Bankruptcy timing is one of the most common issues I see this time of year.  As many people are anxious to file their bankruptcy, there are drawbacks to filing too early.  If you plan to receive a tax refund, you should wait to file your bankruptcy and spend the money.  Your tax refund is a non-exempt asset in the state of Arizona.  This means that the refund is treated much like money in your bank account and can be taken from you by the trustee.  You need to make sure that you spend the tax refund you receive on things that are exempt.  Here is a list of Arizona Exemptions. Spending your tax refund on things that are not exempt is dangerous and the trustee can take those assets from you.  Spending money on living expenses like: Food, electricity bills and home supplies is a good idea.  Make sure you keep the receipts for everything you have bought with your tax return money.  Paying your bankruptcy fees is one of the safest and most legitimate ways to spend the money and will get you a fresh start sooner.

 Bankruptcy is one of the most difficult decisions an individual ever has to make.  Before making a decision on whether or not to file for bankruptcy, an individual should talk to an attorney and explain his or her situation.  According to http://www.daveramsey.com/article/the-truth-about-bankruptcy/ <http://mail.ssrl.com/exchweb/bin/redir.asp?URL=http://www.daveramsey.com/article/the-truth-about-bankruptcy/> , bankruptcy is not something that he would recommend any more than he would recommend a divorce.  Few people who have been through bankruptcy would report that it is a painless wiping-clean of the slate, after which they just start fresh.  Bankruptcy is listed as one of the top five life-altering negative events that a person can go through along with divorce, severe illness, disability, and loss of a loved one.  Bankruptcy leaves deep wounds both to one’s credit report and to one’s psyche. 

            According to http://www.debtconsolidationcare.com/avoid-bankruptcy.html <http://mail.ssrl.com/exchweb/bin/redir.asp?URL=http://www.debtconsolidationcare.com/avoid-bankruptcy.html> , there are seven reasons to avoid bankruptcy.  One, an individual’s credit is badly hit if that person files for bankruptcy.  Two, an individual may lose their property.  Three, not all of an individual’s debts can be eliminated.  Four, creditors and lenders of an individual may repossess property.  Five, bankruptcy has an adverse effect on an individual’s other finances such as buying a house, renting a home, or buying a car.  Six, an individual may not qualify for a secured loan for at least 2-4 years.  Finally, not all retirement plans are protected, if an individual files for bankruptcy. 

            Remember, there are a lot of benefits to filing bankruptcy, if a person has no other option.  However, a person who is contemplating filing for bankruptcy has to consider the negative effects of filing for bankruptcy. 

            According to http://www.financial-edu.com/why-should-you-avoid-bankruptcy.php <http://mail.ssrl.com/exchweb/bin/redir.asp?URL=http://www.financial-edu.com/why-should-you-avoid-bankruptcy.php> , there are four good ways to avoid bankruptcy.  One way to avoid bankruptcy is to do debt consolidation.  Another way to avoid bankruptcy is through individual voluntary arrangements which enable an individual to reach a compromise with their creditors and avoid the consequences of bankruptcy.  Third, an individual could use counseling services from many free organizations for effective debt management.  Finally, an individual has the option to sell off everything, including their valuable assets, to pay off their various debts.

Think of the refund as money you gave to your “uncle” to hold for you until after your bankruptcy was filed.  Here is how it works:

When your employer pays you, the employer is required to withhold a portion of your earnings for payment of various taxes including the state and federal income tax.  These withholdings are sent to the federal IRS and state Department of revenue but the money still belongs to you until the amount of your tax liability is determined from the tax return you filed.  If the amount withheld by your employer exceeds the tax liability, you are owed a refund.

Income taxes for a given year are generally due by April 15 of the following year.  If you filed your tax return early in the year during which you filed bankruptcy, you may have received your tax refund and spent the money before you filed bankruptcy.  This is the best practice and that is why we routinely advise our clients to file their tax return and spend the tax refund before filing bankruptcy.  If you are not going to receive a tax refund, there is no refund for the trustee to claim.

If you are owed a refund or if you have received the refund and not spent the money before you filed bankruptcy, the trustee will claim that money as a non-exempt asset which is part of the debtor’s estate to be administered by the trustee for the benefit of the creditors.  So, even though you have already filed bankruptcy, if you receive a refund that was from tax withholdings on earnings prior to the date you filed bankruptcy, the refund is going to be claimed by the trustee.

The trustee, for the benefit of your creditors, is entitled to any of your money which the government (your “uncle”), or anyone else, was holding for you as of the date you filed bankruptcy.  One exception is that you have an exemption for up to $150 per debtor for money in one bank account.  You can also exempt money held for you in a qualified retirement account.  The tax refund is not exempt.

If your tax liability for 2009 was determined prior to the date you filed bankruptcy, and you were not entitled to a refund, or if the refund check was already sent to you and spent by you prior to the date you filed bankruptcy, the trustee is not going to get anything because, as of the date you filed bankruptcy, the government was not holding any of your money.

As for the trustee’s claim to any tax refund owed to your from over-withholdings paid to the government during the same year you filed bankruptcy, that claim is limited to a pro-rata share of any refund attributable to the money withheld from your earnings prior to the date you filed bankruptcy.  If you filed bankruptcy half way through the year, the trustee will claim ½ of the refund you receive the next year.

If you typically get a refund each year, you are over-withholding.  You are depriving yourself of the use of some of the money you earn each pay period and sending that money off to the government to hold until it is time to calculate your tax liability.  You may need the help of some tax advisers to calculate the amount you should withhold or you may just need to speak with someone in your employer’s HR department.  The best practice is to end up with no surprises when tax time rolls around each year.  Remember, in the context of bankruptcy planning, over-withholding can result in losing some of your money to the trustee for the benefit of your creditors.

Many trustees will not claim a small refund for the estate because the amount involved is too small to justify their time and expense.  This is especially true if the tax refund is the only non-exempt asset to be administered.  If you send your tax refund check to the trustee, the trustee will calculate the amount that can b be claimed by the estate and may decide to abandon that claim and return the check to you.

IF A BORROWER SELLS HIS HOME IN A SHORT SALE WILL THERE BE A TAX ON THE FORGIVEN DEBT?

Although I do not offer tax advice and will refer questions regarding tax liability associated with any transactions to a CPA or tax attorney, it is well known that a short sale of one’s personal residence does not result in taxes on the forgiven debt.   The Mortgage Debt Relief Act of 2007 [PL 110-142 (Dec. 20, 2007)] would probably apply.  The IRS web-site (http://www.irs.gov/individuals/article/0,,id=179414,00.html) indicates there is no debt forgiveness on a “non-recourse” loan (see IRS Publication 4681, p.11 updated Dec. 11, 2008).  In Arizona a purchase money loan for a residence, even if it is not your residence but is used as a residence by a tenant you rent to, is a non-recourse debt because of the Arizona anti-deficiency statutes (see A.R.S. Sec. 33-729(A).  Remember that this information is not a substitute for competent legal advice after an attorney is able to review your entire financial situation.