Tax Lien

The existence of a Federal Tax Lien in a Chapter 7 bankruptcy case is a dangerous thing. Especially in cases where a debtor has substantial equity in a home or other assets.

Why are tax liens so dangerous?  Because property exemption laws, such as the Homestead Exemption, do not apply to federal tax liens.

Exemption laws protect a debtor’s property when they file bankruptcy. For example, the Nebraska Homestead Exemption protects up to $60,000 of home equity (the difference between the home’s value and the balance of the mortgage).  So, if a debtor owns a home worth $100,000 and the home is subject to a mortgage loan of $40,000, the home is generally protected in chapter 7, unless a federal tax lien is present.

What is alarming is that most bankruptcy attorneys seem to be oblivious to the fact that federal tax liens are not subject to state exemption laws.  In fact, I have spoken to attorneys who falsely believe a federal tax lien actually protects a home since the lien takes away the home equity.  Yes, the lien takes away equity, but it also puts a mighty power in the hands of the Chapter 7 Trustee.

What drives this dangerously false idea of a tax lien protecting property is that few attorneys have witnessed a bankruptcy trustee use the power of bankruptcy code Section 724(b).  I’ve never seen a Nebraska trustee tap the power of 724(b), nor is there any case I’ve seen in Nebraska where a trustee took away a home with this power. Yet, cases exist in other jurisdictions where debtors have lost homes due to the trustee’s use of 724(b).

Martin and Elvira Laredo owned a home in Illinois valued at $320,235 that was subject to a mortgage loans of $245,000.  They owed the IRS $282,268 and reported that a federal tax lien was filed against their home.  The debtors claimed a $15,000 homestead exemption.  In re Laredo, 334 B.R. 401 (2005).  The Chapter 7 Trustee motioned the court for a ruling to determine that the homestead exemption was subordinate to the federal tax lien and the administrative expenses the trustee would incur in selling the home.  The court agreed with the trustee and ordered the home sold even though the only parties who benefited were the IRS and the Trustee.

This result should not surprise bankruptcy attorneys.  Those who represent debtors in Chapter 13 cases should be aware that the IRS will file a secured claim on exempt property when federal tax liens are present.  So, why would the result  in a Chapter 7 be any different?  In theory, the payments to creditors in Chapter 13 should be no less than payments made in Chapter 7 under what is known as the “best interest of creditors test“, so this result should  not be surprising.

At least one Nebraska case has spoken to the power of 724(b), In re Netal, Inc., Case #09-82992.

I suspect the reason we do not see Chapter 7 Trustee’s use the power of 724(b) more is that although the bankruptcy schedules may report that federal tax debts are present, they debtor may not be reporting that a federal tax lien has been filed prior to the bankruptcy.  The debtor’s attorney may also be unaware of the presence of the tax lien unless they perform a public records search.  However, given the duty of a bankruptcy attorney to perform a “due diligence” investigation of the debtor’s assets, income and debts, there is probably a duty to search for and report the existence of such liens.  Also, unless the Trustee seeks out independent confirmation of the existence of the lien, he or she may be ignorant of its presence.  A smart trustee should assume the presence of a tax lien when substantial tax debt is reported even if the lien itself is not disclosed.

A second reason for the lack of 724(b) seizures in Nebraska is the lack of prior history of using this tool.  There is no tradition of 724(b) property seizures in Nebraska, but I suspect that tradition will change over time, especially in a rising housing market.

In conclusion, when substantial tax debts exist, be careful when filing Chapter 7.  Choose your Nebraska bankruptcy attorney carefully.