There are times when the creditors write off debts after a set period of time like one, two, or three years after default. The creditor stops all its collection efforts, declares the debt not collectable, and reports it to the IRS as lost income to reduce its tax burden. IRS will still want to collect tax on this money and turns to the debtor. Generally, when a creditor dissolves the debtor’s obligation to repay a debt, the amount of that debt becomes income and it is taxed to the person owing the debt. However, the amount canceled is not treated as income if a debt is canceled under a bankruptcy proceeding.
A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. The discharge prohibits the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts. Even if the debt is a secured one such as a mortgage or a car loan, still the creditor cannot collect the debt. However, the creditor has the right to recover the collateral.
The discharge happens when a bankruptcy case is concluded. For Chapter 7 filers, that is typically about three and a half months after the bankruptcy petition is filed. For Chapter 13 filers, this typically occurs a month or two after the Chapter 13 payment plan is completed.
If the debt, that is forgiven or written off is more than $600.00 of the debt’s principal the creditor is required to file Form 1099-C, a federal tax form to both the debtor and to the IRS. The box marked “bankruptcy” should be checked on 1099-C to demonstrate to the IRS that the listed debt has been discharged. In case this is not done, the debtor can file Form 982 to inform the IRS that this debt was included in bankruptcy and should therefore be free from taxation. Form 982 allows the debtor to reduce the amount of taxable income by the amount of any debts that is discharged in bankruptcy.