A foreclosure or repossession of property on which you have a debt is treated as a sale or exchange for income tax purposes. You may realize a gain or loss on the foreclosure or repossession. This is determined the same way as for a sale or exchange – the difference between the amount realized and your adjusted basis in the property.
Cancellation of Debt
In the case of a foreclosure or repossession, the amount realized is the debt that is cancelled. Part of the amount realized may constitute ordinary income, rather than gain or loss on the foreclosure or repossession. If the amount of debt that is cancelled is more than the fair market value of the property, and you are personally liable for the loan (a recourse loan), the difference is ordinary income, subject to the normal income tax rate that applies in your case. If you are not personally liable for the debt (non-recourse loan), you do not have any ordinary income from the cancellation of the debt.
Gain or Loss
Your adjusted basis in the property is the same as it would be in the case of a sale or exchange – your original basis (cost or other basis, depending on how you acquired the property), plus any additions or improvements, and less any depreciation claimed on the property, casualty losses, or other adjustments.
The difference between the amount realized (the amount of cancelled debt plus any other proceeds you may have received from the foreclosure) and your adjusted basis, is your gain or loss on the foreclosure or repossession. If there is a gain, it could be a personal capital gain (reported on Schedule D) or a capital gain on business property (reported on Form 4797). If it is a loss, it could be a non-deductible personal loss, a loss on property held for investment (Schedule D), or a loss on business property (Schedule 4797).