With the housing market collapse and the rise in short sales and foreclosures, many former homeowners are faced with the consequences of left-over debt from their mortgage. While deficiency judgments will force many into bankruptcy, there are also problems when the debt is forgiven in the form of cancellation of debt income.

What is cancellation of debt income? Generally, debt that is forgiven by a lender creates tax consequences for the debtor – the lender issues a 1099-C on the cancelled debt, and the IRS considers the cancelled debt as income to the debtor. However, there are exceptions to this rule, and, depending on the circumstances, cancelled debt may not create any tax liability, even if the debtor is no longer required to pay the debt. This (rather lengthy) article discusses the impact of bankruptcy on cancelled debt. (Note: The IRS Code has other exemptions that may apply and eliminate some or all tax liability on cancelled debt, such as The Mortgage Forgiveness Debt Relief Act or the insolvency exception to cancelled debt income. These exceptions are beyond the scope of this article.)

Scenario 1: You file for bankruptcy, and receive a discharge of your dischargeable consumer debts. Are you required to pay taxes on the debt that was discharged in the bankruptcy?

Answer: No. According to 26 U.S.C. § 108(a)(1)(A):

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

(A) the discharge occurs in a title 11 case [i.e., Bankruptcy],

(B) the discharge occurs when the taxpayer is insolvent,

(C) the indebtedness discharged is qualified farm indebtedness,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013.

Therefore, as long as the debt was properly discharged in bankruptcy, the cancelled debt will not create any taxable events for the debtor.

Scenario 2: You have your house listed in a short sale, which the bank approves. Unfortunately, other factors ultimately require that you file bankruptcy. After you file (or after you receive your discharge), the mortgage lender sends you a 1099-C for the cancelled debt income of the forgiven balance of the mortgage. Do you have to pay taxes on the cancelled debt income?

Answer: No. As above, since the discharge of the underlying debt (the first mortgage, in the example above) occurs in a bankruptcy case, 26 U.S.C. § 108(a) applies. In this case, the code requires that the amount of the debt, although “forgiven" by the mortgage lender, was discharged in bankruptcy, and therefore, excluded from the debtor’s gross income.

Scenario 3: You are attempting to avoid bankruptcy, and have your house listed in a short sale. The bank approves the short sale, and you are hoping that your real estate attorney will be able to convince your lender to “forgive" the deficiency. The lender does in fact forgive the deficiency, and sends you a 1099-C for the cancelled debt income of the forgiven balance of the mortgage. Unfortunately, other factors (such as a second mortgage that will not be “forgiven" or credit card debt) ultimately require that you file bankruptcy. Do you have to pay taxes on the cancelled debt income?

Answer: Scenario 3 creates a question of timing. Here, the difference between this example and the example above is that the lender “forgave" the debt and issued a 1099-C before the debtor filed a bankruptcy case. This raises the question as to whether the debt was legally cancelled by the lender, and therefore could not have been discharged in bankruptcy.

So, then, the question becomes: “Can a bankruptcy filing discharge debt that has already been forgiven, in order to avoid the tax consequences of cancellation of debt income?"

The mere fact that a creditor has issued a 1099-C is not, in and of itself, an admission by the creditor that it has released the debt and can no longer pursue collection, nor does a 1099-C legally discharge the debtor from liability of the debt that is described on Form 1099-C. See In re: Zilka, 407 B.R. 684, 688-689 (2009).

Zilka was not the first time the Court was required to address this issue, and specifically stated in its ruling:

The Internal Revenue Service, which regulatory agency is the one that promulgated 26 C.F.R. § 1.6050P-1, and whose interpretation of the same is thus entitled to great deference (citation omitted), does not view a Form 1099-C as an admission by the creditor that it has discharged the debt and can no longer pursue collection [thereon]. See 2005 WL 3561135 at 689 (Dec. 30, 2005).

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Forms 1099-C, as a matter of law, do not themselves operate to legally discharge debtors from liability on those claims that are described in such Forms 1099-C. See Owens v. Commissioner, 67 Fed.Appx 253, ___, 2003 WL 21196200 at 3 (5th Cir.2003) (issuance and filing of Form 1099-C does not constitute actual cancellation of the loan).

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Form 1099-C…only serves to report (strictly for tax purposes) information regarding an event that has already happened, which reporting of information cannot possibly be stretched or strained to also constitute a present contractual agreement not to sue, or a present contractual renunciation of rights against, a debtor. See Leonard v. Old National Bank Corp., 837 N.E.2d 543, 545-546 (Ind.Ct.App.2005) (filing a Form 1099-C is merely an informational filing with the I.R.S., done to report an event that has already happened, and thus does not operate to cancel debt itself).

See In re: Zilka, 407 B.R. 684, 688-689 (2009). See also IRS Publication 4681.

Based on the above precedent, even if a lender issues a 1099-C prior to a bankruptcy filing, the issuance of the 1099-C does not serve to legally discharge the debt. If that debtor then files bankruptcy, they should then include that debt on their bankruptcy schedules to ensure that it is discharged. And as long as the debtor included the underlying debt in the debtor’s bankruptcy case (and ultimately received a discharge of that debt), 26 U.S.C. § 108 applies, and the mere issuance of the 1099-C prior to the bankruptcy case, the cancelled debt will not create any taxable events for the debtor.

Finally, when a lender issues 1099-C, even if no tax is due, the debtor should discuss this issue with a CPA to ensure that his tax returns are properly filed to exempt the 1099-C income from the debtor’s gross income.