You bought rental property for $240,000. You paid 10% down, $24,000, and took out a mortgage loan for the balance of $216,000. You are not personally liable for the mortgage loan. After making payments that reduced the principal amount of the loan by $18,000, you can no longer continue to make payments. At that time, you had taken depreciation of $8,000 on the property. The bank holding the mortgage forecloses on the property when its fair market value is $190,000.
You realize $198,000 on the foreclosure for the cancellation of debt ($216,000 initial mortgage minus principal payments of $18,000).
Your adjusted basis is $232,000: your original cost of $240,000 less depreciation of $8,000.
You have a loss of $34,000 on the foreclosure ($198,000 realized minus $232,000 adjusted basis). Since this loss is on property held for rental, you may be able to claim the loss, subject to at-risk and passive activity loss limitation rules, and subject to your overall capital gains and losses.
If in this same case, you were personally liable for the debt:
The amount your realize is $190,000, the amount of the cancelled debt ($198,000) up to the fair market value of the property.
Your loss is $42,000 ($190,000 realized minus $232,000 basis).
You have ordinary income of $8,000 ($198,000 unpaid balance of the mortgage loan minus $190,000 fair market value of the property). You would report this income as rental income since it was a rental property.
Exceptions to Having to Report Ordinary Income
The same exceptions that apply for abandonment of property, also apply in the case of foreclosures and repossessions. Income from the cancellation of debt does not have to be reported as ordinary income if the cancellation was intended as a gift, the debt is qualified farm debt, the debt is qualified real property business debt, or you are insolvent or bankrupt.