Chapter 7 and Chapter 13--An Income Tax Lien on Your Home

 Posted on November 16, 2015 in Income Taxes

Which kind of bankruptcy to file depends on whether there is equity for the lien and whether the underlying tax can be discharged.

If you’ve had an income tax lien recorded on your home, there are two big considerations about how that tax and that lien will be handled in a bankruptcy. These two considerations will also affect whether you would want to file a Chapter 7 “straight bankruptcy” or a Chapter 13 “adjustment of debts” to deal with that tax and lien.

Equity to Cover the Tax Lien

First, there can be a world of a difference whether your home has enough equity—value beyond any property tax, mortgage(s), and perhaps other prior other liens—so that the tax lien attaches to present value in your home. Under certain circumstances this can make the difference between having to pay that tax in full and not needing to pay any of it.

That’s because when there is equity in your home to cover the income tax debt, that turns an unsecured debt into a secured one, secured by your home. That’s a little like the difference between an unsecured promissory note and one mortgaged against your home. If you want to keep your home you have to deal with that debt and can’t just write it off in bankruptcy.

Dischargeable Tax or Not

The second consideration for how an income tax with a tax lien on your home is handled is whether the tax on which the lien was recorded can be discharged—legally written off—in bankruptcy. If that underlying tax meets the conditions for discharge you may not need to pay the tax in spite of the tax lien.

(See our last blog post for the conditions an income tax debt must meet for it to be discharged in bankruptcy.)

A Tax Lien with No Equity on a Dischargeable Tax

For the rest of today’s blog post imagine the following scenario. Assume your home is worth about as much as you owe in property taxes and your mortgage (or two). So it has no equity securing the IRS tax lien recorded a few months ago on the $6,000 income tax you owe for the 2011 tax year. Assume also that you filed the tax return for that 2011 income tax at the usual April 2012 deadline. That means that this tax is now dischargeable in bankruptcy since it’s been more than 3 years since that tax return was due (April 2012) and more than 2 years since that tax return was actually filed (the same date).

Treatment under Chapter 7

In a Chapter 7 “straight bankruptcy,” if the IRS had NOT recorded its tax lien before the case was filed, the $6,000 income tax debt would simply be discharged, usually within about 4 months after the bankruptcy filing. You’d never owe that tax again.

Furthermore, once you filed that Chapter 7 case, doing so would immediately prevent the IRS from recording a tax lien on your home. Then after the discharge of debts was entered by the bankruptcy court and the tax debt was gone, the IRS could not record a lien on that discharged debt.

But if the tax lien is recorded before the Chapter 7 case is filed the situation is completely different.

The tax lien survives the bankruptcy, similar to a vehicle lender’s lien on your vehicle continuing in spite of a bankruptcy. In the case of the vehicle lien you have a choice of paying off the debt and thereby getting a release of the lender’s lien, or surrendering the vehicle and then not having to pay the discharged debt.

With the tax lien, the underlying debt may be discharged but the lien on your house survives. Under certain limited circumstances the IRS might release its lien, eventually, such as if the home was worth much less than the debts ahead of the IRS and so there was no hope that there would ever be any equity for the IRS. Or the lien would just expire at some point.

But that’s not likely in our scenario where the prior liens on the home are close to the value of the home. That means that any upcoming increase in the home’s value, together with your progress in paying down the property taxes and mortgage(s), would build equity for the tax lien to attach to. The IRS could just sit on its lien until you sell or refinance the home, releasing its lien only when it’s paid in full (including all the interest and penalties that have accrued in the meantime), or perhaps at some negotiated reduced amount if there isn’t enough equity.

Note the contrast between this scenario vs. just discharging the debt if there was no recorded tax lien.

Treatment under Chapter 13

Chapter 13 “adjustment of debts” can do better with the tax lien under these facts.

In contrast to Chapter 7, the Chapter 13 has a valuable legal mechanism that would affirmatively require the IRS to release the tax lien if you can show that it does not attach to any equity in the home.

Under Chapter 13 you and your attorney propose a formal payment plan, the IRS has the opportunity to object to its terms, any objections are negotiated or resolved by the bankruptcy judge, and then the plan is approved by the judge. Within that procedure the $6,000 tax debt would be determined to have no equity securing it (assuming that can be established with evidence of the home’s value and the amounts of the prior liens), and thus would be an unsecured debt.

The tax debt would thus be lumped in with and treated like your other “general unsecured” debts. That is, that $6,000 would be paid only as much as you could afford to pay it during the life of your 3-to-5-year Chapter 13 plan. Often that would be little or nothing because you are allowed—indeed often required—to first pay other legally more important debts. These other debts can include secured ones like a home mortgage arrearage or vehicle loan payments. And they can include “priority” debts like more recent income taxes that can’t be discharged.

Furthermore, even if you do pay some percentage of your “general unsecured” debts adding that $6,000 tax debt to that “general unsecured” pool usually doesn’t increase what you pay. That’s because most of the time you pay a fixed amount of that pool of debts, so that adding the tax debt to that pool simply reduces what the other creditors receive without you paying any more.

At the end of the Chapter 13 case, with usually little (and sometimes nothing) having been paid on that $6,000 debt, any portion that hasn’t been paid is forever discharged, and the IRS releases its tax lien. You are then tax-debt free, and your home is tax lien-free.

Conclusion

In this scenario, with prior liens totaling close to the value of your home, and with the income tax being a dischargeable one, Chapter 13 is the safer way to go. Unlike Chapter 7 it doesn’t leave you at the mercy of the IRS taking advantage of future equity in your home. And—depending on your income and what other important debts you have to pay—Chapter 13 would likely enable you to pay less on that tax, often much less.