A Fresh Start for Your Home Partly Encumbered by a Tax Lien

 Posted on February 12, 2016 in Income Taxes

Chapter 13 handles a tax lien on a home especially well when the home has enough equity to cover some but not all of the tax lien amount.

In our last two blog posts we dug into tax liens, and we do so one more time today. Two blog posts ago it was about tax liens that have no equity at all to attach to. Then the last blog post was about tax liens that have enough equity in the home to cover the entire amount of the tax lien.

Today we get into the in-between situation—where there’s enough equity in the home to cover part of the tax lien but not all of it. How can you get a fresh start on you home in this situation?

A Quick Summary about Tax Liens

A recorded tax lien on your home turns an income tax debt that you could have completely discharged (legally written off) in a Chapter 7 “straight bankruptcy”case into one that you may have to pay in full. If that income tax debt meets the conditions for discharge (mostly by being old enough), whether and how much you have to pay that tax depends mostly on whether there is equity in the home to cover this tax debt.

If there’s no equity at all for the tax lien because the mortgage and other liens legally ahead of the income tax lien eat up more than the full value of the home, you may not have to pay anything, or relatively little, of the tax at issue.

If there is enough equity in the home to cover the entire value of the secured by the recorded tax lien, you will have to pay the tax if you want to keep the home.

So what happens if the tax lien is neither completely unsecured for lack of equity nor completely secured by more than enough equity? What happens with a partially secured tax lien?

The Problem with a Partially Secured Tax Debt under Chapter 7

A Chapter 7 case is great if you owe an income tax which meets the conditions for discharge, IF there’s no tax lien. But if there IS a recorded tax lien, and there’s some equity that the lien attaches to, you finish the Chapter 7 case with that dangerous tax lien still encumbering your home equity. Then the IRS/state will use that tax lien as leverage to make you pay as much of the tax as possible. 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 agreeing to release its tax lien.

The problem is that there is no legal mechanism under Chapter 7 to divide the partially secured tax lien into two parts, the secured part and the unsecured part. You can’t discharge the unsecured part and just pay on the secured part. Instead the IRS/state takes advantage of its tax lien by making you pay all or most of the tax.

A Partially Secured Tax Debt under Chapter 13

However, Chapter 13 “adjustment of debts” does have exactly this kind of legal mechanism. The bankruptcy court helps you fix in time the amount of equity in your home to which an income tax lien attaches. 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.

The rest of the tax beyond the secured part is treated as a “general unsecured” debt. So it’s lumped in with the rest of your bottom-of-the-barrel “general unsecured” debts. So that unsecured part of the tax is paid only to the extent that you have money left over after paying the secured part, and after paying all your other legally more important debts in full.

In practice you usually don’t increase the amount you pay into your 3-to-5-year Chapter 13 payment plan payments when you add the unsecured part of your income tax. There can be two reasons for this.

First, sometimes you can only afford 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—leaving nothing for ANY of the “general unsecured” debts. Paying nothing on your “general unsecured” debts means paying nothing on the unsecured part of the income tax with the tax lien.

Second, in most Chapter 13 cases, after paying the secured part of the tax with the tax lien and the other legally more important debts you have only a certain amount of money available during the life of your payment plan to pay to all of your “general unsecured” debts. So adding the unsecured part of the lien tax debt to that pool of “general unsecured” debts does not increase the amount of money you have to pay of the debts in that pool of debts, You pay the same amount and that amount is just spread out among more debts. Having the unsecured part of the tax with the tax lien just results in the other “general unsecured” debts getting less of that fixed amount that you pay.

Chapter 13 Example

This makes more sense with an example. Assume that a home is worth $225,000 with a first mortgage of $190,000 and second mortgage of $30,000, leaving equity of $5,000. The equity is increasing as property values increase and the mortgages are paid down. The IRS is owed $20,000 for the 2010 and 2011 tax years. That $20,000 could have been discharged without paying anything because the tax returns for those two years of taxes were due more than 3 years ago and were indeed filed more than 2 year ago. But then the IRS recorded a tax lien on the home for that $20,000.

That tax lien covers the $5,000 in present equity. But after a Chapter 7 was filed the IRS would not likely release its tax lien for $5,000 because it could just wait for the property values to increase and the mortgages to be paid down for the equity covered by its lien to increase.

However under Chapter 13 the bankruptcy court could order the $20,000 tax debt to be divided into a $5,000 secured part and a $15,000 unsecured part. The $5,000 would then be paid over the 3-to-5-year court-approved payment plan, throughout which time the IRS would be prevented from taking any collection action. The remaining $15,000 unsecured part would be lumped in with the other “general unsecured” debts, usually not increasing the amount paid into the plan.