The Relationship Between Bankruptcy and Tax Debt

Millions of people struggle with debt, and bankruptcy can be an effective tool for eliminating some kinds of debt. However, the intersection between bankruptcy and tax debt is more complex than many realize, with specific rules surrounding what kind of debt can and cannot be discharged. Understanding these nuances can help people decide whether or not filing for bankruptcy is an appropriate strategy for their unique financial circumstances.

The Relationship Between Bankruptcy and Tax Debt

When it comes to addressing tax debt, the rules can be even more complicated than with other kinds of consumer debts. For example, while bankruptcy can effectively eliminate many kinds of credit card debt, it typically can’t erase medical bills or student loans. Additionally, federal income taxes — including interest and penalties — are not dischargeable in bankruptcy. However, state taxes and property taxes may be eligible for discharging through the process.

A qualified bankruptcy attorney can help individuals determine the best course of action in their individual circumstances. They can review past tax returns, payment histories and IRS assessments to see if the debts meet specific criteria. These include the following:

The Three-Year Rule: Tax debts must have been due at least three years prior to your bankruptcy filing date in order to be considered for discharge. The Two-Year Rule: In order to be considered for discharge, the tax return that generated the debt must have been filed at least two years before your bankruptcy filing. The 240-Day Rule: Tax debts must be formally assessed by the IRS at least 240 days before your bankruptcy filing in order to be considered for discharge. The Fraudulent Tax Return Rule: If you owe tax debts because of fraudulent activities like underreporting your income or inflating deductions, these types of debts won’t be discharged in bankruptcy.

While you can usually get rid of most tax debts in a Chapter 7 bankruptcy, the federal tax lien will remain in place. A tax lien is a legal claim against your property that protects the government’s interests in your personal property, real estate and financial assets. A tax lien can be removed during a Chapter 13 bankruptcy by paying off the amount of the owed debts from disposable income in a repayment plan over the course of three to five years. However, this does not apply to property tax liens or state income tax liens that were recorded before you filed for bankruptcy. In addition, the bankruptcy code explicitly states that third-party acquired tax claims are not subject to modification of interest rates in a bankruptcy case.