AM I correct about selling rental House?

[Pacun]

Clients bought a house in 1996 for $150K and made improvements for $52K. 6 years ago they bought a second house and started renting this house and took about $30K in depreciation. The bank repossessed the house in 2012 and the FMV of the house is $212K and the outstanding loans is $300K. The document also states that the client is personally liable.

Clients filed for bankcruptcy and they said that the attorney told them that they shouldn't pay any taxes on the capital gain, to which I don't agree.

Before I reply to my clients' email I want to make sure I am correct.

I told them that they will have to pay taxes on $40K of which $30 will be recaptured as ordinary income. I said that filing bancruptcy will allow them NOT to pay taxes if the bank forgives them the $88K remaining of the unpaid loan.

Is that correct?

[JJStephens]

As I understand it, debt forgiven in a bankruptcy is not subject to tax. It does, however, reduce certain other tax 'attributes' like NOLs, AMT credits, the property's basis, etc. There is a strict order in which the cancellation is used to offset these attributes (see Form 982).

The cancellation of mortgage debt does not always equate with foreclosure on the house. Sometimes the foreclosure occurs inside the bankruptcy but often it occurs later. Although the client would not have to pay tax on the debt cancellation, (s)he may have a taxable event when the house is foreclosed on.