Do Tax Liens Survive in Chapter 7?
What Is a Tax Lien?
A lien is a security interest, or claim, against specific property. A home mortgage, for example, is a lien against a residence. If you don’t pay the debt, the creditor can sell the property that is subject to the lien to get reimbursed.
A federal tax lien is like a mortgage, except that it secures your obligation to the IRS instead of a lender. A tax lien can be imposed if you fail to pay taxes on a timely basis. However, just because you owe taxes does not mean that you are subject to a tax lien.
If you fail to pay taxes, the government can slap a tax lien on your property. The lien gives the Internal Revenue Service or local taxing authority a claim on the amount you receive if and when the property is sold. Ordinarily, back taxes are a priority debt in bankruptcy, meaning the court will not discharge them. However, bankruptcy law allows some exceptions.
The primary reason people file Chapter 7 Bankruptcy is to discharge, or eliminate, their debts and get a fresh start with their finances. Tax liens, however, are not discharged simply by filing bankruptcy. Tax liens continue in effect after a Chapter 7 filing until they are paid off or otherwise released.
This article will focus on federal tax liens. Similar principles apply to state tax liens. Laws vary from state to state, however, on specific issues such as how state tax liens are created and what property they cover.
How state tax liens are imposed. Laws vary between states as to what is required to impose a state tax lien.
How federal tax liens are imposed. The IRS files a notice in order to get a federal tax lien recorded against your property. The notice must be filed in the county where you live or where the property is located. Once the IRS files its notice, it has a lien against all property — real or personal — that you own. The lien attaches to all property that you own from and after the date that the IRS files its lien. Federal tax liens continue in effect for up to 10 years after the IRS assesses the taxes that you owe.
Priority Claims
Normally, a Chapter 7 bankruptcy will not discharge income or property taxes, which are priority claims. There are exceptions: Income taxes assessed more than three years before the bankruptcy filing, for example, can be discharged. Property taxes also survive a bankruptcy filing. However, if the property is sold through foreclosure, the property taxes due on the property remain with the property, not with you personally. The lien attaches to the property and does not follow you after discharge if you should buy another home.
Foreclosure
Chapter 7 will not cancel any IRS tax liens — these remain priority claims even if the tax debt is more than three years old. Bankruptcy does halt any legal proceedings against you — temporarily. After the discharge, the IRS may still foreclose on the lien, forcing you to sell the property. The IRS has a claim on any equity that remains after the mortgage is paid.
Determining Lien Value
In order to clear off the lien, you must establish that it is not worth anything, or worth less than the value of your assets. You can do this by filing a Motion to Determine Lien Value. You will have to show that the equity in your home, or the value of your property, is less than the amount of the tax lien. If the lien was for dischargeable tax debt, then the court will reduce it to the amount of equity you do have available, or to zero if you have no equity.
Lien Survival
If the court does not act on a motion to determine lien value, then the IRS retains its lien no matter how much, or how little, equity you have in your home. In addition, the lien on the home will remain even after the bankruptcy is discharged. This will remain the case until the house is sold, or until the IRS fails to renew the lien after 10 years, the collection statue.
IRS Errors and Exceptions
There are also circumstances in which liens can be found invalid in bankruptcy. The IRS may have established an installment agreement with you for repayment of the tax debt. If you make timely payments, then the agency cannot assert a lien. In addition, if you can show that withdrawal of the lien will help you pay the back taxes (by making it easier to sell the home, for example), then the IRS may cancel it. Tax debts expire by statute after 10 years, so no lien can be asserted after this time has passed since the tax was due. If the IRS or any other agency files a lien after you petition for Chapter 7 bankruptcy protection, then the lien is barred by law.
What Happens to Tax Liens When You File Chapter 7 Bankruptcy
What happens to tax liens when you file for bankruptcy depends on whether or not the tax lien was in place before you filed for bankruptcy.
Tax Liens Imposed After Your Bankruptcy Filing
Filing Chapter 7 triggers a statutory protection known as the automatic stay. The automatic stay bars creditors, including the IRS, from taking action to collect most types of debt except through the bankruptcy process.
Among other things, the automatic stay bars the IRS from filing a tax lien post-bankruptcy. This means that the IRS cannot impose a tax lien during your Chapter 7 case unless it previously filed a notice.
Tax Lien Notices Filed Before Your Bankruptcy Filing
A tax lien filed before your bankruptcy, however, continues in effect. The bankruptcy court cannot set aside a tax lien as long as it was filed properly before your Chapter 7 case.
Paying Off Tax Liens Through Bankruptcy
Tax liens may be paid, in whole or part, through the bankruptcy process. A Bankruptcy Trustee is appointed after you file Chapter 7 to administer and liquidate assets in your bankruptcy estate to raise money to pay your debts. In some Chapter 7 cases, debtors have assets that the trustee can sell to pay creditors, including the IRS. The IRS is entitled to any money raised through the sale of assets covered by a federal tax lien except to the extent there are prior mortgages or security interests.
Example. Say your house is worth $350,000 and is subject to a $100,000 mortgage and a $75,000 federal tax lien. Let’s assume that you are entitled to a homestead exemption of $100,000. If the bankruptcy trustee sells your home, the trustee would pay $100,000 to your mortgage lender and $75,000 to the IRS. The trustee would also pay you $100,000 for your homestead exemption. The balance of $75,000 would go to pay costs of sale and other creditors in your bankruptcy case.
