When you are foreclosed on a rental property you need to know what your potential tax issues will be with regard to the foreclosure. First, you need to know that a foreclosure is considered a sale for tax purposes. You also need to know that when debt is canceled or forgiven by a lender and you are personally liable for the debt, the amount of debt forgiven is consider cancellation of debt (COD) income.
First, lets look at the deemed sale portion of the transaction. Just as if you sold the property yourself, you will need to determine your capital gain of loss on the property. The fair market value of the property will be the sales price and you will deduct your tax basis in the property from this amount to determine your capital gain or loss. Your basis is typicaly the amount you paid for the property, less any depreciation allowed or allowable, and any adjustments to basis for cancellation of debt, improvements, etc. The result of this calculation will give you your capital gain or loss. Depreciation allowed or allowable will also be recaptured as in a normal sale.
Next, you must calculate your COD income. This is the difference between the Fair Market Value of the property and the amount of the debt. The amount of the debt that is cancelled is COD income. This is typically ordinary income, but there are several exclusions in the code for this income. If you are insolvent you can exclude COD income to the extent you are insolvent, if the debt is non-recourse you can exclude COD income, and if you are bankrupt and include the debt in your petition for bankruptcy the COD income is excluded from your income.
Also, don't forget to pick up any prior suspended passive losses in your calculation of capital gain or loss on the property. Since this is considered a sale for tax purposes you can now use these suspended losses.