You have gain on a foreclosure if the sale price is greater than the adjusted/depreciated basis. For example, in 1980, D buys house for $25,000. Because it’s an investment property, he depreciated $5000 off of that. Meanwhile, he borrowed $50,000 against it in 1995 to put on an addition, and then in 1998 he borrowed $200,000 against it to buy Dot Com stock, and in 2005 he borrowed another $300,000 against it to buy Lehman stock. His debt on the house is now $510,000, let’s say. It’s now worth $250,000, and that’s what it forecloses for. He has $260,000 cancellation of indebtedness of income ($510,000 – $250,000) (some of which may be excludible), and he has $180,000 in capital gain ($250,000 – $70,000 basis ($25,000 + $50,000 – $5000)). The gain is just as if the house sold in a private sale for that price. Gain is excludible if the house is a primary or secondary residence, but not for investment property. COI income can be excluded from taxability on 3 grounds: 1) discharge in bankruptcy (so if the BK is filed first, there is no taxable COI income); 2) to the extent of insolvency, which uses a no-exemption balance sheet approach. If our debtor has $5000 of “stuff” apart from the underwater house — since all of his stock is worthless — and $50,000 of other debt, the entire COI income would be excluded because the debtor remained insolvent after the forgiveness. But if he had $5000 in other debt and $100,000 of “stuff” (including an IRA), he is solvent by $95,000 after the forgiveness, and thus $95,000 of the COI income is taxable; 3) for foreclosures in late 2008 and 2009, on principal residences, the COI income would be excludible to the extent attributable to the acquisition and improvement cost. But in our example, the foreclosure proceeds more than covered the acquisition and improvement cost, so no exclusion there. For any of these, Form 982 is used. If property is abandoned pre-foreclosure, the estate benefits if there is a taxable capital gain and no net proceeds (surplus). Debtor would benefit if there is a surplus (yeah, right…), or if there is a loss on the foreclosure that is allowed to be claimed as a deduction/offset against gains taxable to the debtor on the return. In bk, COI income is not taxable to the debtor or the estate, so that does not come into play.
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