This issue has come up several times in the last few days.  In fact, I as type this, Neal Boortz is discussing it on his radio show.  He even called in Clark Howard to discuss it. First, and most important, I am not a CPA! If you have questions, please discuss it with a qualified tax expert. 

The basic issue is this – if you borrow money, and the debt is later forgiven, it may be characterized as taxable income and you may get a Form 1099 from the lender.  For example, if you borrow $1,000 it is usually not taxable income because you have to pay it back.  However, if the lender tells you to forget about it and "forgives" the debt, you have $1,000 that you don’t have to pay back and it is treated as income.  Similarly, if a lender forecloses on your home, and later sells it for less then you owe, the lender may "forgive" the difference and send you a 1099. 

Does this mean you will have significant tax liability? Maybe, maybe not.  At least two exceptions apply to the bankruptcy context.

Bob Lawless discussed this issue on Monday with this article on the Credit Slips Blog.  Here are the exceptions to the potential tax hit (emphasis mine) —

(1) There are numerous exceptions to the COD rules. For example, "qualified farm property" is an exception. Also, debt canceled in a bankruptcy case is not counted as income. Congress can fix this, if it wants, simply by making excluding from income debt canceled in a bona fide foreclosure or workout on the debtor’s primary residence.

(2) The New York Times story relates the tale of one taxpayer where Wells Fargo had taken back the residence on a credit bid of $1 because no one else appeared at the foreclosure sale. Wells Fargo then reported the entire difference between the mortgage debt and $1 as COD income to the IRS. .. The IRS has enforcement authority over the accuracy of the matters reported to it, and it should make sure financial institutions report the difference between the outstanding debt and the full appraised value of the residence.

(3) The COD rules do not apply when debt is canceled while the debtor is insolvent. One might think that anyone who gives up their home in foreclosure is insolvent, but that may not necessarily be the case. If the mortgage foreclosure makes the debtor solvent, then the COD rules apply to the extent the canceled debt made the debtor solvent. Normally, the burden of proof to show insolvency would be on the taxpayer, as it is for most everything in tax law. The IRS could ease the burden of proof rules here and make it easier for homeowners to show insolvency at foreclosure and avoid COD income.

 The applicable Code section is 26 U.S.C. § 108, which provides, in part, the following —

(a) Exclusion from gross income

(1) In general
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,
(B) the discharge occurs when the taxpayer is insolvent,
(C) the indebtedness discharged is qualified farm indebtedness, or
(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness.

(2) Coordination of exclusions

(A) Title 11 exclusion takes precedence Subparagraphs (B), (C), and (D) of paragraph (1) shall not apply to a discharge which occurs in a title 11 case.
(B) Insolvency exclusion takes precedence over qualified farm exclusion and qualified real property business exclusion. Subparagraphs (C) and (D) of paragraph (1) shall not apply to a discharge to the extent the taxpayer is insolvent.

(3) Insolvency exclusion limited to amount of insolvency In the case of a discharge to which paragraph (1)(B) applies, the amount excluded under paragraph (1)(B) shall not exceed the amount by which the taxpayer is insolvent.