A reader asks: If a second lien is stripped in a chapter 13, and the mortgage lender issues a 1099 before the discharge is entered, is the cancellation of debt income still excluded from gross income under IRC Section 108?
Answer: The debt is not uncollectible until there is a discharge that gets rid of it. The lender can’t issue the 1099, even if there is a confirmed plan that hoses it on 70% of the debt, because the debtor may flake out and never complete the plan, win the lottery, and HELOC lender can collect. But lenders aren’t always rational about their issuance of 1099s. If the debtor gets a 1099 during or after a year when he was in bankruptcy, the debtor should file Form 982 with his return explaining why the 1099 doesn’t represent taxable income.
IRS can’t assess the tax on COD income until either the taxpayer reports it on his return, or it goes through the deficiency process audit, Tax Court, the whole enchilada. FTB can assess as soon as it thinks it’s being abused, but it would just about never open an audit on this issue before the IRS would.