Bankruptcy / Income Taxes

Chapter 7 Bankruptcy Income Taxes: 4 Things to Know

Written by Ben Tejes
Updated Oct 11th, 2023

A common question many people have about filing Chapter 7 bankruptcy regards taxes. Will Chapter 7 erase my tax debt? Is Chapter 7 discharged debt taxable as income on tax returns? Will the Chapter 7 Trustee tax my tax refunds? Let’s discuss these questions and other issues related to Chapter 7 income taxes.

Is Chapter 7 Discharged Debt Taxable as Income on Tax Returns?

One of the disadvantages of debt settlement is a potential increase in your income taxes. In most cases, the debt forgiven by a creditor is taxed on that year’s tax return. The creditor reports the canceled debt to the Internal Revenue Service. You report the income on your tax return. Unfortunately, reporting discharged debt on your income tax return can increase the amount of taxes you owe for that tax year.

However, when you discharge debts in bankruptcy, the IRS does not count those debts as income. Therefore, you do not report the discharged debt on your tax returns or pay taxes on the discharged debts.

Congress enacted the Bankruptcy Code to help individuals who could not afford to repay their debts and needed a fresh start. If debtors had to pay Chapter 7 income taxes on the discharged debt, they would not receive a fresh start unburdened by debts they could not pay.

Will the Chapter 7 Trustee Take My Income Tax Refunds?

Another common question about Chapter 7 income taxes is whether the trustee takes income tax refunds. A Chapter 7 trustee seizes assets to pay creditors. However, bankruptcy exemptions allow you to protect the equity in many of your assets. Trustees cannot use protected equity to repay your debts.

Therefore, if the bankruptcy exemptions cover the entire amount of your tax refunds, you can keep the refunds. However, it is essential to understand that anticipated tax refunds are an asset in bankruptcy too. Therefore, you must protect any anticipated tax refunds with bankruptcy exemptions, or you could lose the refunds.

Learn more about bankruptcy exemptions by using your free bankruptcy exemptions calculator.

If bankruptcy exemptions do not cover your tax refunds, you might want to time your bankruptcy filing to protect your tax refunds. For example, delay your bankruptcy filing until after you receive your tax refunds.

However, you need to spend the tax refunds before filing bankruptcy. For example, you can use tax refunds to pay utilities, mortgage payments, and other necessary expenses. However, if you use the tax refunds to purchase luxury items, the Chapter 7 trustee might seize those assets if bankruptcy exemptions do not cover them. Likewise, if you use the tax refunds to pay relatives or unsecured creditors, the Chapter 7 trustee may file a lawsuit to take those payments back for the bankruptcy estate.

If you have non-exempt Chapter 7 income taxes or need to spend tax refunds before filing Chapter 7, it is best to discuss your situation with a Chapter 7 bankruptcy lawyer. Bankruptcy lawyers offer free consultations. Once you file Chapter 7, you might be unable to undo it. Therefore, it is best to seek legal advice before filing Chapter 7 to ensure your tax refunds and other assets are not in jeopardy.

Ascend can help you locate a bankruptcy lawyer in your area who offers free consultations. Learn more in our Definitive Guide to Hiring a debt Relief Lawyer.

Can Chapter 7 Discharge Income Taxes?

Most tax debt cannot be discharged in bankruptcy. However, there are exceptions. For example, older Chapter 7 income taxes might be dischargeable in bankruptcy.

For the tax debt to be dischargeable, it must meet each of the following requirements:

  • Only income tax debts may be discharged in Chapter 7. Payroll, excise, sales, and other types of tax are not dischargeable.
  • The tax debt must be at least three years old or older. The date began when the tax became due.
  • The tax return associated with the income tax debt must have been filed at least two years before filing for bankruptcy relief.
  • The tax debt must have been assessed by the Internal Revenue Service at least 240 days before filing the bankruptcy petition.

Chapter 7 discharges most unsecured debts. Find out if you could qualify for Chapter 7 by using our free Chapter 7 calculator.

Filing Taxes After Chapter 7 Discharge?

In most cases, future Chapter 7 income taxes are not impacted by filing a Chapter 7 bankruptcy case. You continue to file your income tax returns as you did before filing for bankruptcy. There is one exception.

As discussed above, if you anticipate receiving a tax refund for the following tax year, you must disclose that information on your Chapter 7 asset schedules. Depending on the tax refund size, the Chapter 7 trustee could keep the bankruptcy case open to take the tax refunds not covered by bankruptcy exemptions.

If the income tax refund is small, the Chapter 7 trustee might abandon the refund. Abandoning the refund means the trustee will not take the refund because it is of “inconsequential value.” Experienced bankruptcy lawyers generally know the value range trustees in their jurisdiction might abandon.

How Much Does Chapter 7 Cost and Do I Qualify?

One of the most important questions may be whether you qualify for Chapter 7 bankruptcy and what the all-in cost of bankruptcy is, including your attorney fees. Take the Chapter 7 calculator below to estimate cost and qualification based on your data and where you live.

Get Help Taking Control of Your Debt Problems

Are you struggling with debts you cannot pay? If so, Ascend can help. Call or text us at (833) 272-3631 or contact us online for a free case evaluation.