Foreclosures and Involuntary Conversions

If your property is foreclosed upon, repossessed, or destroyed due to theft, condemnation, or other casualty, you should report the event as a sale of the property.

A foreclosure or repossession is generally treated in the same way as a sale. Your gain or loss for tax purposes is the difference between your adjusted basis in the property, and the amount (if any) you receive. Cancellation of debt is treated as an amount that you received for this purpose.

If your property is lost or destroyed by theft, vandalism, condemnation, or a natural disaster such as a fire, tornado, flood, landslide etc., you may have a taxable gain if you receive some insurance payment, condemnation award, or damages in a lawsuit. If the amount you receive is less than the amount of your loss, you may have a deductible casualty loss provided that the property was used in a trade or business or was investment property.

However, even if there is a taxable gain, you generally can postpone payment of tax on the gain if you reinvest the proceeds in similar property costing at least as much as the amount you received.

Your tax basis in the new property would be the same as your tax basis in the old, destroyed property, and you would not be taxed on the cumulative gains until you sell the replacement property. The replacement property would generally have to be purchased within two years of receiving any payments that exceed your tax basis in the old property, or within three years if the property was used in a trade or business, or for investment. A special four-year replacement period applies to homes (and their contents) damaged by presidentially declared disasters.

The Katrina Emergency Tax Relief Act of 2005 extends the replacement period for both business and personal residence property from four to five years. The longer time period applies to property damaged on or after August 25, 2005, as a result of Hurricane Katrina. In addition, the replacement property must be located in the Katrina disaster area to qualify for the extended replacement period.