When Tax Liens Are Not Paid Through Bankruptcy
Unfortunately, tax liens usually are not paid in Chapter 7 cases. Most Chapter 7 cases as “no asset” cases. In a no asset case, creditors receive nothing because there is no assets that the trustee can sell for the benefit of the bankruptcy estate after taking into account secured claims (like mortgages and tax liens) and exemptions. Ordinarily, trustees will not attempt to sell property if all of the proceeds would have to be paid to secured creditors or the debtor.
Example. Let’s take the example of a house worth $200,000, with a $150,000 mortgage, a $25,000 federal tax lien, and a $100,000 homestead exemption. In most cases, the trustee would not try to sell the house, because there would be no proceeds available to pay other creditors after taking into account the mortgage, tax lien, and homestead exemption.
In this situation, the tax lien would still remain on your property after your Chapter 7 case is over. In order to get rid of the lien, you could sell the property and pay the IRS from the proceeds. Or, you could attempt to work out a payment plan with the IRS to pay the balance due and have the tax lien released. Simply filing Chapter 7, however, would not make the lien disappear.
Tax Liens on Personal Property
Tax liens also attach to personal property, such as cars and household furniture. In most Chapter 7 cases, trustees do not try to sell personal property, because it is either worth too little, encumbered by liens (like auto loans), or subject to exemptions. You have to continue to deal with tax liens that cover personal property you are able to retain after a Chapter 7 filing.
Dealing With Tax Liens After Bankruptcy
Generally, your options to deal with a federal tax lien that remains in effect after bankruptcy are to:
- pay the tax lien and obtain a release
- negotiate a payment plan or compromise to release the tax lien
- redeem a specific item by paying its value, as determined by the bankruptcy court, to the IRS
- pay the tax lien over time by filing for Chapter 13 bankruptcy after your Chapter 7 (this is often referred to as a “Chapter 20” Bankruptcy, or
- do nothing and gamble that the IRS will not take action to collect on its tax lien.
Taking no action can make sense when the value of property subject to a tax lien is relatively nominal and your personal liability for the tax obligation was discharged through your Chapter 7 filing.
The Requirements for Discharging Income Tax Debt
You will be able to get rid of your tax debts in Chapter 7 bankruptcy if you meet the following requirements:
- The taxes are income-based. Income taxes are the only kind of debt that Chapter 7 is able to discharge. The tax debt must be for federal or state income taxes or taxes on gross receipts.
- The return was due at least three years ago. The taxes must be from a tax return that was due (including all valid extensions) at least three years before you filed for bankruptcy. For example, if taxes were disclosed in a 2005 income tax return for which extensions to file the return expired on October 15, 2006, the tax return due date test will be satisfied if the bankruptcy petition is filed after October 15, 2009.
- You filed the return at least two years ago. You must have filed the tax return at least two years before filing for bankruptcy. In most courts, a late return does not count as a “return” and you won’t be able to discharge the taxes (late means your extensions have expired and the IRS filed a substitute return on your behalf). In other courts, you can discharge tax debt even if you file a late return, assuming you meet the other criteria.
- The taxes were assessed at least 240 days ago. The taxing authority must have assessed the tax (entered the liability on the taxing authority’s records) against you at least 240 days before you filed for bankruptcy. This time limit may be extended if there was an offer in compromise between the taxing authority and you or if you had previously filed for bankruptcy.
- No fraud or willful evasion. The tax return must not be fraudulent or frivolous and the you cannot be guilty of any intentional act of evading the tax laws. If you file a joint return, the taxing authority must prove that both you and your spouse committed an act of fraud related to the applicable return or willfully attempted to evade the tax in order for the court to deny the discharge of the tax debt.
Non-dischargeable Tax Debts
You cannot get rid of most non-income-related tax debts. The following debts won’t be discharged in Chapter 7 bankruptcy:
- Tax liens. A Chapter 7 bankruptcy discharge of income taxes wipes out the personal obligation to pay the tax and prevents the taxing authority from going after your bank account or wages. However, tax liens, also known as secured taxes, will remain attached to your property. This rule applies only to tax liens recorded against your property before you file for bankruptcy. This means that although you might not be personally liable for the tax debt, you’ll have to pay the lien from any profits when you sell the property.
- Recent property taxes. If a property tax is incurred before you file for bankruptcy, the tax is non-dischargeable. However, this only applies to property taxes last payable within one year of your bankruptcy filing. You can discharge your personal liability for property taxes that were payable (without penalty) more than one year before your bankruptcy filing. Keep in mind, though, that many counties attach a lien to your property upon assessment or one year afterwards. If you have a lien against your property for the property tax, that lien will remain after your Chapter 7 discharge (although your personal liability will be removed). T
- Taxes that a third party is required to collect or withhold. This covers the so-called “trust fund” taxes such as FICA, Medicare, and income taxes than an employer must withhold from the pay of employees, and sales taxes paid by the debtor’s customers that the debtor is required to send to a governmental unit.
- Certain employment taxes, excise taxes, and custom duties, depending on specific time periods.
- Non-punitive tax penalties on non-dischargeable taxes if the transaction or event that sparked the penalty occurred less than three years before filing the bankruptcy petition.
- Erroneous tax refunds or credits relating to non-dischargeable taxes.