/Nachawati law firm states, the court can take it along with much of the rest of your money to pay off your creditors; if you've filed your taxes but haven't received the refund yet, the court can take it as an asset. In Chapter 13, the court can rule that the money is disposable income -- money above what you need to survive -- and that you're therefore obligated to turn it over to your creditors.
Each state exempts some property from being sold in Chapter 7. In Florida, for example, you can exempt $1,000 of personal property, as of 2010; in Kentucky, you can exempt up to $3,000 in clothing, jewelry and furniture. If you receive your refund before filing Chapter 7, and spend it on something exempt from sale, you can protect it. If you're filing Chapter 13, the court can't sell your assets, so money can't be touched if you spend it, the Bankruptcy Law Network states. Future refunds received while you're working through your Chapter 13 payment plan may go to your creditors though.
Paying off your creditors might be a legitimate use of your refund, but it can cause problems, Fears/Nachawati states. If you owe money to a friend or business associate and pay that debt first, the bankruptcy court might decide that's a "preferential transfer." In that case, the bankruptcy trustee could require that your friend repay the money so that it can be evenly distributed. Even paying off one credit card before another might not be acceptable.
Although you file bankruptcy in a federal court, state bankruptcy laws may include rules specifically for income-tax refunds, the Bankruptcy Law Network states. In New York, for example, bankrupts filing Chapter 13 who make above the state median income don't have to include refunds as part of their disposable income. Check your state's bankruptcy laws to see if they offer you protection.
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