Under IRS regulations, some creditors are required to report the cancellation of debt to the IRS with form 1099-C and send a copy to the party whose debt was cancelled. The cancellation of debt can occur by a settlement with the creditor, by a foreclosure, repossession of personal property or other circumstances. As cancellation of debt is not usually perceived by a consumer as "income", it often comes as a surprise to learn that the IRS considers the cancellation as taxable income--what I have taken to calling "phantom income."
IRS Form 982. Offsetting Phantom Income
If the income tax return filed for the applicable year does not include the "phantom income", the IRS treats the dollar amount of the cancellation on the 1099-C report as unreported income and recalculates income, taxes and penalties owed. However, the recipient of a form 1099-C may be able to file IRS form 982 to effectively offset the income. (Generally, the form requires that the person prove they were "insolvent," at the time of the forgiveness of the debt: having filed bankruptcy is presumptive proof of insolvency.)