Actually (and speaking as an Enrolled Agent) I wouldn't be panicking yet either. There is a significant loophole in the taxability of discharged debt that many people facing this issue overlook.
I direct you to Internal Revenue Code Section 108(a)(1)(B) and 108(a)(3) which allows a taxpayer to exclude from income "indebtedness that occurs while the taxpayer is insolvent (but not involved in bankruptcy proceedings) up to the amount by which the taxpayer is insolvent."
Translated into common language and everyday usage, as long as, after the debt cancellation, you still owe
more than you own
then you can exclude the cancelled debt from your income and tell the IRS to stuff their 1099C. In the absence of anything to the contrary, IRS will always assume the taxpayer solvent and the 1099C is fully taxable.
How do you show you are insolvent? First, let's take a look at the concept of insolvency. The IRS' own Procedure Manual, the Internal Revenue Manual, defines Insolvency thus:
Generally understood to mean an inability to pay debts as they become due. However, the Bankruptcy Code refers to an insolvent entity as one whose debts are greater than the fair market value of its assets (11 USC § 101(32)). A debtor need not be insolvent to file bankruptcy.
So... for tax purposes, if you cannot pay your debts, then discharging a debt is some sort of assistance (and hence the concept of taxability - being relieved of the requirement to repay it makes what you recieved in the form of a loan de facto income). BUT.... if you still can't pay your remaining debt after the discharge, you are still insolvent. Think of it this way - you are on a ship in the middle of the ocean and the ship starts to sink - and you have no life boat, no life preserver and you can't swim. Does it matter how deep the ocean is as long as you cannot reach the bottom?
Congress, recognizing this dilemma, allows the exclusion of cancelled debt that allows no real relief from the debt burden. As long as, after the cancellation of the debt, you are still insolvent, you are still insolvent and have realized no constructive taxable income.
How does one take this benefit? Simple - when you file the return where the 1099C income is to be recognized, you add the 1099C into the Other Income line of teh 1040 and then prepare aBalance Sheet as of the date of the debt cancellation listing what you own (at fair market value) and what you owe (at full value). As long as you owe more than you own, you are still insolvent. You attach the balance sheet to the tax return and take the 1099C out of your income as an Adjustment to Income. If the cancellation
makes you solvent, you recognize the cancellation income only up to the amount that you became solvent by. If the 1099C coms to your battention after you have filed, you can amend the tax return or (if the IRS is sending you a CP2000 document matching letter) reply to the letter with the balance sheet and the statement that you are excepting the 1099C under IRC 108(a)(1)(B) and 108(a)(3). Here are some examples:
1099C in the amount of $10,000 in all cases.
Case 1: Balance sheet shows assets after debt cancellation of $50,000 and debts of $65,000. The taxpayer is still insolvent, and none of the cancelled debt is income.
Case 2: Balance sheet shows assets after debt cancellation of $50,000 and debts of $45,000. Since the taxpayer is solvent by only $5,000 after the cancellation of debt, that is the amount of debt cancellation income the taxpayer recognizes.
Case 3: Balance sheet shows assets after debt cancellation of $50,000 and debts of $5,000. Since the amount of debt cancellation is less than the amount by which the taxpayer is solvent, the taxpayer recognizes the full $10,000.
BTW, Rotty - your Accounting theory is a bit off. The tax benefit to the lender is realized at the charge off of the debt, not at the issuance of the 1099C.