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What can be done about Federal Tax Liens in Bankruptcy?

Many are our clients are shocked to learn, that if done correctly and if other criteria are met, a Chapter 7 Bankruptcy can discharge all personal 1040 back taxes.  That’s right, huge tax debts can be completely wiped out a a Chapter 7 personal bankruptcy.

But one of the problems is in cases where the taxpayers own real property and a federal tax lien was filed. See, a personal bankruptcy discharges the personal debt. But when the IRS files a notice of federal tax lien, it in a sense, makes the personal debt in rem (fancy Latin legal phrase meaning “against the property”). So while Chapter 7 will get rid of a personal debt, the IRS can still enforce the debt through a property, if possible.

A strange concept. So let’s use a hypothetical.

Bill and Murray Johnson owe the IRS $450,000.00 to the IRS for tax years 2004-2006 for returns that were filed on time. They own a property free and clear that is worth $500,000.00 at 123 Caddyshack Lane (in the town of Spaulding).  In 2009, the IRS filed a Notice of Federal Tax Lien in the amount of $450,000.00 After research is completed, it is determined that a Chapter 7 Bankruptcy will discharge the the entire $450,000.00 tax bill for 2004-2006.

So… should they file bankruptcy?

Well they need to consider something very carefully. While the $450,000.00 against them personally is gone, the tax lien, despite the bankruptcy discharge, is still attached to 123 Caddyshack Lane. Meaning, the IRS can still take enforcement action (that is foreclosure or seizure) against their property. With no other liens or mortgages on the property, and no other means of collection (after all the IRS can’t go after wages or bank accounts as the persona debt is gone), the IRS, if no other collection alternative is accepted, could very well collect on the debt, even though it was discharged in bankruptcy.

Now on the other hand, let’s suppose same facts, but that Bill and Murray have a first and second mortgage on the property at 123 Caddyshack Lane  in the amounts of $400,000.00 that were recorded in 2007 well before the Federal Tax lien. Would be be a good idea to file Bankruptcy?

Well now it looks much better. If they keep the mortgages out of bankruptcy, the IRS will be discharged, but the mortgages will stay on as is. And as well, the tax lien stays on. But here’s the thing —

In that case, because the IRS is well behind the mortgages, the IRS tax lien is essentially worthless — in a seizure or foreclosure the first and second mortgages have to be paid off and there is no way if a property is worth $450,000 in optimum fair market conditions that the IRS would even get $350,000.00 at auction. The IRS can’t seize the property when there are these two large mortgages ahead of them.  So in that case, if the IRS isn’t going to take any action on the lien, a taxpayer may request a discharge on the Federal Tax lien — meaning it has become of no affect. Once they pay off their mortgage or sell their house, they will not have to worry about the tax lien.

So to recap:

Chapter 7 and abundant equity? Not usually a great idea, even if possible.

 
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