Filing bankruptcy? What you can and can't do with your tax refund

I am a bankruptcy attorney in Phoenix ($995/Chapter 7) and find that most people considering filing for bankruptcy have no idea that it is very serious how they treat their tax refund. In fact, it is so important that it can affect when someone files for bankruptcy. The reason is because the bankruptcy laws prohibit you from spending that money frivolously. If you receive a tax refund and spend it on frivolous items within 90 days of filing for bankruptcy, the court may demand that you pay it back into the bankruptcy for your creditors. It is best to spend it on necessities like rent, food, gas and utilities. Don't spend it on creditors you intend to discharge, like credit cards and medical bills, because the bankruptcy court may seize it back and redistribute it amongst all your creditors. And if you intend to file for bankruptcy, you're really just throwing that money away by paying creditors you intend to write off.

If you receive a tax refund during your bankruptcy, the bankruptcy court will seize it and distribute it amongst your creditors. So if you are expecting a tax refund, it's best to file bankruptcy after you have received it and spent it on regular expenses. 

The timeframe for scrutinizing your tax refunds lasts well after your bankruptcy is discharged, until you receive your next refund. The bankruptcy court will likely seize that refund too, so many of my clients choose to have the least amount possible withheld from their paychecks after filing bankruptcy to avoid that scenario.

The most important thing to be aware of about tax refunds in bankruptcy is that you could get into real trouble in this area if you are not careful. A couple of weeks ago when I was in a 341 Meeting of the Creditors with a client, we observed another bankruptcy proceeding go sour. The woman filing bankruptcy told the trustee that she had received a $5000 tax refund a few days earlier, which her daughter took out of her checking account. The trustee announced that she was going to hire an attorney and sue her daughter to get the money. The lesson is to always be upfront about your activity and consult an attorney about bankruptcy so you don't make mistakes like that.

The good news is you can safely spend your tax refund on a bankruptcy proceeding. More than 200,000 households around the country will do that this year.