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In a few weeks taxpayers will begin filing their 2012 tax returns, and for those taxpayers who are also filing bankruptcy at the same time a large number of them will forfeit the refund to the Chapter 7 Trustee. For nearly 20 years I have witnessed the Chapter 7 Trustee seize tax refunds from unsuspecting debtors. This happens every year, over and over again. The sad part is, this should almost never happen.

Are tax refunds protected in bankruptcy?

Tax refunds and other financial assets are protected in Nebraska, but there is a limit as to how much. The laws that protect property in bankruptcy are called exemption laws, and there are two Nebraska exemption laws that protect tax refunds:

  1. Wild Card” Exemption (Nebraska Statute 25-1552). This exemption law protects up to $2,500 per debtor of any type of personal property, including tax refunds. Married couples filing a joint tax return may thus protect up to $5,000.
  2. Earned Income Credit (Nebraska Statute 25-1556). This exemption protects whatever amount of the tax refund that comes from the federal and state earned income credit. There is no dollar limit to this exemption.

 What happens if my tax refund exceeds the amount of exemptions?

If your tax refund exceeds the amount of available exemptions, then the Chapter 7 Trustee has the duty to claim the non-exempt portion of the tax refund and to pay that amount over to your creditors.

Losing a tax refund to the Chapter 7 Trustee should almost never happen, but it frequently occurs because the debtor’s attorney fails to conduct a thorough interview of the debtor and fails to properly estimate the amount of the tax refund.

Estimating the amount of a tax refund is tricky since tax laws change every year and the deductions or credits a person may claim change as well. The practice rule here is that if you are not 100% sure of what the tax refund will be, delay filing the case until the tax return is prepared.

Don’t pay back loans to relatives with the tax refund prior to filing bankruptcy!

Another nasty problem associated with tax refunds occurs when a person uses the refund to repay loans owed to family members and then files bankruptcy shortly thereafter. This is a big mistake. Because bankruptcy law is designed to ensure fair and equal treatment to creditors, any payment made to a family member or “insider” (such as a business partner) must be disclosed and the Chapter 7 Trustee may be able to reclaim the money to redistribute to all of your creditors on a pro rate basis.

Be prepared to tell the Trustee how you spent the tax refund.

If you received a large tax refund and then shortly thereafter file bankruptcy, the Trustee will ask you what you did with the money. Where did all that money go? A good bankruptcy attorney will anticipate this question and provide the answer within the bankruptcy papers (usually on the line where tax refunds are listed). If you received a $10,000 refund and then filed bankruptcy 3 days later, be prepared for a lot of questions at court about how you spent the money.