The IRS rules require the 1099 reporting when the lender experiences certain events. Your legal obligation to pay ended, but the lender still was owed money - it just could not collect from you anymore. You need to file form 982 for the tax year of the 1099. This form tells the IRS that you discharged the debt in bankruptcy (among other possibilities) and it is not considered income, despite the 1099
I would suggest that you stop taking legal advice from your creditors. Although the bank is free to send you a 1099 if it makes them happy, the IRS isn't going to assess taxes on you for a debt discharged in a bankruptcy.
Take a look at the link below to see what the IRS says about your tax responsibility after bankruptcy/ Hope this perspective helps!
You wrote, "What good is a Chapter 7 if I am liable for the debt after they sell the house? HELP!"
It is not a question of your liability to the lender, but rather your obligation to pay taxes on this "phantom" income