What right to they have to those monies?
1. When a lender initially makes a loan, the lender has both an accounting and a tax basis equal to the principal of the loan.
2. If a borrower cease to repay the loan, the lender obvious has a loss of the principal and the interest income it would have received. Writing off the value of the asset is an accounting decision which is required when the lender determines the loan is not collectible. 3. As a result of the write-off, the lender may be able to deduct the amount written off from its taxes (whether as a capital loss or as ordinary income, depending).
4. At that point, the lender's tax basis in the loan is 0, but the debt is still valid. If it is subsequently collected by the lender, the lender would have to take the amounts collected on the principal into income, where originally only the interest would have been income.
5. Similarly, if the lender sells and assigns the defaulted loan for $.10 on the $1.00 outside of bankruptcy after it has written the loan off, it would have to take the net proceeds of the sale into income. (Though not in bankruptcy).
6. Note that all of this affects the lender's (and purchaser from the lender, whose basis in the loan will be what he paid for it) balance sheet and tax return, not the borrower's obligations.
7. As mentioned before, the borrower's obligations can only be changed by (a) express forgiveness by the lender (or a successor in interest) to the borrower, (b) foreclosure without a deficiency, or (c) the borrower's bankruptcy discharge.