The income tax consequences of a foreclosure or short sale of real property depend on whether the mortgage debt is recourse or nonrecourse to the taxpayer.  If the mortgage debt is recourse, then the taxpayer is personally liable for any deficiency on the loan.  If the lender forgives such a deficiency, the taxpayer recognizes cancellation-of-indebtedness income, which is taxed as ordinary income.  In contrast, if the mortgage debt is nonrecourse, then the entire balance of the debt is treated as proceeds from the sale of the property, even if it exceeds the fair market value or actual sales price of the property.

As an example, assume that a taxpayer owned a property with a tax basis of $40, subject to mortgage debt of $100, and that the property is sold in a short sale for $75.  If the mortgage debt is recourse, then the taxpayer will recognize $35 of capital gain from the sale, and if the lender forgives the $25 deficiency, then the taxpayer will also recognize $25 of cancellation-of-indebtedness income.  In contrast, if the mortgage debt is nonrecourse, the taxpayer will recognize $60 of capital gain and no cancellation-of-indebtedness income.

A recent U.S. Court of Appeals for the Ninth Circuit case illustrates these rules and raises a number of interesting issues relating to distressed debt.  In Milkovich v. United States, 28 F. 4th 1 (9th Cir. 2022), the taxpayers originally purchased a home with mortgage debt for which they were personally liable.  The debt was subsequently refinanced with another recourse loan, and several years later, the home was underwater and the taxpayers stopped making payments on the loan.