Federal tax liens present special problems in bankruptcy cases, especially in chapter 7 cases where a debtor has equity in their home.  Tax liens in chapter 7 cases can be very dangerous.  That is because the IRS is not subject to the protections afforded by Nebraska exemption laws.

Exemption laws  protect the equity in a debtor’s property.  For example, the Nebraska Homestead Exemption protects up to $60,000 of the equity in a person’s home.  (Value – Mortgage = Equity).  So if a home is worth $100,000 and it is subject to a $40,000 mortgage, the $60,000 of equity is protected by the homestead exemption. Unless . . . . a Federal Tax Lien is present.

The scary part of this is that most bankruptcy attorneys are completely unaware of this danger.  Why?  Because they have never seen a Chapter 7 trustee claim exempt homestead equity.


Bankruptcy Section 724(b) gives the Chapter 7 Trustee the power to utilize a tax lien to liquidate property that they would normally not be able to attack.  State exemption laws do not apply to federal tax lien.  Federal law trumps state law.

Martin and Elvira Laredo found out the hard way how federal tax liens an destroy a chapter 7 case.  The Laredos owned a home valued at $320,235 subject to a first mortgage lien of $224,971 and a second mortgage of $25,000.  The debtors claim a homestead exemption to protect their $70,264 of homestead equity.  They also reported owing the IRS $114,842 and that a Federal Tax Lien had been filed with the county deeds office.

The Chapter 7 Trustee exercised the power of §724(b) and sold their home for $380,000.  The bankruptcy court cited a long list of cases and statutes allowing the trustee to utilize the power of the tax lien normally reserved to the IRS.

Even though the homestead might be exempt under state law from the claims of private creditors, ‘no provision of a state law may exempt property or rights to property from levy for the collection of’ federal taxes owed. See United States. v. Estes, 450 F.2d 62, 65 (5th Cir. 1971).

The power granted in 724(b) allows the bankruptcy trustee to use the secured tax lien powers to benefit other administrative and priority creditors of the estate.

Section 724(b) permits a Chapter 7 trustee to liquidate property subject to a tax lien and to distribute the proceeds to priority claimants before making any distribution to taxing authorities.

The only parties affected by the operation of 724(b) are the priority claimants and the tax lien creditors.  General unsecured creditors do not benefit from this provision.  However, remember that the fees of the Chapter 7 Trustee is a priority claim itself, so a trustee may be disposed to exercise this power for no other reason than to pay his or her trustee commissions. The IRS is normally fine with this result even though their share of the proceeds is reduced since the sale of a home results in some payment of the tax debt.

Is the tax lien problem limited to debtors with substantial home equity?  

No, the tax lien problem in chapter also extends to personal property.  If a debtor owns substantial equity in vehicles, retirement accounts, life insurance policies or other personal property, the tax lien can have the same devastating result.

Is filing Chapter 13 a safer response to the presence of federal tax liens?

As a general rule, chapter 13 is always a safer bankruptcy choice. The bankruptcy trustee in chapter 13 is not empowered to liquidate assets.  However, the IRS will file a secured Proof of Claim for the value of its tax lien in a Chapter 13 case.  So, if a debtor has $20,000 of equity in a home and the IRS files a secured bankruptcy claim, the secured portion of that claim must be paid in full.

The bottom line is that tax liens are dangerous in bankruptcy cases.  Many attorneys fail to investigate if a tax lien accompanies a tax debt, and good attorneys are always seeking out the possible existence of a lien.  Federal tax liens are filed in the county Register of Deeds office, so this is a matter of public record that can be verified.  Avoid hiring cheap bankruptcy attorneys who skip over this important public record search.

Image courtesy of Flickr and John Morgan.