Chapter 13 protects you from a recorded tax lien in crucial ways, and can reduce how much you pay on the underlying dischargeable tax debt.
Last week’s blog post was about dealing with a recorded tax lien by filing a Chapter 7 “straight bankruptcy” case. Usually the IRS’ or state’s recording of a tax lien against you effectively requires you to pay the underlying tax. That’s true even if that tax otherwise qualifies for total discharge—legal write-off in bankruptcy. That’s because a recorded tax lien converts that tax debt from being unsecured to being fully secured by your property and possessions. You pay the tax—sooner or later—to avoid losing what you own.
When Chapter 7 Might Help
Last week we outlined some circumstances in which Chapter 7 might satisfactorily deal with a recorded tax lien. Those circumstances were when the tax lien either failed to apply to any assets you own or the assets were worth much less than the tax debt at issue. For example, the IRS/state may record a lien on your home which in the process of getting foreclosed. If you’re letting the house go then that tax lien has no leverage over you. Your Chapter 7 case would discharge the income tax debt and the subsequent home foreclosure would undo the tax lien.
But these situations are quite rare. Usually a recorded tax lien (or more than one) covers everything you own. Usually the value of your assets encumbered by the lien(s) well exceeds the amount of the tax at issue. Or even if your assets’ value is less than the tax(es) owed, you don’t want to lose those assets. So you have no choice but to pay the tax owed. That’s true even if that tax otherwise qualified to be fully discharged.
However, if filing a Chapter 7 case takes care of all your other debts, maybe that’s okay. It would have been better to file before the tax lien’s recording so you could have just discharged the tax. But if it’s too late for that, clearing the deck of all or most of your other debts so you can concentrate on the tax debt afterwards may be your best option.
When Chapter 13 Could Be Much Better
The last paragraph assumes you could afford to pay the tax covered by the tax lien. But what if after finishing your Chapter 7 case you still didn’t have enough money each month? The protection from creditor collections (the “automatic stay”) you get from filing bankruptcy disappears when the case is over. That’s only about 3-4 months after your bankruptcy lawyer files your Chapter 7 case. With the tax lien putting your assets at risk you’d have tremendous pressure on you to pay the tax. So if you couldn’t afford to pay as fast as the IRS/state would demand you’d have a serious problem.
Filing a Chapter 13 “adjustment of debts” case could significantly help.
First, the automatic stay protection against the IRS/state usually lasts the 3 to 5 years that a Chapter 13 case takes to complete. That alone greatly reduces the constant tension of being at the mercy of the tax authorities. During the Chapter 13 case your assets that are encumbered by the lien are protected from seizure. And your income and other assets are protected from any other tax collection efforts.
Second, you usually have much more flexibility in your payoff of the underlying tax. You have much more control over the amount and timing of payments on the tax debt. Your monthly Chapter 13 plan payments are based on your realistic budget. In earmarking where the money from those payments goes you can often pay other even more urgent debts (such as catching up on a home mortgage or child suport) ahead of the tax debt. You can sometimes delay paying the tax until some future event, like the sale of your home or other asset.
When Chapter 13 Is Even Better
When the assets covered by the tax lien have no present value, Chapter 13 is particularly powerful.
Consider a tax lien on a home with no present equity beyond the prior liens. After a Chapter 7 case the IRS/state could just sit on that recorded tax lien until you built up equity in the home. You’d pay down the obligations and the property would rise in value until there was equity to cover the tax lien. The IRS/state would have huge leverage over you. But under Chapter 13 the bankruptcy judge would declare that there’s no present equity secured by the tax lien. The tax would effectively be unsecured—as if there was no tax lien. You’d lump that tax debt in with your general unsecured creditors. You would likely pay only a small portion of that tax debt. Often you would actually pay no more into your Chapter 13 payment plan as a result of that tax.
For example, assume you owed $10,000 in dischargeable income tax. The IRS recently recorded a tax lien on your home for that tax. Your home is worth $250,000, has $5,000 in property taxes, $210,000 on a first mortgage and $40,000 on a second mortgage. Owing $255,000 you have no equity in the home. But as you pay down the property taxes and the mortgage, and assuming the property value increases, there’d soon be equity securing the tax lien. But Chapter 13 allows you to freeze the present equity situation. The tax lien presently does not cover any equity in your home, the tax debt is thus unsecured, and would be treated just like the rest of your unsecured debt. Adding the tax debt to your other unsecured debt would usually result in you paying no more than you would have otherwise.