Foreclosure is a taxable disposition
The IRS treats a foreclosure as a sale or exchange. Your \"amount realized\" depends on whether the debt is recourse or non-recourse. For non-recourse debt, the amount realized is the full outstanding loan balance — even if the property is worth less. For recourse debt, the amount realized is the fair market value of the property; the excess of the loan over FMV is cancellation of debt (COD) income, separately taxable (unless an exclusion applies, such as insolvency or qualified real property business debt).
In either case, if your amount realized exceeds your adjusted basis, you have a taxable gain — and the portion equal to accumulated depreciation is unrecaptured Section 1250 gain taxed at up to 25%.
Phantom income: when you owe tax but received nothing
Consider a rental with: $350,000 non-recourse mortgage, $270,000 adjusted basis (after $80,000 depreciation), FMV $310,000. At foreclosure, amount realized = $350,000 loan balance, gain = $350,000 − $270,000 = $80,000. Of that, $80,000 is depreciation recapture taxed at 25% = $20,000 federal tax — owed even though you received no cash and lost the property. This is the \"phantom income\" problem of foreclosures.
Short sales and the COD income risk
In a short sale, the lender accepts less than the outstanding balance. The deficiency (loan balance minus proceeds) may be forgiven, creating COD income taxable at ordinary rates. Some exclusions apply: Insolvency exclusion (assets minus liabilities at time of discharge), qualified principal residence indebtedness exclusion (only for a main home, not a rental), or bankruptcy discharge. Rental property COD income rarely qualifies for the principal residence exclusion.
Frequently asked questions
Do I owe depreciation recapture if I lose a property in foreclosure?
Yes. Foreclosure is treated as a sale; accumulated depreciation is recaptured as income, regardless of whether you received cash.
What is the difference between recourse and non-recourse debt in a foreclosure?
With non-recourse debt, the lender's only remedy is the property — the full loan balance is your amount realized even if it exceeds FMV. With recourse debt, amount realized is capped at FMV; the excess is cancellation-of-debt income, which is a separate type of taxable income.
Is there any way to avoid the tax on a foreclosure?
Not easily. Insolvency exclusion can eliminate some COD income. A 1031 exchange is not available because you don't control the sale timing. Consult a tax professional before foreclosure to explore options.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.