What are the tax implication of foreclosures?

On November 21, 2008, in Bankruptcy, Foreclosure, Mortgages, Taxes, by David C. Winton

An issue where questions keep recurring and I’m hearing from a variety of sources that there is not much good advice available is with the tax treatment of cancelled debt on foreclosure of investment property.

I posted a few months back on the tax treatment of foreclosure of one’s principal residence, but how, if at all, does that change if the real estate securing the debt is investment property?

The short answer is that if the real property is Qualified Business Real Property and the debt that is being cancelled is Qualified Real Property Business Debt, then there is NO income tax on the cancelled debt.

Now we need to back up to figure out how you get there.  I think the easiest way to approach it is through a gatekeeper or flowchart approach.

Here are the various IRS publications which address the issue.

The uber-publication in the IRS library that deals with the tax treatment of canceled debt is IRS Publication 4681.    This deals with the the subject from several different angles, and addresses both the principal residence exception, as well as the exception for so-called “qualified real property business indebtedness.”

1.  There is no tax liability incurred for the cancellation of debt when the cancellation is incurred in a bankruptcy proceeding.  (See 26 USC 108(a)(1)(A).)  It doesn’t matter what the property securing it is, how much the cancelled debt is, or what the nature of the property that secured the debt might have been.

2.  There is no tax liability for the cancellation of debt that was incurred to purchase, improve or construct one’s principal residence.  This subject is addressed elsewhere on this blog, and I won’t repeat myself here.

IRS Publication on taxation of cancelled debt.

IRS Publication 523 on Selling Your Home

IRS Publication 544 on Sales and Other Dispositions of Assets

IRS Publication 908 Bankruptcy Tax Guide

IRS Publication 334 (Chapter 5, page 23) on “Qualified Real Property Business Debt.”  Page 23

Also IRS Publication 334 here.  This is a better cite.  With hyperlinked sections.  This is done by filing IRS Form 982.


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