Will Filing Bankruptcy Affect My Tax Return?

Filing for bankruptcy is a significant legal and financial decision with wide-ranging effects, including on your tax obligations. The process introduces specific rules and procedures that interact directly with how you handle past, present, and future tax matters.

Discharging Past-Due Taxes in Bankruptcy

One of the primary concerns for individuals with tax problems is whether bankruptcy can eliminate their existing tax liabilities. Under specific circumstances, federal income tax debts can be discharged in a Chapter 7 bankruptcy. This relief is not automatic and is subject to a strict set of timing rules that must be satisfied for the debt to be eligible.

The first condition is the “Three-Year Rule,” which requires that the tax return’s original due date, including extensions, must be at least three years before you file for bankruptcy. For example, a tax debt for the 2021 tax year, due on April 15, 2022, would not be eligible for discharge until after April 15, 2025.

Another requirement is the “Two-Year Rule,” which mandates that the tax return for the debt in question must have been filed at least two years prior to the bankruptcy petition. This prevents individuals from filing long-overdue returns right before bankruptcy to have the associated debt discharged. Taxes from unfiled returns or those associated with fraudulent filings are not dischargeable.

The “240-Day Rule” stipulates that the IRS must have formally assessed the tax liability at least 240 days before the bankruptcy filing date. Assessment is the official recording of the tax debt by the IRS, and this period can be extended by events like an offer in compromise. Even if the underlying tax debt is discharged, a pre-existing tax lien filed by the IRS against your property may survive the bankruptcy, meaning the lien remains attached to the property until it is paid.

Filing Tax Returns During Bankruptcy

When an individual files for Chapter 7 or Chapter 11 bankruptcy, the law creates a new legal entity known as the “bankruptcy estate,” which consists of the debtor’s property at the time of filing. This creates distinct tax filing obligations for both the individual debtor and the estate, which is managed by a court-appointed trustee.

The debtor is required to file their personal federal income tax return, Form 1040, for the entire tax year in which the bankruptcy was filed. The return covers income earned both before and after the filing date, and failure to file can lead to the dismissal of the bankruptcy case.

If the bankruptcy estate generates sufficient income, the trustee must file a tax return for the estate using Form 1041, the U.S. Income Tax Return for Estates and Trusts. The trustee must obtain a new Employer Identification Number (EIN) for the estate, as the debtor’s Social Security Number cannot be used. The estate’s return reports income earned on its assets during the administration of the case.

A strategic option available to debtors is the “split-year election,” which allows the debtor to divide the tax year of the bankruptcy filing into two short tax periods. The first short year ends the day before the bankruptcy petition is filed, and the second begins on the filing date. The benefit is that the income tax liability from the first short year becomes a claim against the bankruptcy estate, potentially being paid from the estate’s assets rather than the debtor’s post-bankruptcy income.

What Happens to Your Tax Refund

A tax refund is considered an asset, and its treatment in bankruptcy depends on when the income that generated it was earned. Any refund attributable to earnings from before the filing date becomes property of the bankruptcy estate. The trustee has the legal authority to claim this portion of the refund to pay your creditors.

The refund is prorated based on the filing date. For instance, if you file for bankruptcy on July 1st, approximately half of your tax refund for that year is considered a pre-petition asset belonging to the estate. The remainder, attributable to income earned after the filing date, is a post-petition asset that belongs to you.

The IRS is authorized to send the pre-petition portion of the refund directly to the bankruptcy trustee. While the refund is property of the estate under federal law, some state exemption laws may allow a debtor to protect a portion or all of it. Any refund generated from income earned after the bankruptcy case is closed belongs entirely to the individual.

Refunds for tax years that concluded before the bankruptcy filing are entirely pre-petition assets. For example, if you file for bankruptcy in March 2025 before filing your 2024 tax return, the entire 2024 refund is considered property of the estate.

Tax Implications After Your Bankruptcy Case

When a creditor cancels a debt, the forgiven amount is normally considered taxable Cancellation of Debt (COD) income. A significant benefit of bankruptcy is that debts discharged within a formal case are excluded from your gross income. To claim this exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your tax return for the year the debt was canceled.

There is a trade-off for this exclusion, as the law requires you to use the excluded COD income to reduce certain tax attributes. By reducing these attributes, the tax on the canceled debt is effectively postponed, as you lose future tax benefits you might have otherwise claimed. The attributes that must be reduced include:

• Net Operating Losses (NOLs)
• Certain tax credits like the general business credit
• Capital loss carryovers
• The tax basis of your property