When you sell an investment property or rental property at a loss and you have an outstanding debt on the property that is cancelled, you may have ordinary income for tax purposes for the cancelled debt and a tax deductible loss, depending on the circumstances. This could be the case for a short sale, in which you sell the property for less than the balance outstanding on a mortgage loan.
Whether the cancellation of debt is taxable or not depends on whether the debt is recourse or non-recourse. Recourse debt is debt for which you are personally liable, beyond the value of the property that secures the debt. Non-recourse debt is debt that is secured by the property and you cannot be held personally liable for the excess of the debt over the value of the property. As indicated by David M. Fogel, CPA, loans secured by rental property may be recourse loans, such as in California, and it may be necessary to consult a real estate attorney if there is any doubt.
If the debt is recourse debt and the debt is discharged, you would have ordinary income subject to federal income tax for the cancelled debt. This cancellation of debt income would be the principal balance of the debt owed minus the fair market value of the property.
As pointed out by Curtis Webley, CPA, Ph.D. there are some exclusions for which the cancelled debt would not have to be included in taxable income. These include bankruptcy, insolvency, qualified farm indebtedness, and qualified real property business indebtedness. You may also qualify for the qualified principal residence exclusion if you used the property as your principal residence and later converted it to a rental property. As indicated by Michael C Gray, CPA, this exclusion from gross income of the discharge of qualified principal residence debt has currently been extended until the end of 2013.
If you exclude the cancellation of qualified real property business debt from your ordinary income, you would have to reduce your basis in the property by the amount of cancelled debt. In the case of a short sale, this reduction of your basis would be done immediately and would reduce the amount of your loss.
According to the IRS, property held for the production of rents is generally considered business property and the loss on the sale would therefore generally be deductible as a Section 1231 transaction. Whether the loss is treated as ordinary or capital depends on whether you have other Section 1231 transactions and whether the net result of all your transactions is a net gain or loss. If the net result of all your Section 1231 transactions is a net loss, it is treated as an ordinary loss for federal income tax purposes.
A Section 1231 loss would be reported on Form 4797 and could offset the ordinary income that may have to be reported for the cancellation of debt.
The loss on the sale of the property would be considered a capital loss if the property was not business property, such as rental property, but instead was property held as an investment. The capital loss can be deducted up to a maximum of $3,000 per year and the unused loss can be carried over and deducted in future years indefinitely.
Curtis Webley, CPA, Ph.D., Taxation of abandonments, foreclosures and repossessions, Journal of Accountancy
Tax Consequences of a “Short Sale” of Real Estate vs. Foreclosure, Michael C. Gray, CPA
Publication 544, Sales and Other Dispositions of Assets, IRS
Tax Aspects of Rental Property Foreclosures and “Short Sales”, David M. Fogel, CPA