Many debtors in California file chapter 7 bankruptcy with a home that has an IRS tax lien on it. What happens in these cases? If the IRS has a federal tax lien on real property in California prior to a bankruptcy being filed, then that lien will survive bankruptcy. In other words, debtors cannot use bankruptcy to escape an existing federal tax lien on a California property, despite the fact that California bankruptcy law allows chapter 7 filers to take up to $678,000 in equity in a primary residence through bankruptcy. The IRS’s lien supersedes California’s Homestead Exemption and the Bankruptcy Trustee may even sell a California house with an IRS lien to repay the back taxes owed. Ouch. This does not happen often for reasons I explain below, but it’s always a possibility in a bankruptcy involving a house with an IRS lien, so extra planning is critical before filing such a bankruptcy. How does this work?
IRS Tax Liens Attach to the Debtor AND Property
A bankruptcy discharge erases the tax debt of the person filing bankruptcy but it does not erase the IRS’s lien on the house. A California debtor thus can get through bankruptcy with their debts discharged (erased), but the house still owes the taxes, even after the debtor does not. The lien attaches to the property itself, not just to the person owning the property. Bankruptcy discharges the debts of the person, but not of the liened property.
This raises an obvious question: Does the IRS withdraw its lien when a Californian successfully goes through bankruptcy? (Insert soundtrack of my raucous laughter here): no. The IRS will not withdraw liens unless the tax debt is paid off; the only other way to get an IRS lien removed is to have it expire. The IRS won’t withdraw liens because it is a law enforcement agency, tasked both by Congress and by internal norms and procedures, to administer the enforcement of US tax laws fully and consistently. If the IRS lifts the liens on the homes of people in bankruptcy, then that is “special” treat that invites many other exceptions. And the IRS won’t go there.
Why Doesn’t the IRS Sell a House with a Tax Lien Before the Bankruptcy?
The IRS very rarely sells homes on which it has tax liens, even though it has every legal right to do so. The IRS almost never forces a sale and eviction for two reasons, both of which contribute to the IRS’ goal of maximizing voluntarily compliance by taxpayers with US tax laws.
First, if the IRS attempts to throw the owner of a home on which it has a tax lien out of the house almost as soon as it files the lien with the County Recorder, then the IRS has not given that taxpayer a reasonable opportunity to willingly pay their tax debt. The IRS wants taxpayers to cooperate and pay what they owe, and it avoids harsh collection actions. In this way, the lien on the house is more of a carrot than a stick. The IRS uses the lien notice as an inducement to the taxpayer to cooperate and begin repaying their tax debt, usually by entering an Installment Agreement. Significantly, the IRS doesn’t place liens on homes until it has tried for months and even years to negotiate a payment plan with the taxpayer. And this “lien as carrot” approach works: many of my clients come to me only after the IRS has filed the Notice of Federal Tax Lien (many were hoping – foolishly – that their IRS problem would go away if they just ignored it).
Second, throwing people out of their houses creates a public relations nightmare for the IRS. Aggressively moving to evict causes the taxpayer to stop cooperating with the IRS and resist the IRS instead. Not only does the taxpayer become more hostile toward the IRS, but so do that taxpayer’s friends and family. Increased resistance and hostility to the IRS undermines the agency’s legitimacy, and makes it less effective in enforcing US tax laws – so the IRS mostly avoids enforcing its legal right to sell properties with tax liens on them. In 25 years at the IRS and then in my own tax law practice, I have only twice seen the IRS move to sell a house with a tax lien on it and, in both instances, the taxpayers continued to be uncooperative for years after the Notice of Federal Tax Lien was filed on the house.
So, if the IRS almost never enforces its liens on houses before a bankruptcy is filed, then why would a debtor’s home with a Notice of Federal Tax Lien on it be in jeopardy of being sold after a bankruptcy is filed? The danger comes not from the IRS but from the Bankruptcy Trustee. If certain highly specific conditions are met, then the Bankruptcy Trustee overseeing the bankruptcy can and will sell that house. How does that work?
What’s the Bankruptcy Trustee’s Incentive to Sell A House with a Tax Lien?
The Bankruptcy Trustee (who is like the Judge on a bankruptcy) faces very different incentives from the IRS – incentives that tilt toward selling the house. When a person files for bankruptcy, everything they own temporarily becomes the legal property of the Trustee administering their case. This means the Trustee now gains the legal right to sell the house with the tax lien, particularly if selling will pay off some part of the debt owed to unsecured creditors (such as credit cards). The Trustee also gets paid primarily with fees from administering the sale of assets and paying off creditors with the proceeds. Thus, the Trustee not only has a profit incentive to sell, but also a broad mandate to sell: pay off creditors and get paid to do so.
But the Trustee also faces disincentives to sell: it takes time and effort to administer the bankruptcies. No Trustee will go through the hassle of doing so for just a few thousand dollars, either in fees or in repayment of creditors. And the trustee is not allowed to do so if the sale does not generate funds for unsecured creditors. There’s an “activation” threshold that needs to be met before Bankruptcy Trustees seriously consider selling a house. Unfortunately, there is no single standard or precise amount that triggers a sale. Individual Trustees have full discretion over when and whether they will sell. The more an attorney has worked with a specific Bankruptcy Trustee, the better the chance that attorney knows what that Trustee’s activation amount is for a sale. This is one of many reasons why having an experienced bankruptcy attorney administer the bankruptcy is a good idea. (Call me!)
