Foreclosures and Repossessions
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).
When you abandon property, you voluntarily and permanently give up possession with the intent to terminate your ownership. An abandonment represents a total loss of your investment or interest in the property. If the property is business or investment property you may have a deductible loss. And the loss may be an ordinary loss (as opposed to a capital loss) even if the property is a capital asset. The amount of the loss is the adjusted basis of the property at the time of abandonment. Abandonment of personal property, such as a home, is not a deductible loss for federal income tax purposes.
An abandonment may lead to the property subsequently being foreclosed on or repossessed. In this case, the gain or loss would be determined according to the rules for foreclosures and repossessions.
Cancellation of Debt
If there is a debt that secures the property, such as a mortgage loan, and as a result of abandoning the property, that debt is cancelled, the amount of the cancelled debt constitutes ordinary income to the person who was personally liable for payment of the debt. This ordinary income for the cancellation of the debt is separate from the ordinary loss for abandonment of the property. Pledging the underlying asset as security for the payment of the debt is not necessarily the same as being personally liable for payment of the debt.
So in the case of abandoned property, it would be possible to have both an ordinary loss, for the abandonment of the property, and ordinary income for the debt that is cancelled, if you are personally liable.
The loss on the abandonment is for the adjusted basis in the property, which could be the purchase price or another basis, depending on how the property was acquired. There could be adjustments to the original basis, such as increases for additions or permanent improvements, and reductions for depreciation deductions or casualty losses.
The income is for the cancelled balance of the debt. This could be the balance of the original mortgage loan to purchase the property. Or the debt could be another type of loan secured by the property that is abandoned.
How To Report Income from Cancellation of Debt
Income resulting from the cancellation of debt related to business or rental activity should be reported as business income or rental income (for example on Schedule C, Profit or Loss from Business, or Schedule E, Supplemental Income and Loss). Income from the cancellation of a non-business, personal debt would be reported on the “Other Income” line on Form 1040.
Income from the cancellation of debt does not have to be included in taxable income
if any of the following apply:
Non-recourse and Recourse Debt
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.
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.
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.