I don’t usually post about questions I don’t know the answers to.  Llooking stupid in public is just not something I go out of my way to do.  Today, however, is an exception.

Here is the question.  What are the tax consequences for someone who is in a Chapter 13 Bankruptcy in which a 2nd mortgage is being lien stripped (treated as wholly unsecured with a lien release at the end of the plan) if the mortgage company as part of the National mortgage settlement forgives the 2nd mortgage?

Answer?  I have absolutely no idea.  The general rule is that forgiveness of debt is taxable income.  There are three exceptions to that:  1.  if the debt is discharged in bankruptcy;  2.  if the Debtor is insolvent at the time of the transfer; or 3.  if the property was bought as the debtor’ homestead and the forgiveness qualifies for the Mortgage Forgiveness Debt Relief Act.

Problems — the Mortgage Forgiveness Debt Relief Act is set to expire the end of this year.  As far as I can tell extending it is not a partisan issue, it just is a not important enough to get it done when you could be out campaigning issue.  So, if the debt forgiveness isn’t done in time, that act sunsets December 31, 2012.  So, that might help you; and it might not.

Insolvency seems like a no-brainer, this question assumes a bankruptcy filing.  Except the IRS definition of insolvency includes exempt assets like retirement accounts.  That can be a problem.

Bankruptcy discharge should be the safe and easy one — except it’s not.   Here’s the problem.   Mortgage company issues its 1099 after the first of the year.  (Taking the forgiveness outside of the statutory relief, although, that would not apply to a rental property.)  Tax liability will be assessed on the 2013 tax return.  Debtor is in year two of a five year Chapter 13 plan.  Debtor doesn’t get his discharge until 2015.  Taxes have already been assessed.   Discharge exception might not work, but then again, it might.

Oh, and this is the simple reading of this issue.  I’ve been reading discussion between tax geeks that I don’t even understand about this issue.  Now, if you will excuse me, I’m going to go bang my head slowly against hard objects until I feel better.

Elaine