Losing a rental or investment property to foreclosure is hard enough. Many investors are surprised to learn it can also come with a tax bill, even when the property was worth less than the loan. Here is why that happens and what you can do about it.

The IRS treats a foreclosure like a sale

When the lender takes the property, the IRS looks at it as if you sold it. So the question becomes the same as any sale: what did you "get," and what was your cost?

What you "get" is debt relief. The loan goes away. Your cost is what you paid, plus improvements, minus all the depreciation you took over the years.

Why depreciation creates the surprise

Depreciation is the yearly write-off you take on a rental. It lowers your taxes each year. It also lowers your cost in the property for tax purposes.

Here is a simple example. Say you bought a building for $1,000,000 and took $400,000 of depreciation over the years. Your tax cost is now $600,000. The loan balance is $900,000, but the market has dropped and the property is worth only $750,000.

You might think you lost money. On paper, the IRS may see a gain.

It depends on what kind of loan you have

If you were not personally on the hook (often called a nonrecourse loan, where the lender can take the property but cannot come after you for the rest), the IRS treats you as receiving the full loan balance. The Supreme Court settled this, even when the loan is bigger than the property's value.

In the example, that is $900,000 minus your $600,000 cost, a $300,000 gain. There is no separate canceled-debt income on top of it.

If you were personally on the hook (a recourse loan, where the lender can come after you for any shortfall), the IRS splits it in two:

  • The sale part uses the property's value. $750,000 minus $600,000 is a $150,000 gain.
  • If the lender forgives the remaining $150,000 of the loan, that forgiven amount is canceled-debt income, taxed like ordinary income unless an exception applies.

How the gain is taxed

Gain that comes from building depreciation you took is taxed at up to 25 percent federally.

If you did a cost segregation study, part of your depreciation was on shorter-life items like fixtures, appliances, or land improvements. Gain tied to that depreciation is taxed as ordinary income, at your regular rate.

On top of that, many investors owe the 3.8 percent net investment income tax on gain from rental property.

Ways to reduce canceled-debt income

If the lender forgives debt, a few exceptions may help:

  • Insolvency. If your debts were more than everything you owned just before the debt was forgiven, you can leave out forgiven debt up to that shortfall.
  • Business real estate debt. If the loan was tied to real estate you used in a business, you may be able to elect to leave out the forgiven debt. The amount is limited to how far the loan was above the property's value, and to your tax cost in the depreciable real estate you own. In exchange, you lower your cost in that real estate, so the tax comes back later when you sell.
  • Paying for the exclusion. Most exclusions are not free. You reduce other tax benefits, such as loss carryforwards or your cost in property.

You claim these on Form 982.

The forms you will get

The lender usually sends Form 1099-A when it takes the property. If it also forgives debt of $600 or more, you may get Form 1099-C instead of, or along with, the 1099-A. Check that the numbers match your loan statements. Lenders make mistakes.

If you own through a partnership or LLC

Many investors hold real estate through a partnership. The tax still lands on you, through your K-1.

When the partnership loses the property, your share of its debt goes away. The IRS treats that drop as if the partnership handed you cash. If that "cash" is more than your tax cost in your partnership interest, you have gain. A negative capital account on your K-1 is often a warning sign that this could happen.

The canceled-debt exceptions are decided at your level, not the partnership's. For example, whether you were insolvent depends on your own finances.

California

California taxes all capital gains as ordinary income. There is no lower rate. The 3.8 percent tax is federal only.

California has its own rules on forgiven debt. The FTB lists the business real estate debt exclusion among items that can make your California numbers differ from your federal ones. Your California return may not match your federal return line for line.

What to do now

  1. Get your loan documents. Find the note, the deed of trust, and any personal guarantee.
  2. Ask whether the loan is recourse. In plain terms, can the lender come after you personally? The answer changes the math.
  3. Figure your tax cost. Pull your purchase records, improvements, and every year's depreciation schedule.
  4. Look at the options. A deed in lieu (handing the property back), a short sale, or a loan modification can each come out differently on taxes. A modification may avoid a sale altogether.
  5. Call your CPA before anything closes. Once the foreclosure or sale happens, the choices narrow.

These situations are stressful, and the numbers are rarely what people expect. If your property is heading toward foreclosure, or you just got a 1099-A or 1099-C, reach out. We are glad to walk through it with you.

This article is general information and not tax advice for your situation.

Sources: IRS Publication 4681. Treas. Reg. §1.1001-2, including Example 8. Commissioner v. Tufts, 461 U.S. 300 (1983). IRC §§108, 1016, 1(h), 1245, 1411, 731, 752. Form 982 and Form 1099-A/1099-C instructions. FTB 2025 Schedule CA (540) instructions. Full links in SOURCES.md.