Your accountant is correct. I always advise my clients of this possibility, particularly when they have loss carryforwards they are taking on their taxes each year because they will lose those before any basis reduction is required. It all depends on the amount of debts discharged and the amount of attributes you have.
Section 108 of the Internal Revenue Code (26 U.S.C. 108) provides for the exclusion of debt discharged in bankruptcy from income, but requires a reduction in specific tax attributes in the following order:
Any net operating loss for the taxable year of the discharge,
and any net operating loss carryover to such taxable year.
(B) General business credit
Any carryover to or from the taxable year of a discharge of
an amount for purposes for determining the amount allowable as
a credit under section 38 (relating to general business
(C) Minimum tax credit
The amount of the minimum tax credit available under section
53(b) as of the beginning of the taxable year immediately
following the taxable year of the discharge.
(D) Capital loss carryovers
Any net capital loss for the taxable year of the discharge,
and any capital loss carryover to such taxable year under
(E) Basis reduction
(i) In general
The basis of the property of the taxpayer.
(ii) Cross reference
For provisions for making the reduction described in clause
(i), see section 1017.
(F) Passive activity loss and credit carryovers
Any passive activity loss or credit carryover of the taxpayer
under section 469(b) from the taxable year of the discharge.
(G) Foreign tax credit carryovers
Any carryover to or from the taxable year of the discharge
for purposes of determining the amount of the credit allowable
under section 27.
Congress has the power to make any laws it wants. This is how they modified the Internal Revenue Code with regard to bankruptcy cases.
It sounds like you're upset at the law. This country has many laws. Some are fair and some are not. Not everyone likes every law. But it is the law. The way to change laws is to contact your Congressional representatives.
Mark Markus has been practicing exclusively bankruptcy law in California since 1991. He is a Certified Specialist in Bankruptcy Law by the State Bar of California Board of Legal Specialization, AV-Rated by martindale.com, and A+ rated by the Better Business Bureau. His webpage is www.bklaw.com
Legal disclaimer: Mark J. Markus practices law in California only. The information is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation. Answering this question does not in any way constitute legal representation.
You wrote, "So now my accountant says I have to reduce my cost basis [in the real estate] by the amount discharged . Therefore in the future if I sell the house I could potentially pay capital gains tax . What ? If I sell the bank get all the money to cover the liens . Why do I have to pay cap gain ?"
I am not a tax attorney, but if the hypothetical future sale covers the existing lien and puts $10,000 of sales proceeds in your pocket, it sounds like income to me.