1038L Tax Code: Repossession Gain, New Basis, and Form 1099-A

When a buyer defaults on seller-financed real estate and you take the property back, Section 1038 of the tax code governs the repossession of real property and generally shields you from recognizing gain or loss on the return itself. Gain is recognized only to the extent the payments you already collected exceed the gain you already reported as income, and even that amount is capped. The rules are mandatory when the conditions are met, and they cover only real property.¹

When the Rule Applies

Section 1038 turns on two facts: the original sale of real property created a debt owed to you (typically a promissory note secured by a deed of trust), and you later reacquire that same property to satisfy the debt in whole or in part. If both are true, the rules apply whether you want them to or not. There is no election.¹

The debt must be secured by the real property that was sold. If the note was secured by a different parcel or by business assets, Section 1038 does not govern. The reacquiring party must be the original seller (or in limited cases the seller’s estate or heir). A third party who buys at a foreclosure auction is outside the rule.

One boundary worth flagging: Section 1038 covers real property only. Sales of vehicles, equipment, or other personal property fall under a different set of repossession rules, and the gain and basis mechanics below do not carry over.

No Gain, No Loss, No Bad Debt Deduction

The starting point under Section 1038(a) is that the reacquisition produces no taxable gain and no deductible loss. The return of the property is treated as a continuation of the original deal. This matters most when values have fallen. Sold a house for $300,000, collected $50,000 before the default, and the property is now worth $200,000? You cannot claim a loss on the repossession.¹

The statute also blocks you from treating the unpaid balance on the buyer’s note as a worthless or partially worthless debt. You cannot write off the remaining balance as a bad debt just because the buyer stopped paying and you took the property back. Sellers who assume a defaulted note automatically produces a deduction get this wrong.

How to Calculate Taxable Gain

Section 1038(b) does require gain recognition in one specific situation. Gain is recognized to the extent that the payments you already received (cash plus the fair market value of non-cash property, but not the buyer’s own notes) exceed the gain you already reported as income in prior tax years.¹

If you reported $10,000 of installment sale income over the years but actually collected $15,000 in payments before the buyer stopped paying, you have $5,000 of gain on the reacquisition. Tax on the first $10,000 was already paid, so the statute reaches only the untaxed piece of what you kept.

That gain is then capped. It cannot exceed the original gross profit on the sale (selling price minus adjusted basis and selling expenses), reduced by gain you already reported and any money you spent to reacquire the property. Publication 537 lays this out as a worksheet:²

Total all payments received before repossession.
Subtract the gain already reported as income. The result is your gain on repossession.
Calculate the original gross profit on the sale.
From that gross profit, subtract previously reported gain and your repossession costs.
Your taxable gain is the lesser of the two figures above.

Repossession costs include attorney fees, court filing fees, and other expenses tied directly to getting the property back. These costs reduce the cap on your taxable gain, so detailed records of every dollar spent during foreclosure or deed-in-lieu proceedings translate straight into a lower tax bill.

Your New Basis in the Repossessed Property

Once the property comes back, you need a new basis for future depreciation (if it is rental or business property) or for calculating gain when you sell again. Basis is the sum of three amounts:²

The adjusted basis of the installment obligation. Start with the unpaid balance on the buyer’s note, then subtract the unrealized profit (unpaid balance multiplied by your gross profit percentage from the original sale). What remains is your adjusted basis in the note.
The taxable gain you recognized on the repossession, calculated as described above.
Repossession costs. Legal fees, recording fees, and other out-of-pocket expenses paid to get the property back are added to basis rather than deducted currently.

If any debt from the buyer remains outstanding after the reacquisition (the repossession did not fully satisfy the note), the basis of that remaining debt is reduced to zero.¹

If You Already Wrote Off the Note as a Bad Debt

Section 1038(d) covers a scenario that catches some sellers off guard. If you previously claimed a bad debt deduction on the buyer’s note, treating it as wholly or partially worthless before you reacquired the property, the reacquisition triggers income recognition equal to the amount you wrote off. That deduction goes back into income.³

Your adjusted basis in the note increases by the same amount, which flows through to a higher basis in the repossessed property, so nothing is permanently double-taxed. But the timing is uneven. The income hits in the year of reacquisition; the basis benefit only pays off when you sell.

If the Property Was Your Former Home

When the repossessed property was your primary residence and the original sale qualified for the gain exclusion under Section 121 (up to $250,000 for single filers, $500,000 for married joint filers), Section 1038(e) offers a way to preserve that exclusion.⁴

Resell the reacquired home within one year of taking it back, and the entire sequence (original sale, repossession, and resale) is treated as a single transaction for Section 121 purposes. The repossession itself triggers no gain, and the normal Section 1038(b), (c), and (d) calculations are set aside.¹

Miss the one-year window and the special treatment is gone. The standard Section 1038 gain calculation applies, the Section 121 exclusion from the original sale stands as it was, and you do not get a second exclusion on the resale unless you independently re-qualify by living in the home long enough to satisfy the two-out-of-five-year ownership and use tests. The deadline is absolute.

If the Note Was Inherited

A seller who financed a sale and then dies before the buyer defaults raises a common question: can an estate or heir use Section 1038? Yes, under Section 1038(g), when specific conditions are met.¹

The exception applies when the installment obligation inherited from the decedent is treated as income in respect of a decedent under Section 691(a)(4)(B). If that condition is met, the estate or heir who reacquires the property is treated as the original seller for the full Section 1038 framework. Basis in the reacquired property also gets an additional increase equal to the estate tax deduction that would have been available under Section 691(c) for the gain on exchanging the obligation for the property.³

Where Section 1038(g) does not apply, the reacquisition falls outside Section 1038 and is treated as a separate purchase under general tax principles.

How to Report the Repossession

Report the repossession on the same form used for the original sale. For most seller-financed real estate reported under the installment method, that is Form 6252 (Installment Sale Income). If the original sale was reported on Form 4797 because the property was used in a trade or business, use Form 4797 again. Capital gains that flow from these forms are carried to Schedule D of Form 1040.²

Form 1099-A

Sellers who financed the sale and then reacquire the property are treated as lenders for information-reporting purposes. If you acquire secured property in full or partial satisfaction of the buyer’s debt, you generally must file Form 1099-A (Acquisition or Abandonment of Secured Property) reporting the transaction to the IRS and the defaulting buyer. You do not need to be in the lending business for this requirement to apply.⁵

If you also cancel $600 or more of the buyer’s remaining debt in the same calendar year, you can file Form 1099-C (Cancellation of Debt) instead of filing both forms.⁶

Penalties for Getting It Wrong

Failing to report the repossession accurately can produce interest and penalties on any underpayment. The failure-to-pay penalty is 0.5% of the unpaid tax for each month or partial month the balance remains outstanding, up to a maximum of 25%.⁷

1
Office of the Law Revision Counsel. 26 U.S.C. 1038 – Certain Reacquisitions of Real Property
2
Internal Revenue Service. Publication 537 (2025), Installment Sales
3
Office of the Law Revision Counsel. 26 U.S. Code 1038 – Certain Reacquisitions of Real Property
4
Office of the Law Revision Counsel. 26 U.S.C. 121 – Exclusion of Gain From Sale of Principal Residence
5
Internal Revenue Service. About Form 1099-A, Acquisition or Abandonment of Secured Property
6
Internal Revenue Service. Instructions for Forms 1099-A and 1099-C
7
Internal Revenue Service. Failure to Pay Penalty