The short answer
Usually not in any useful way. A foreclosure, deed in lieu or short sale is treated as a sale, and because the debt you are relieved of counts as amount realized, it can produce taxable gain even though you walk away with nothing. A 1031 exchange can only defer that gain if the disposition is structured as an exchange through an intermediary and you take on replacement property with at least as much debt, which a borrower in default is rarely able to do. Any canceled debt beyond the property's value is separate ordinary income that section 1031 does not reach, though section 108 exclusions may.
At a glance
| Foreclosure or deed in lieu | Treated as a sale or exchange of the property |
|---|---|
| Nonrecourse loan | Amount realized is the full debt, even above the property's value |
| Recourse loan | Amount realized is the smaller of debt or value; the excess forgiven is canceled-debt income |
| Phantom gain | Gain can exceed the cash you receive, often zero |
| Debt relief in an exchange | Treated as money received unless offset by debt on the replacement |
| Canceled debt | Not deferrable by 1031; may be excluded under section 108 |
| Lender forms | Form 1099-A for the transfer, Form 1099-C for canceled debt |
Losing the property to the lender is a sale for tax purposes
IRS Publication 4681 states that 'when your property is foreclosed upon or repossessed and sold, you are treated as having sold the property and you may recognize taxable gain', and that a voluntary conveyance in lieu of foreclosure 'is treated as the exchange of property to satisfy a debt'. Gain is figured as in any sale: amount realized minus adjusted basis.
The amount realized depends on the loan. Under Reg. section 1.1001-2(a), it includes the liabilities you are discharged from. For a nonrecourse loan, Publication 4681 says the amount realized 'includes the full amount of the outstanding debt' even if the property is worth less. For a recourse loan, it is the smaller of the debt or the property's fair market value, and any forgiven excess is ordinary canceled-debt income.
Because depreciation has been lowering your basis for years, the debt can exceed basis by a wide margin. That is the phantom gain: tax due on a disposition that put no money in your hands.
An exchange would have to replace the debt, and the canceled-debt piece is outside section 1031 entirely
In an exchange, debt you are relieved of counts as money received unless you take on at least as much debt, or add cash, on the replacement; Reg. section 1.1031(d)-2 works through the netting. With no equity, there are no proceeds for the intermediary to hold, so the replacement would have to be financed almost entirely with a new loan of at least the old balance.
Structure is the second obstacle. A deferred exchange needs your sale contract assigned to a qualified intermediary before the transfer under Reg. section 1.1031(k)-1(g)(4). In a foreclosure the lender or trustee conducts the sale; in a short sale you are the seller, so the paperwork is possible, but the lender's approval and a new lender willing to fund the replacement both have to line up.
Even then, only gain on the property is deferrable. Reg. section 1.1001-2(a)(2) excludes canceled-debt income from amount realized on recourse debt, and it stays ordinary income unless section 108 excludes it.
Worked example: a $750,000 loan on a rental worth $650,000
Hypothetical, round figures; run your own numbers with your CPA. You bought a rental for $600,000 and took $200,000 of depreciation, so your adjusted basis is $400,000. The loan balance is $750,000 and the property is worth $650,000.
If the loan is nonrecourse and the lender forecloses, your amount realized is the full $750,000 and your gain is $350,000, with no canceled-debt income. The first $200,000 is unrecaptured section 1250 gain taxed at up to 25%.
If the loan is recourse and the lender forgives the $100,000 deficiency, your amount realized is $650,000, your gain is $250,000, and the $100,000 is ordinary income unless an exclusion applies. Either way you received no cash, and the tax is due for the year of the foreclosure.
- Nonrecourse: $750,000 realized, $350,000 gain, no canceled-debt income.
- Recourse: $650,000 realized, $250,000 gain, $100,000 canceled-debt income.
- Cash received in both cases: none.
Section 108 exclusions, not section 1031, are where the canceled-debt relief usually comes from
Publication 4681 explains the main exclusions: debt canceled in a title 11 bankruptcy case, debt canceled while you are insolvent to the extent of the insolvency, and an elective exclusion for qualified real property business indebtedness. Each is claimed on Form 982.
The real property business exclusion is limited. Under section 108(c), it applies to debt incurred or assumed in connection with real property used in a trade or business and secured by it, it cannot exceed the amount by which the debt exceeds the property's value, and the excluded amount reduces the basis of your depreciable real property. Residential rental property generally qualifies, Publication 4681 notes, unless you also use the dwelling as a home.
Expect a Form 1099-A from the lender reporting the transfer and a Form 1099-C if debt is canceled. Reconcile both with your CPA before filing.
Sell while you still have equity, because that is when an exchange or a trust interest can help
A property worth more than its loan can be sold in an ordinary exchange before the lender acts: the sale pays off the loan, the equity goes to the intermediary, and the replacement must carry debt and equity at least equal to what you gave up. A Delaware statutory trust interest can supply the replacement debt through the trust's own loan, which Rev. Rul. 2004-86 treats as eligible property, but it still needs your equity to buy in. With no equity, a trust interest does not solve anything.
If the property is already underwater, the decision is about minimizing tax and liability rather than deferring it. Read replacing debt in an exchange, recapture with no cash, selling at a loss and the guide for highly leveraged owners before talking to the lender.
Related questions
Is a deed in lieu of foreclosure treated differently from a foreclosure?
Not for gain. Publication 4681 treats a deed in lieu as an exchange of the property to satisfy the debt, so the same amount realized rules apply.
Can I put the short sale proceeds into a DST?
In a short sale the lender takes all the proceeds, so there is nothing to invest. A trust interest only helps when the sale leaves you equity.
Does it matter whether my loan is recourse or nonrecourse?
Yes. Nonrecourse debt is all amount realized and produces gain; recourse debt above value produces canceled-debt income instead, which has different exclusions.
Can I exchange into a property bought at a foreclosure auction?
That is the reverse situation, buying distressed property as a replacement; see auction, foreclosure or REO replacement.
If the gain is taxed, does the depreciation recapture still apply?
Yes. Gain from a foreclosure is figured like any sale, so depreciation you took is taxed first as unrecaptured section 1250 gain at up to 25%.
Sources
Checked against these publications on September 30, 2026. Rules and figures change; confirm the current version with your CPA or attorney before you act. This page is general information, not tax or legal advice.
- IRS Publication 4681 (2025), Canceled Debts, Foreclosures, Repossessions, and Abandonments
- Treas. Reg. Section 1.1001-2, discharge of liabilities (Cornell LII)
- Treas. Reg. Section 1.1031(d)-2, treatment of assumption of liabilities (Cornell LII)
- Treas. Reg. Section 1.1031(k)-1, deferred exchanges (Cornell LII)
- 26 U.S.C. Section 108, income from discharge of indebtedness (Cornell LII)
- IRS Topic 409, capital gains and losses
- Rev. Rul. 2004-86, Internal Revenue Bulletin 2004-33