What Is Bad Debt in Real Estate? Recourse, Foreclosure, and 1099s

In real estate, a bad debt is a mortgage or other property-secured loan that the lender has concluded it will not be able to collect, usually after the borrower stops paying and the collateral property is not worth enough to cover the balance. What sets these loans apart from ordinary uncollectible debts is the property itself: because nearly every real estate loan is tied to a physical asset through a mortgage or deed of trust, the write-off, the foreclosure, and the tax consequences all run through that collateral. The rules differ sharply depending on which side of the loan you are on and whether the loan is recourse or nonrecourse.

When a Real Estate Loan Becomes Uncollectible

Most bad real estate debts follow a familiar path. A loan is generally considered delinquent after 30 days of non-payment, and defaults that continue for 90 days or more often give the lender the right to accelerate collection or buy the loan out of a security pool.¹ A deeper problem arises when the property’s fair market value falls below the outstanding balance, leaving the lender underwater on the collateral. A completed foreclosure, a bankruptcy filing, or a borrower who simply walks away can each be the event that confirms the debt is uncollectible.

Recourse vs. Nonrecourse: The Distinction That Drives Everything

Before any tax question can be answered, you need to know which kind of loan you have. With a recourse loan, the lender can pursue a deficiency judgment against the borrower’s other assets if the property sale does not cover the balance. With a nonrecourse loan, the lender’s recovery is limited to the collateral property itself. Most commercial real estate loans are nonrecourse; residential mortgages vary by state. That single fact changes how foreclosure is taxed, whether forgiven debt becomes income, and what the lender can write off.

How Creditors Deduct a Bad Real Estate Debt

If you are the creditor on a real estate loan that has gone bad, the first tax question is whether the loss is a business bad debt or a nonbusiness bad debt. The distinction under IRC Section 166 controls both the size of the deduction and how you can use it.²

Business Bad Debts

A business bad debt is one created or acquired in connection with your trade or business. For a bank, a mortgage lender, or a real estate professional whose lending activity rises to a trade-or-business level, an uncollectible loan qualifies. The treatment is generous: business bad debts are deductible against ordinary income with no cap, and the IRS allows deductions for partially worthless debts as long as you charge off the uncollectible portion during the tax year.² Partial worthlessness matters in real estate, where a foreclosure might recover some value but not the full balance. Sole proprietors report business bad debts on Schedule C (Form 1040); other entities report on their applicable business return.³

Nonbusiness Bad Debts

Nonbusiness bad debts are those not connected to a trade or business. A common real estate example: you lend money to a friend or family member to buy property, secured by a personal note, and they never pay you back. The IRS treats this loss as a short-term capital loss regardless of how long the debt was outstanding.² Capital losses can only offset capital gains plus up to $3,000 per year of ordinary income ($1,500 if married filing separately).⁴ Excess losses carry forward, but on a large real estate loan, absorbing the full deduction can take decades.

Two more restrictions apply to nonbusiness bad debts. The debt must be totally worthless; no partial deduction is available. And you report the loss on Form 8949 as a short-term capital loss with a detailed statement explaining the debt, the debtor, your collection efforts, and why you concluded the debt was worthless.³

Timing and Documentation

Either way, you claim the deduction in the year the debt became worthless, which may lag behind the year payments stopped. The IRS expects evidence that you took reasonable steps to collect before writing the debt off. Completed foreclosures, confirmed bankruptcy filings, and documented collection attempts all support a worthlessness claim.³ Most bad debt deductions fall apart on audit because of thin records. Keep every demand letter, every communication, and documentation of the property’s value when you wrote the debt off.

