A charge-off usually happens after you’ve been delinquent on a debt for 180 days or six months. This is the creditors way of taking a loss on the debt. In their accounting books, they’ve written it off as uncollectible and they no longer count the debt as an asset. However, creditors can still continue collecting on a charge-off until you pay.
In some circumstances, the creditor may cancel the debt completely. When this happens, you no longer have responsibility for the debt. However, the creditor will report the cancelled charge-off to the IRS using Form 1099-C cancellation of debt. The IRS considers any cancelled debt as income and you’re to report the income on your tax return for that year. This could increase your tax liability and result in a smaller income tax refund or even require you to pay additional income taxes to the IRS.
You’re also required to do this when a charge-off is settled because the creditor cancels a portion of the debt in the settlement offer.
If you were insolvent, meaning you had a negative net worth, at the time the debt was cancelled you may not have to report all or part of the charge-off to the IRS. You must file IRS Form 982 (PDF link), Reduction of Tax Attributes Due to Discharge of Indebtedness, to claim the insolvency exemption.