What Happens to Tax Liens After Bankruptcy and Foreclosure?

If you have fallen behind on several of your debts, tax liens may only be one part of your financial difficulties. When unpaid debts pile up, you could end up facing tax liens, bankruptcy proceedings and foreclosures, sometimes all at once. But what happens to tax liens after bankruptcy and foreclosure? Can you escape your tax liens by discharging your debts or walking away from a foreclosed property?

Taxpayer Faces Over a Decade of Financial Trouble

The recent Federal District Court decision, Mock v United States, decided in the Eastern District of Michigan, provides a useful guide to what happens when a taxpayer faces financial difficulties in its many forms. Mr. Mock faced over $500,000 in tax liabilities accrued between 1996 and 2006 (along with $17,000 in trust fund recovery penalties, which he admitted he still owed). In 2010, the IRS obtained a judgement against Mr. Mock. In June 2011, the IRS recorded an abstract of judgment against Mr. Mock’s property in Southfield, Michigan. It also issued Notices of Federal Tax Liens (NFTLs) for the debts.

Around the same time, Mr. Mock filed a Chapter 7 bankruptcy petition. His Southfield home was not included because his mortgage lender had a secured interest, and he did not claim a bankruptcy exemption on the property. When the bankruptcy court issued a discharge on July 30, 2012, the trustee did not administer the property, and deemed the property abandoned. In response, the IRS released its NFTLs before the bankruptcy case was closed.

Statutory IRS Tax Liens vs Judgment Liens

Before digging into the details of what happens to tax liens after bankruptcy and foreclosure, it is important to distinguish between the IRS’s statutory right to impose liens for unpaid tax liabilities, and a judgment lien that is created when the IRS asserts its right as a creditor by filing a claim against the taxpayer in the county in which the taxpayer resides or owns property. The notice of federal tax lien generally states a final date for refiling (ten years and 30 days from the date of assessment) and often contains “self-releasing” language.

A general (statutory) federal tax liens arises automatically by law when a federal tax is owed and unpaid and the IRS makes demand for payment. This can happen without any court filings, simply by the IRS issuing an NFTL. In contrast, a judicial lien is what happens after the IRS files an NFLT in the county in which the taxpayer resides or owns property and stakes a claim against all the taxpayer’s property located there. This judgment lien is considered a secured debt and has priority for payment over other liens filed later by other creditors. A filed lien can lapse based on the language in the NFTL. The IRS can reinstate the lien if the 10-year collection statute of limitations (CSED) has not expired, but it loses its place in line for priority.

Does a Chapter 7 Bankruptcy Discharge Tax Liens?

The federal Bankruptcy Code specifically excludes tax liens against a debtor’s property from discharge. That means that if you have received an NFTL before you file for bankruptcy, that tax lien will survive after discharge, even when other debts don’t. In general, the validity of a lien – including a federal tax lien or a judgment lien – in bankruptcy depends on whether the debtor has property with equity that debt can attach to. If there is equity in the property but the pre-petition tax debts are dischargeable, the bankruptcy will sever the taxpayer’s personal liability to pay the debt (called “in personam” liability), but not the property related obligations to satisfy the tax lien (called “in rem” liability). That obligation will continue along with the property until it is sold or the debt is satisfied, even if the debtor is not personally required to pay it.

What Happens to Tax Liens After Foreclosure?

Mr. Mock’s financial troubles did not end with his bankruptcy. His mortgage holder foreclosed on the Southfield home and held a sheriff’s sale where it purchased the property, subject Michigan state laws allowing for redemption by the debtor. Mr. Mock redeemed the property on May 29, 2015. Around the same period, Mr. Mock ran up new tax liabilities for 2013 through 2016.

This raised the question of whether the foreclosure and sheriff’s sale invalidated the IRS’s judgment lien. As a general rule, when a mortgagor has first priority and forecloses on a property, the sheriff’s sale cuts off the interests of all lower-priority lien holders. However, in Michigan, where this case occurred, the foreclosure deed does not take effect if the taxpayer redeems the property. When Mr. Mock paid off the redemption amount, he also redeemed the junior lienholders’ claims against the property. That included the IRS’s NFTL.

What if the IRS Releases and Then Revokes Release of a Tax Lien

In Mr. Mock’s case, the IRS inadvertently issued a Certificate of Release, which revoked his federal tax liens after the bankruptcy discharge, but before the bankruptcy case was closed. Later, in 2022, (which was within the collections period), it revoked that certificate and reinstated the liens. It was allowed to do that because it followed the required IRS procedures and because the lien attached to the property (in rem liability), rather than to the person (in personam liability). However, as mentioned above, when the IRS reinstates a tax lien, it has a new priority date – in this case 2022 – meaning it will only be paid after any earlier lien holders or creditors have been satisfied.

As for the judgment lien, the IRS doesn’t have the authority to release that type of obligation. Once the case is referred to the Department of Justice, it controls the collections case, including the enforcement of the judgment. The judge in Mock said, even though federal law says that “the underlying obligation might merge with the judgment, a tax lien exists independent of a judgment lien.”

Why Debtors and Attorneys Should Consult Tax Attorneys During Bankruptcy

Mr. Mock could, in theory, have escaped the unpaid tax debts on his property simply by walking away after the sheriff’s sale. While no one wants to lose their home to foreclosure, sometimes the financial and tax consequences of holding on can outweigh the value of the property. That is why debtors and their bankruptcy attorneys should consult with tax attorneys any time there is an NFTL or IRS judgment lien filed against the debtors’ property. Strategic use of bankruptcy exemptions, foreclosure proceedings, and resisting the urge to redeem the property could be far better for the taxpayer and their family in the long run.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 35 years experience. If you have questions about contesting an IRS tax liens or collections efforts, contact Joe Viola to schedule a free consultation.