Unless a statutory exception applies, when a debt is discharged without payment being made, the debtor will have discharge of indebtedness income under Section 108 of the Code. So that the IRS is alerted to this income, Section 6050P requires applicable financial entities to issue an information report to report the discharge of debt.
There are 8 events that give rise to this reporting – 7 of them relate to an event that coincide with an actual discharge of debt. One of them does not – under the 36 month rule reporting is required if no payment has been received on the indebtedness for 36 months (unless debt collection action occurs within 12 months or there are facts and circumstances showing the debt has not been discharged).
This can result in the debtor receiving notice on a Form 1099-C of a discharge, even though one may not really have occurred. There is no law that says that a debt discharge occurs either legally or for federal income tax purposes just because a payment hasn’t been made for 36 months.
This reporting can lead to various problems if the debt was not actually discharged. The IRS may initiate compliance activities based on the Form 1099-C, if the debtor does not report the corresponding income. The debtor may still be subject to collection enforcement activity from the creditor. The debtor may believe he has to report discharge of indebtedness income even though the debt has not been discharged. If the debt is discharged in a later tax year, the IRS may not be alerted to it in that later year.
For these reasons, the IRS has issued proposed regulations to remove the 36 month rule. Presumably neither debtors nor lenders will be interested in raising objections to this rule, and it will be made effective and incorporated in final regulations soon.
Prop Reg § 1.6050P-1
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