What Is Bad Debt in Real Estate? Deductions, Foreclosure, and Reporting

Bad debt in real estate is a mortgage or other property-secured loan that the lender treats as uncollectible, usually after the borrower stops paying and the collateral cannot cover what is owed. Because nearly every real estate loan is tied to a physical asset, the resulting tax consequences depend on two questions above all others: whether the loan is recourse or nonrecourse, and whether the person claiming the loss is a lender in the trade or business of lending or a private party who made a one-off loan. Those two questions decide the size of the deduction, whether the borrower owes tax on any forgiven balance, and which forms have to be filed.

What Makes a Real Estate Loan Uncollectible

A loan typically slides into bad-debt territory after a stretch of missed payments, a bankruptcy filing, an abandonment, or a foreclosure that leaves the lender short. The other common trigger is a collateral value that has dropped below the loan balance, leaving the lender underwater on the property that was supposed to secure repayment.

Before anything else, identify whether the loan is recourse or nonrecourse. With a recourse loan, the lender can pursue a deficiency judgment against the borrower’s other assets when the property sale falls short. With a nonrecourse loan, the lender’s recovery stops at the collateral. Most commercial real estate loans are nonrecourse; residential mortgages vary by state. That single distinction reshapes the tax result for both sides of the transaction.

How a Lender or Investor Deducts the Loss

IRC Section 166 splits uncollectible loans into two categories, and the category controls almost everything about the deduction.¹

Business Bad Debt

A business bad debt is one created or acquired in connection with a trade or business. Banks, mortgage lenders, and real estate professionals whose lending activity reaches trade-or-business level fall here. The treatment is favorable in two ways. The loss is deductible against ordinary income with no dollar cap, and a partial deduction is allowed for the uncollectible portion of a loan that is only partly worthless, as long as the creditor charges off that portion during the tax year.¹ That partial-worthlessness rule matters in real estate, where a foreclosure sale often recovers something but not enough to make the lender whole. Sole proprietors report business bad debts on Schedule C; other entities use their applicable business return.²

Nonbusiness Bad Debt

A nonbusiness bad debt is any uncollectible loan not connected to a trade or business. Lending money to a friend or relative to buy property, secured by a personal note, is the classic example. The IRS treats the loss as a short-term capital loss regardless of how long the debt was outstanding.¹ Capital losses can only offset capital gains plus $3,000 of ordinary income each year, or $1,500 for married filing separately.³ Excess amounts carry forward, but a large real estate loss can take decades to absorb at that pace.

Two more restrictions apply. Nonbusiness bad debts must be totally worthless before any deduction is allowed; there is no partial write-off. And they are reported on Form 8949 as a short-term capital loss, with an attached statement describing the debt, the debtor, the collection efforts, and the reasoning for treating it as worthless.²

Timing and Evidence

The deduction is claimed in the year the debt actually became worthless, which is often later than the year payments first stopped. The IRS expects proof of reasonable collection efforts before a write-off: completed foreclosures, confirmed bankruptcies, and documented demands all support a worthlessness claim.² Keep demand letters, communications, and evidence of the property’s value at the time of the write-off. Weak documentation is where bad-debt deductions collapse on audit.

What Foreclosure Does to the Borrower’s Taxes

For the borrower, losing a property to foreclosure or handing it back to the lender is a taxable event, and the recourse/nonrecourse label drives the calculation.

On a nonrecourse loan, the IRS treats the foreclosure as a single sale transaction. The amount realized equals the full unpaid loan balance, even if the property is worth less. Gain or loss is the difference between that amount and the borrower’s adjusted basis. There is no cancellation of debt income, because the lender never had a right to pursue the borrower personally.⁴

On a recourse loan, the transaction splits in two. First, the property disposition uses the property’s fair market value as the amount realized, producing gain or loss against basis. Second, any loan balance forgiven above that fair market value is cancellation of debt income, which is taxable unless a Section 108 exclusion applies.⁵ The result catches many borrowers off guard: it is possible to owe tax on a property that lost money, because the forgiven slice of the loan is treated as income.

Two forms track the paperwork. Form 1099-A reports the lender’s acquisition of the property or the borrower’s abandonment of it. Form 1099-C reports canceled debt of $600 or more.⁵ If both events fall in the same calendar year, the lender may issue only a 1099-C covering both. Errors on these forms are common, and a borrower who ignores an incorrect one can end up paying tax on phantom income.

