If you have a rental property that is foreclosed upon or that you abandon, you may have two separate federal income tax issues. You may have a gain or loss on the disposition of the property. And you may have cancelled debt that must be included in your taxable income.
If the lender forecloses on your rental property or you abandon the property, the lender should send you a Form 1099-A, Acquisition or Abandonment of Secured Property. According to the IRS, a foreclosure or repossession is treated as a sale and you may have a gain or loss for tax purposes.
To report the sale of the rental property as a result of the foreclosure or abandonment, you would use Form 4797, Sales of Business Property. Form 1099-A shows the date of the lender’s acquisition or knowledge of abandonment in box 1. This would be considered the date of sale. Box 2 shows the balance of principal outstanding, and box 3 shows the fair market value of the property.
The amount realized on the sale would be either the amount of the principal outstanding or the fair market value of the property, depending on whether the loan is a nonrecourse loan or a recourse loan. Generally, if you were personally liable for payment of the loan it would be a recourse loan and you would use the lesser of the fair market value or the balance of principal outstanding as the sale price. If the loan is a nonrecourse loan, in which you are not personally liable, the amount of the principal balance outstanding would be considered the sale price.
From the amount considered to be the selling price you would subtract your adjusted basis in the property to determine the gain or loss. Your adjusted basis would be your original cost plus any capital improvements you made to the property, less any depreciation allowed or allowable on the property. You would generally have to recapture the depreciation as ordinary income.
If the loan on the property was a nonrecourse loan, the lender’s foreclosure and repossession of the property used to secure the loan is considered satisfaction of the debt and you generally could not be held personally liable for any debt remaining if the fair market value of the property was less than the outstanding loan balance.
But if you were personally liable for the debt and the lender cancels the debt owed on the property, you will receive a Form 1099-C, Cancellation of Debt. The amount of the debt cancelled would normally be included on your tax return as ordinary income. As indicated by the IRS, if the foreclosure or your abandonment of the property and the cancellation of the debt occur in the same year, you may receive only a Form 1099-C.
There are some exceptions when you would not have to include the cancelled debt in your taxable income. These include debt that is cancelled in a bankruptcy or when you are insolvent, the cancellation of qualified farm debt, and the cancellation of qualified real property business debt. If the debt on the rental property is cancelled and you receive a Form 1099-C, you should complete Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), IRS
Form 1099-A, Acquisition or Abandonment of Secured Property, IRS
Form 1099-C, Cancellation of Debt, IRS
Form 4797, Sales of Business Property, IRS
Publication 544, Sales and Other Dispositions of Assets, IRS
Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals), IRS
Topic 160 – Form 1099-A (Acquisition or Abandonment of Secured Property) and Form 1099-C (Cancellation of Debt), IRS
Topic 431 – Canceled Debt – Is It Taxable or Not? IRS