In the case of a non-recourse debt, in which the debtor is not personally liable, but the property secures the debt, the amount realized on a foreclosure or repossession is the full amount of the cancelled debt, even if the fair market value of the underlying property is less.
Recourse Debt
If the debtor is personally liable for the debt, the amount realized (for purposes of calculating the gain or loss on the foreclosure or repossession) does not include the amount of the cancelled debt that had to be included in ordinary income. If the fair market value of the underlying property is less than the amount of the cancelled debt, the amount realized includes the cancelled debt only up to the fair market value of the property. In this case, the amount that would have to be included as ordinary income is the amount by which the cancelled debt exceeds the fair market value of the property transferred in the foreclosure or repossession.
In general, in the event of a foreclosure or repossession of property that secures a debt for which you are personally liable, you will have to report as ordinary income the amount by which the canceled debt exceeds the fair market value of the property.
Example 1
You bought a car (for personal use) for $24,000, paying $2,000 down and taking out a loan for the balance of $22,000. You pledged the car as security, but are not personally liable for the debt. After making payments reducing the loan balance by $3,000, you find that you can no longer continue making payments and the lender repossesses the car. The fair market value of the car at that time was $15,000.
You realize $19,000 on the repossession – the amount of debt that was cancelled ($24,000 price minus $2,000 down payment minus $3,000 payments on loan principal).
Your adjusted basis is $24,000, your original cost.
You have a non-deductible personal loss of $5,000 ($19,000 realized minus $24,000 adjusted basis).
If in this same case, you were personally liable for the debt:
The amount you realize is $15,000, the amount of the cancelled debt ($19,000) up to the fair market value of the car.
Your non-deductible personal loss is $9,000 ($15,000 realized minus $24,000 basis).
You have ordinary income of $4,000 from the cancellation of debt ($19,000 unpaid balance of the debt minus $15,000 fair market value of the car). You would report this income as “Other Income” on Form 1040 since the car was a personal asset.