When Canceled Real Estate Debt Is Excluded From Income

Forgiven debt is generally treated as taxable income under IRC Section 61.⁶ Section 108 lists five exclusions that can pull that income back off the return.⁷

Debt discharged in a Title 11 bankruptcy case is excluded entirely.
Insolvency lets a borrower exclude canceled debt up to the amount by which total liabilities exceeded the fair market value of total assets immediately before the cancellation. This is the exclusion distressed real estate borrowers use most.
Qualified real property business indebtedness applies to non-C-corporation borrowers whose canceled debt was incurred in connection with real property used in a trade or business and secured by that property. The exclusion is capped at the excess of the principal over the property’s fair market value, and cannot exceed the total adjusted basis of the borrower’s depreciable real property.
Qualified farm indebtedness is a parallel exclusion for farming operations.
Qualified principal residence indebtedness previously sheltered debt discharged on a primary home, but it expired for discharges occurring after December 31, 2025, unless the borrower had a written discharge arrangement in place before that date. For 2026, this exclusion is effectively unavailable for new arrangements.⁸

The qualified real property business indebtedness election is often overlooked by rental and commercial property owners who hold through pass-through entities. It can shelter substantial canceled debt, but it requires reducing the basis of depreciable real property by the excluded amount, which raises taxable gain on a later sale. That trade-off runs through every exclusion. None of them are free; each requires a corresponding reduction in tax attributes such as basis, net operating losses, or credit carryforwards.

Any exclusion is claimed on Form 982, filed with the return for the year the cancellation occurred.⁹

Alternatives That Precede a Write-Off

Lenders usually work through several options before treating a real estate loan as uncollectible, and each option comes with its own tax footprint.

Foreclosure forces a sale of the collateral, either through the courts or under a power-of-sale clause. The proceeds are applied to the balance, and if the loan is recourse and comes up short, the lender may pursue a deficiency judgment.
A deed in lieu of foreclosure transfers title voluntarily to the lender in exchange for release from the mortgage. It skips the formal foreclosure process but produces the same tax consequences.
Loan modification changes the original terms, often by cutting the rate, extending the term, or reducing principal. A principal reduction triggers cancellation of debt income for the borrower.
A short sale lets the borrower sell at market value with the lender accepting less than the full balance. The shortfall is reported on Form 1099-C.

Recoveries After a Bad Debt Write-Off

If a creditor writes off a real estate debt and later recovers some of it, the tax benefit rule under IRC Section 111 controls the outcome. The recovery is included in gross income only to the extent the original deduction actually reduced the creditor’s tax in the prior year.¹⁰ If part of the deduction produced no benefit, perhaps because the creditor had no taxable income that year, the matching part of the recovery stays out of income. Creditors carrying real estate portfolios need to pair every write-off with its later recovery precisely, because the IRS expects the two to match.

Reporting Duties on the Lender’s Side

Under IRC Section 6050P, any applicable entity that cancels $600 or more of a borrower’s debt must file Form 1099-C with the IRS and send a copy to the borrower by January 31 of the following year.¹¹ Reporting is triggered by an identifiable event: a bankruptcy discharge, a foreclosure, a negotiated settlement, or a decision to stop collection. Separately, when a lender acquires secured property through foreclosure or knows the borrower has abandoned it, Form 1099-A is required.⁵ Borrowers should read both forms carefully before filing, because the amounts drive whether an exclusion needs to be claimed on Form 982 and how the foreclosure gain or loss gets computed.

1
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
2
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
3
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
4
Internal Revenue Service. Recourse vs. Nonrecourse Debt (Continued)
5
Internal Revenue Service. Topic No. 432, Form 1099-A, Acquisition or Abandonment of Secured Property and Form 1099-C, Cancellation of Debt
6
eCFR. 26 CFR 1.61-12
7
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
8
Internal Revenue Service. Publication 4681 (2025), Canceled Debts, Foreclosures, Repossessions, and Abandonments
9
Internal Revenue Service. About Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness
10
Office of the Law Revision Counsel. 26 USC 111 – Recovery of Tax Benefit Items
11
Office of the Law Revision Counsel. 26 USC 6050P – Returns Relating to the Cancellation of Indebtedness by Certain Entities