I assume the estate in question has probably received some 1099-C(s) now or in the future (income from the cancellation of indebtedness). Assuming the Estate can file that form for forgiveness -- which I seriously question for several policy reasons -- it would work like it does for living people. You can "ignore" any 1099-Cs you have received.
I am sure you can use it (or similar form) in the "short run" on Form 1041 (very similar to 1040 but for estates) to show why you are not paying income tax on a 1099-C income in that year. However, Form 5495's purpose is "to cut a break" to living taxpayers who are technically bankrupt to save them from having to file a bankruptcy in federal court. In bankruptcy, discharged debt is not income or no one would ever get out of bankruptcy. Note that there is a big difference between cancelled debt (where you may be someone in a tax shelter so it's only fair to charge you with the income from cancellation of indebtedness) and discharged debt which involves a court order to give the person a "fresh start."
First, when the estate settles, if there is money, I have very little doubt the estate is going to have to pay any taxes it may have "escaped" (temporarily) by using Form 5495. You, as executor, can probably use 5495 (or similar form) to explain that you can't pay until the house sells. The estate will owe interest but there should be no penalties, so long as you pay the IRS immediately after the house sale.
These bankrupt estate issues are usually all handled by state law. Usually, creditors, including the IRS, are quite patient in waiting for payment in the probate process. If say a bank, literally, "gets out of line" by attempting to foreclose on a house in an estate, the state judge is just going to tell them "to get back in line" and wait their turn and s/he may award frivolous litigation fees or impose a fine for violating probate procedure.
I think you are worried about personal liability and you should be. But not in the situation you describe unless you have done something illegal or violated probate procedure. However, bankrupt estates are no "fun," you should get an attorney and let him or her handle it. This can be a problem if it looks like they won't ever get paid.
In general, don't worry, about 5%-10% of estates are bankrupt (nearly all are short on cash until assets get sold -- that's a "cash flow" problem, not a bankruptcy). A typical case would be grandma or grandpa have $20,000 equity in their house (usually thanks to 2nd mortgage) but owe $50,000 on his or her credit cards. Sell the house, pay the lawyer and executor (say $10,000) and the credit cards get 20 cents on the dollar (with a copy of the final order of the court stating the estate is bankrupt), hand in the accounting to the court and you are done. There should NOT be a 1099-C in that situation because the debt is discharged, not cancelled.
Now, probate judges, surrogates, etc. do look over bankrupt estates more carefully because there is no other check on the executor or attorney(s) over-paying themselves because the named heirs know they are getting zero. If you've been honest, you won't have a problem.
I have not addressed the incredibly complex issue when such a situation may involve income in respect of a decedent. It also does not consider state inheritance or estate tax.
Good luck -- but make your own "luck" by hiring an attorney!
The above is not legal advice. To give legal advice, I would need to know many more facts and particulars. It is simply a commentary on an interesting question posed by a member of the public and it is answered, under the Constitution, as free speech for the public good. Beware that the answer may be wrong or not apply in all situations. You must privately consult with an attorney to have your exact question in your particular situation answered accurately. No attorney-client relationship exists and no such relationship is anticipated from the answer. The answer is made to provide a commentary or a resource to all members of the public in the future and is not actually made solely for the benefit of the particular person asking the question in the present. Thank you and good luck.
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