What’s the IRS’s Power over the Sale of a House by A Bankruptcy Trustee?
So the Bankruptcy Trustee has more incentive to sell a house with a tax lien than the IRS does. But it still rarely occurs. Why? Because the numbers need to work, and a bankruptcy judge must approve the sale. Because the numbers rarely work without the IRS agreeing to a discount on what it is owed, the Trustee needs to negotiate with the IRS first, then bring the deal to a judge for blessing. A lot can go wrong here.
The bankruptcy code allows the Trustee to avoid the tax lien to the extent that it secures penalties, not principal. 11 USC § 724(a), 726(a)(4). If the house sale would pay off only tax principal, the Trustee has no power to sell the house: all the proceeds would go to the IRS, a secured creditor, and unsecured creditors would get nothing, a result the bankruptcy code does not allow.
Avoiding the penalties in a tax lien can create a fund for unsecured creditors. But the amount of penalties that can be avoided is usually pretty small, so not worth it for the Trustee to go to the trouble of selling. But what if the Trustee reaches a deal with the IRS? The Trustee can ask the IRS to voluntarily forego some of its principal in return for selling the house at all. Then both parties benefit, at the expense of the taxpayer/debtor: the IRS gets tax money paid that it wouldn’t otherwise see, and the Trustee gets a fee for selling the house. The debtor gets nothing.
It’s a hard needle for the Trustee to thread, because the IRS will not approve the sale of any house that doesn’t full-pay or come very close to full-paying the principal and interest (at least 75% or higher) on the tax debt. Why? The IRS is not in the business of “settling” for what it can get today. Again, the IRS is a law enforcement agency, tasked with the consistent administration of tax laws. It must attempt to collect the debt, no matter how long that takes, or even if the IRS never gets paid, because the taxpayer owes ALL of that tax debt and settling for less is unfair to taxpayers who full pay their taxes. And the unfairness that is the result of IRS discretion erodes the IRS’ legitimacy. And the IRS does everything in its power to prevent that. Which means the IRS always waits in the hope of collecting the full tax owed, even if that’s far in the future such as when the house finally is sold by the debtor/owner or when the debtor has finally paid all that’s owed with decades of monthly payments. Because the IRS won’t approve a sale that doesn’t full pay or come very close to full paying the principal and interest on the principal (federal law allows penalties and interest on penalties to be ignored — geek out and read section 724(a &b) of the US Bankruptcy Code!) that’s owed, a Bankruptcy Trustee won’t even consider selling a house with a tax lien on it.
How Much Must the Proceeds of a Sale Be For the Trustee to Sell a House with a Tax Lien?
A Bankruptcy Trustee needs to raise more money from the sale of a house with a tax lien than is needed to pay off the IRS tax debt on it. The sale also needs to generate money to (1) pay for the administrative costs of the sale (Trustee expenses and cost of the attorneys Trustees hire which is at least $50,000-$100,000), and (2) at least a small pool of money for the unsecured creditors in the bankruptcy. Payment of the unsecured creditors is a legal requirement for the sale of a house. In other words, if both the IRS could be full-paid, and the Trustee’s expenses for the sale fully taken care of, a Bankruptcy judge would still not approve that sale because the unsecured creditors must receive at least something from the sale.
The bottom line: very few bankruptcies involving a house with a tax lien have enough equity in the house to (1) satisfy the full amount of the IRS tax debt, (2) pay for a Trustee’s administrative expenses of the sale of the house, and (3) have a pool of money left with which to at least partially pay unsecured creditors.
But it’s still risky to file bankruptcy when the case involves a house with a tax lien. If there’s equity in the property that comes close to what’s owed the IRS, there’s always the possibility the Bankruptcy Trustee will exercise her discretion and sell the house. But there’s also a way to lower that possibility.
How to Make the Sale of A House with a Tax Lien by the Trustee Even More Unlikely
A debtor’s attorney can lower the risk of having the Trustee sell a house by having their client take out a home-equity-line-of-credit (HELOC) before filing bankruptcy. The HELOC reduces the amount of equity in the home that the Trustee will eye for repayment of creditors, thus reducing the likelihood the Trustee attempts to sell the house.
There are many lenders who will make loans on house with IRS tax liens, as long as the IRS agrees to subordinate its lien to the new loan. Why does the IRS agree to such subordination? Because the IRS gains partial payment of the tax debt immediately, while preserving its ability to collect more of the debt in the future with the lien. Note how the IRS is not giving up on being full paid over time, which is consistent with its law enforcement goal.
Bottom Line: Sales of a House with a Tax Lien by a Trustee are Rare but not Impossible. Moreover, if a debtor has Enough Equity in their Home to Full-Pay a Tax Debt, It Will be Hard to Keep the House From Doing Just That
June 14, 2023