Forgiveness of Tax Liability is Benefit of Colorado Bankruptcy

Due to the turmoil in the real estate markets in the Denver metro area and nationwide, I’ve consulted numerous clients in Colorado facing a potential tax liability stemming from what is referred to a Discharge of Indebtedness income. Normally, the IRS and Colorado Department of Revenue will deem to be gross income (for taxable income purposes) the amount of debt forgiven when a lender voluntarily agrees to forgive a mortgage debt, for instance, when a short sale or deed in lieu of foreclosure is effectuated.

For instance, if your mortgage debt on a house is $300,000 but the house is only valued at $225,000 at the time the mortgage lender agrees to re-take the surrendered property, the mortgage lender is essentially forgiving approximately $75,000. (For purposes of simplicity, I’m not factoring in cost of sale or other transaction costs.) In the year of disposition, both the IRS and Colorado Department of Revenue require that you add $75,000 (the discharge of indebtedness income) to your gross income. Particularly for taxpayers in a higher marginal tax bracket, this can turn out to be a very large tax hit.

But, bankruptcy is an exception to the requirement to include discharge of indebtedness income as taxable income. So, in a chapter 7 or chapter 13 bankruptcy in Colorado, a bankruptcy debtor can not only discharge most or all unsecured debt, including the previously secured debt on a home (which is now unsecured debt due to the surrender of the home) but also avoid the imposition of gross income for agreeing to voluntarily surrender real estate back to the mortgage lender. Particularly for bankruptcy filers in Colorado who are upside down (e.g. have negative equity) by a wide margin, avoiding the imposition of tax liability for the surrender of a home can serve as a significant financial benefit.

Please note that a Colorado bankruptcy blocks the imposition of tax liability EVEN IF the mortgage lender mails you (and the tax authorities) a 1099COD following the property’s surrender.