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Resolving a Recorded Tax Lien Partly Secured by Home Equity

 Posted on May 27, 2016 in Income Taxes

Chapter 13 forces the IRS/state to accept only partial payment on an income tax debt that is only partially secured by a tax lien.

We’re in a short series of blog posts on income tax liens recorded against your home. Last time we explained how to use Chapter 13 “adjustment of debts” to get the release of a tax lien when there is no equity in your home securing that tax lien. That happens when the mortgage(s), property taxes, and other prior liens soak up the whole value of the home.

But what if there is enough equity in the home to cover part of the tax lien but not all of it? That is, the prior liens soak up most of the home’s value but leave SOME equity for the tax lien but not enough to cover the full tax debt.

An Example

This situation will make much more sense with an example.

Take a home is worth $200,000, with a mortgage of $195,000, leaving equity of $5,000. This home equity is increasing over time as the neighborhood home values increase and the mortgage is paid down.

The IRS is owed $20,000 for the 2011 and 2012 tax years. Assume that this $20,000 could normally be “discharged” (legally written off) in a Chapter 7 “straight bankruptcy” without paying anything. That’s because the main conditions for discharge were met in this example: the tax returns for those taxes were due more than 3 years ago and were submitted to the IRS more than 2 year ago.

But recently the IRS recorded a tax lien on the home for that $20,000 owed, securing the tax debt against the home. But there’s currently only $5,000 equity in the home to cover that $20,000 tax lien. What happens?

The Disadvantage under Chapter 7

If no tax lien has been recorded against you and your home, Chapter 7 is an excellent way to get rid of older income tax debts, those that meet both the 2-year and 3-year conditions just mentioned. The problem is that by the time those conditions would be met, there’s a good chance that a tax lien will get recorded. After all, the IRS and state tax agencies know the bankruptcy laws quite well and want to make you pay the taxes!

A recorded tax lien survives a Chapter 7 discharge. So if that lien attached to some equity in the home, you finish the Chapter 7 case with that dangerous tax lien still encumbering your home and that equity. There is no legal mechanism under Chapter 7 to discharge the unsecured part of the tax and just pay on the secured part.

So the IRS or state will use that tax lien as leverage to make you pay as much of the tax as possible. Especially if the value of the home is increasing, the IRS/state will likely be able to make you pay all or most of the tax amount before releasing its tax lien.

The Solution under Chapter 13

Chapter 13 does have exactly the kind of legal mechanism that you need here. Through your court-approved payment plan, the bankruptcy law allows you establish the amount of equity in your home to which an income tax lien attaches as of the time your case is filed. Then that amount—that part of the tax lien—and no more, is paid over time through the Chapter 13 payment plan. That’s the secured part of the tax debt.

In our above example, that’s the $5,000 portion of the $20,000 tax debt, the part secured by the equity in the home.

The rest of the tax beyond the secured part, the additional $15,000 in our example, is treated as a “general unsecured” debt. That means it is grouped with the rest of your debts that are neither secured nor treated in any special way. These debts, including that portion of the taxes, are paid only to the extent that you have money left over after paying off the secured part, and after paying in full all your other legally more important debts.

What’s important to understand is that In practice the unsecured part of the taxes—the $15,000 in our example—usually doesn’t increase the amount you pay into your 3-to-5-year Chapter 13 payment plan payments. This happens one of two ways:

  • Your payment plan doesn’t have any money left over for the “general unsecured” debts, including the unsecured part of the taxes. That’s when you budget only provides you enough “disposable income” over the life of your plan to pay the secured part of the tax and other legally more important debts—like catching up on your home mortgage, paying off your vehicle loan, and paying more recent income taxes that can’t be discharged. This is called a 0% plan—paying nothing of the “general unsecured” debts and paying nothing of the unsecured part of the income tax. In our example, the $15,000 would be paid 0%—it would be paid nothing.
  • In other Chapter 13 cases in which you are paying something to the “general unsecured” debt, that “something” is a definite amount based on what your budget allows. Adding the unsecured part of the lien tax debt to that pool of other “general unsecured” debts does not increase the amount of money you have to pay into that pool. You pay the same amount and that amount is just spread out among more debts, so that the other “general unsecured” debts just get less of that fixed amount that you pay. In our example, if you had $50,000 of other “general unsecured” debts, adding the $15,000 unsecured portion of the taxes would not increase the amount you would pay but rather the remaining $50,000 of debts would just get paid less.

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