What Borrowers Owe When a Lender Forgives Real Estate Debt

When a lender writes off part or all of a real estate loan through a short sale, a loan modification, or a foreclosure settlement, the forgiven amount is generally treated as taxable income to the borrower under IRC Section 61.⁵ A lender that cancels $600 or more must report the amount to both you and the IRS on Form 1099-C.⁶ Receiving the form does not automatically mean you owe tax on the full amount. Several exclusions under IRC Section 108 may apply.⁷

Debt discharged in a Title 11 bankruptcy case is excluded entirely.
If your total liabilities exceed the fair market value of your total assets immediately before the cancellation, you can exclude canceled debt up to the extent of your insolvency. This is the exclusion most distressed real estate borrowers rely on.
Qualified real property business indebtedness: if you are not a C corporation and the discharged debt was incurred in connection with real property used in a trade or business and secured by that property, you can elect to exclude the canceled amount. The exclusion is capped at the excess of outstanding principal over the property’s fair market value and cannot exceed the total adjusted basis of your depreciable real property.
A parallel exclusion exists for qualified farm indebtedness.
The qualified principal residence indebtedness exclusion applied to 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 exclusion is often overlooked by investors who hold rentals or commercial property through a pass-through entity. The election can shelter significant canceled debt from current tax, but you must reduce the basis of your depreciable real property by the excluded amount, which increases your taxable gain when you later sell.

Any of these exclusions is claimed by filing Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with your return for the year the cancellation occurred.⁹ Each exclusion requires a corresponding reduction in tax attributes such as basis, net operating losses, or credit carryforwards. The IRS recaptures the benefit elsewhere.

How Foreclosure Is Taxed

Whether a defaulted real estate loan is recourse or nonrecourse changes the tax math dramatically when the property is lost to foreclosure or surrendered to the lender.

With nonrecourse debt, the IRS treats the foreclosure as a straight sale. Your amount realized is the entire unpaid balance of the loan, even if the property is worth far less. The difference between that amount and your adjusted basis produces a gain or loss. Because the lender cannot pursue you for the shortfall, there is no cancellation of debt income.¹⁰ The entire economic loss is captured in the gain or loss calculation.

With recourse debt, the transaction splits into two tax events. First is the property disposition: your amount realized is the fair market value of the property, not the loan balance, and you calculate gain or loss against your adjusted basis. Second, any forgiven debt above the property’s fair market value is cancellation of debt income, potentially taxable unless a Section 108 exclusion applies.¹¹ That dual-event structure catches many borrowers off guard. You can owe tax on a property you lost money on, because the forgiven portion of the loan is treated as income.

Reading the 1099 Forms a Lender Sends You

Two forms do most of the work when a real estate loan goes bad. Form 1099-A reports the lender’s acquisition of the property or your abandonment of it. Form 1099-C reports the cancellation of $600 or more of debt and must be issued by January 31 of the year after the identifiable event, such as a bankruptcy discharge, a foreclosure, a negotiated settlement, or the creditor’s decision to stop collection activity.⁶ If both the property transfer and the debt cancellation happen in the same calendar year, the lender may issue only a Form 1099-C covering both.¹¹

Review the reported amounts carefully. Errors on these forms are common, and a borrower who ignores an incorrect 1099-C can end up paying tax on income they do not actually owe. If an exclusion applies, file Form 982 with your return; without that filing, the IRS will treat the full forgiven amount as taxable even in a case where bankruptcy, insolvency, or one of the real property exclusions would have wiped it out.

1
Ginnie Mae. Ginnie Mae 5500.3 Rev. 1 – Chapter 18 Mortgage Delinquency and Default
2
Office of the Law Revision Counsel. 26 USC 166 – Bad Debts
3
Internal Revenue Service. Topic No. 453, Bad Debt Deduction
4
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
5
eCFR. 26 CFR 1.61-12
6
Office of the Law Revision Counsel. 26 USC 6050P – Returns Relating to the Cancellation of Indebtedness by Certain Entities
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
Internal Revenue Service. Recourse vs. Nonrecourse Debt (Continued)
11
Internal Revenue Service. Topic No. 432, Form 1099-A, Acquisition or Abandonment of Secured Property and Form 1099-C, Cancellation of Debt