The recording of a tax lien often immediately turns an unsecured debt into a secured one, forcing you to pay what you could have written off.
If you owe income taxes, stopping the IRS or state record a tax lien can be a huge benefit of filing bankruptcy. How much of a benefit turns on details about the taxes you owe and the type of bankruptcy you file. Today and in our next blog post we’ll look at income taxes that would be discharged (forever written off in full). Today we focus on the benefits of filing Chapter 7; next week we’ll do the same for Chapter 13.
Secured and Unsecured Debts in Bankruptcy
The leverage that any creditor has over you depends a lot on whether its debt is secured by your property. For example, if a debt is secured by your home, the home is collateral on that debt. In most situations even after filing bankruptcy you have to either pay the debt or you could lose the home.
The Effect of a Tax Lien
If you can’t pay an income tax, that tax debt is an unsecured one. It’s not secured by anything you own. The IRS and state taxing authorities have some powerful collection techniques they can use to collect the tax. But they can’t simply take anything of yours to pay off the tax debt. That’s because that tax debt is not secured by anything you own.
This completely changes when the IRS/state records a tax lien against your tax debt. The recording legally converts the unsecured tax debt into a debt secured by your property. Which property becomes security against that particular tax debt depends on the details of 1) the tax lien itself and 2) your state’s property laws.
But regardless of these details, IRS/state tax liens can potentially turn pretty much everything you own into security on that tax debt. That means that if you don’t pay the tax, the IRS/state can often take whatever you own in payment of that tax debt. Usually the practical result is not that they take everything, or even anything. Rather, you end up paying the tax debt, sooner or later.
Unsecured Older Income Tax Debts in Bankruptcy
Contrast that from what would happen to that tax if there was no recorded tax lien.
Most ordinary unsecured debts can be legally forever written off in bankruptcy. This is true of some income tax debts as well, if they meet certain conditions. Basically, bankruptcy discharges (writes off) income taxes for which the tax return:
- was due more than 3 years before your bankruptcy case is filed, AND
- was in fact filed more than 2 years before bankruptcy.
An Older Income Tax Debt WITHOUT a Tax Lien Under Chapter 7
If you meet the above 2 conditions (and a couple other seldom applicable ones), filing Chapter 7 will simply forever discharge that tax debt. Within about 3-4 months after you file the case, it will be legally gone. You will not have to pay it.
You filed bankruptcy in time to stop the IRS/state from recording a tax lien. And after discharge they’ll never be able to record a lien, or collect in any other wayr.
An Older Income Tax Debt WITH a Tax Lien Under Chapter 7
But it’s completely different if you did not file bankruptcy until after the tax lien recording.
If the tax debt meets the timing conditions, your Chapter 7 filing would technically discharge the tax debt itself. However, the IRS/state would still have a lien on your property after the bankruptcy case was completed.
Because of this surviving tax lien, the IRS/state would at that point be able to exert its rights under the lien. That means it could take and sell whatever property the lien attached to. That would usually be all your personal property or your real estate, or possibly both.
To prevent this from happening, you’d want to contact the IRS/state to make payment arrangements. As mentioned above, the result is usually that you have to pay the tax in full, along with its continually accruing tax penalties and interest.
The lesson is very clear. If you owe income taxes, file bankruptcy before the tax authorities record a tax lien. If the tax you owe meets the timing conditions, you’ll be able discharge the entire tax and pay nothing on it.