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Be careful what you do with your tax return before bankruptcy

Every tax season, millions of Americans rely on their tax returns to help them catch up on bills and find a little extra for special purchases.

Unfortunately, tax returns can become complicated issues once you file for bankruptcy. Once you've filed, any tax return you are due becomes a part of your bankruptcy estate and you aren't entitled to spend it until the trustee determines if any of that money is exempt.

Even if you wait until after your tax return is received and safely spent to file your bankruptcy, what you did with that money can become a problem.

You may have some debts that you feel guilty about including in your bankruptcy. It isn't uncommon, for example, for people to borrow from their friends or relatives when they're in a financial bind. Maybe when times were good, you even took a significant loan from a parent or sibling.

You can't use your tax return to pay that relative back or selectively pay off any of your debts if you intend to file for bankruptcy. If you do, that's considered a preferential transfer and the trustee on your case can demand the money back in order to divide it up fairly among all your creditors.

So what can you safely use your tax return for if you intend to file for bankruptcy? Some options include:

  • Paying your bankruptcy attorney, plus court fees and filing costs associated with your bankruptcy itself
  • Paying essential bills, like your electric, water and gas bills -- although you should not pay ahead
  • Paying for repairs to your car or home that are necessary in order to maintain its value or usefulness

In general, the closer it gets to tax return season, the wiser it is to discuss your tax return with a bankruptcy attorney before you spend it. An attorney can guide you through your options and help you understand what you're entitled to do and what can lead to trouble down the line.

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