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I lost a rental property to foreclosure. What taxes might I owe?

The IRS treats a foreclosure or short sale of a rental like a sale. You may have a gain or a loss on that sale, and you may also have income from forgiven debt. A loss on a rental may be deductible, which is not true for your own home. The special tax break for forgiven debt on a main home never covered rentals, but other rules may still help.

By Guillermo Serafin, broker and owner of Serve First Realty. Updated October 2026.

How does the IRS see a rental foreclosure?

To the IRS, losing a rental to foreclosure is a sale, even if you handed the keys back on your own. There can be two separate tax pieces:

  • A gain or loss on the "sale" of the property.
  • Ordinary income from canceled debt, if the lender forgave part of what you owed.

Which pieces apply depends on two things: whether you were personally liable for the loan, and whether you owed more than the property was worth.

Were you personally liable for the loan?

A loan you are personally liable for is called recourse debt. A loan where only the property backs the debt is called nonrecourse debt. The IRS treats them differently.

  • Recourse loan: your "sale price" is the smaller of the loan balance or the fair market value. If the lender forgives debt above the value, that forgiven part may be ordinary income.
  • Nonrecourse loan: your "sale price" is the full loan balance, even if the property was worth less. You do not have canceled-debt income, but your gain may be bigger.
  • California's anti-deficiency laws may affect which group your loan falls in. A tax professional can tell you. See our guide on recourse and nonrecourse loans.

Why does depreciation matter?

Each year you took depreciation on the rental, your adjusted basis went down. Your basis is roughly what you paid plus improvements, minus depreciation. A lower basis can create a gain on paper, even when you lost money in real life.

Here is one example from the IRS. An owner bought business property for $200,000 and took $20,000 of depreciation, so the adjusted basis was $180,000. The nonrecourse loan balance was $185,000, but the property was only worth $150,000. The owner still had a $5,000 gain, because the full $185,000 loan counts as the sale price.

If your basis is higher than your sale price, you have a loss. For business or investment property, that loss may be deductible. IRS Publication 544 explains how gain tied to depreciation is treated.

Can forgiven rental debt be left out of income?

The federal exclusion for forgiven debt on a main home does not apply to rentals. For a main home, it generally covers only debt canceled before January 1, 2026, or under an arrangement made and put in writing before that date. But other exclusions may help:

  • Bankruptcy: debt canceled in a bankruptcy case is not taxable income.
  • Insolvency: if your debts were more than everything you owned just before the debt was forgiven, you may leave out income up to that gap. Try our insolvency worksheet.
  • Qualified real property business debt: you may choose to leave out forgiven debt on business real estate. The IRS says residential rental property generally counts, unless you also used it as a home. Limits apply.
  • Each exclusion is claimed on IRS Form 982. Most of them make you lower other tax items, such as your basis or loss carryovers.
  • If forgiven rental debt is taxable, the IRS says it is reported on Schedule E, line 3.

What about California taxes?

  • The Franchise Tax Board says that after a foreclosure on a rental, you may still leave out canceled debt if you were in bankruptcy, were insolvent, or made the federal election for qualified real property business debt.
  • The FTB also says forgiven nonrecourse debt generally does not create canceled-debt income.
  • If you sell in a short sale, California withholding may apply, generally 3 1/3 percent of the sale price. A short sale does not get the loss exemption just because you get no cash. You must actually figure a loss or zero gain on Form 593. See our short sale withholding guide.
  • Foreclosure sales and deeds in lieu of foreclosure are not subject to this withholding.

What papers should you gather?

  • Form 1099-A and Form 1099-C from your lender. These usually come early the next year. Learn more in our 1099-A and 1099-C guide.
  • Your purchase closing statement and receipts for improvements.
  • Your past tax returns showing depreciation for the property.
  • Your last loan statement before the sale, and any proof of the property's value.
  • Any notes on rental losses you could not use in past years. Ask your tax professional about them.

What should you do next?

  • Talk to a tax professional, such as a CPA or enrolled agent, before you file.
  • Use our tax checklist to stay organized.
  • Read more on our taxes page.

General information, not tax advice. Tax rules can change, so check IRS.gov/Pub4681 for updates. Sources: IRS Publication 4681 (2025), IRS Publication 544, California Franchise Tax Board Mortgage Forgiveness Debt Relief page (updated December 17, 2025), and FTB Publication 1016 (revised February 2026).

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