Chapter 7 Permanently Prevents Tax Liens against Your Home

 Posted on October 16, 2017 in Income Taxes

Filing a Chapter 7 case prevents tax liens from hitting your home, and so avoids a dischargeable tax from turning into one you must pay.

Our last blog post was about how filing a Chapter 7 case buys you time with debts on your home. It’s worth expanding on one of those Chapter 7 benefits, one that can go way beyond buying time. It could save you a lot of money, potentially many thousands of dollars.

The Dischargeable Income Tax Scenario

Filing a Chapter 7 bankruptcy can discharge certain, usually older, income tax debts. (See our blog post of this last September 22 about the conditions for writing off income taxes in bankruptcy.) If you file a Chapter 7 case before a tax lien is recorded on a dischargeable tax debt, then that will prevent the IRS or state tax authority from recording that lien against your home. The tax will then be discharged (permanently written off) about 4 months of your bankruptcy filing. After that the IRS/state can never record a lien or take any other collection action on the tax. It’s gone forever, and the threat of a lien against your home is also gone forever.

The Very Bad Alternative

What happens instead if the IRS or state records a lien against your home before you file bankruptcy?

Assume you’d have some equity in your home but no more than the homestead exemption. (That’s the amount of equity that’s protected from most creditors in bankruptcy—the specific amount varies state to state.) If you’d owe a tax debt that would qualify for discharge and the IRS/state had recorded a lien on that debt against your home, that lien would continue on after you’d complete your bankruptcy case. Your homestead exemption would not help with a tax lien. That lien would continue to encumber the equity you have in your home. You’d have to pay the lien in full when you’d sell or refinance your home. The lien would effectively turn a debt that you could have discharged within a few months after filing bankruptcy into an anchor attached to your home.

Assume instead that you’d have no equity in your home. The IRS/state would probably still want to keep its lien against your home. The lien would at the time have no equity to encumber but the lien would still attach to your title. Later the IRS/state could likely renew the lien, leaving it on your home’s title for a very long time. Odds are you’d be forced to pay the tax at some point, maybe when your home’s value increased enough. Instead of you getting the benefit of that equity, it would go to pay a tax that you could have discharged long before, if you’d just filed a bankruptcy case before the tax lien hit your home.

An Example

Let’s say you owe $6,000 in income tax for the 2012 tax year and $3,000 for the 2013 tax year. And this is after you’d paid monthly instalment payments for years. Those amounts include a lot of interest and tax penalties. Assume that both of these tax debts qualify for bankruptcy discharge. (This would mostly be because enough time has passed since their tax returns were due and actually submitted.) Assume also that you own a home worth $250,000 with a $225,000 mortgage. That $25,000 of equity is fully covered by your state’s $30,000 homestead exemption.

The following would happen if you filed a Chapter 7 case with your bankruptcy lawyer before any tax lien was recorded:

• The “automatic stay” from the bankruptcy filing would immediately prevent the IRS/state from recording a tax lien on your home (or on anything else you own). Your home and its equity would be immediately protected.
• Both the $6,000 2012 tax debt and the $3,000 2013 one would be discharged about 4 months later.
• The IRS/state could never file a tax lien on these taxes ever again. They could take no further collection action of any sort. The $9,000 debt would be gone. The IRS’s/state’s ability to attach that debt to your home would be gone as well.

Instead the following would happen if the IRS/state HAD recorded tax liens on both years before you filed a Chapter 7 case:

• The tax lien recorded against your home would continue on after you filed bankruptcy.
• The IRS/state would get paid on those liens whenever you sold or refinanced your home, potentially many years later.
• You would very likely pay $9,000—plus likely lots more interest and penalties—to the IRS/state that otherwise you would not have needed to pay.