As a general rule, when a mortgage lender forecloses on a home, this is usually a result of the homeowner being unable to pay his mortgage regularly or in the full monthly amount. In some less frequent cases, homeowners may choose voluntary foreclosure.

Of course any economic downturn as well as declining property values are important factors that can lead to a rise in foreclosures, but the inability of homeowners to pay their mortgages may be the result of a wide range of other reasons, like unexpected medical bills, divorce, unemployment, death, bad investments, any of these may result in foreclosure even in the healthiest economic conditions.

There are several steps leading to a foreclosure:

• If the home owner does not make the agreed payments, the mortgage company must inform the debtor of the payments that are late and demand that the past-due debt be cleared through a "notice of default";

• Sometimes the owner may sell the property to a third party during the pre-foreclosure period. The sale allows the borrower/owner to pay off the loan and avoid having a foreclosure on his or her credit history;
  

• If the defaulted loan isn't taken care of in this time period, a notice of sale is sent to the owner, posted on the property and in the newspaper and the home is put up for auction;

• In most states, the foreclosure process results in a sale of the property at a public auction. When the loan is of a greater value than the property, the lender generally ends up with title, which is often referred to as a mortgage repossession (although technically repossession is a simpler process that applies mainly to vehicles and other property pledges as collateral.) These properties are also known as bank-owned or REO properties (Real Estate Owned by the lender).
  

Foreclosures may be either judicial, that is processed in court, or nonjudicial, depending on state law.

For federal tax purposes, foreclosures are treated as the sale or disposition of property.

Homeowners going through a foreclosure need to calculate their gain or loss, as well as consider any income tax that might be due on the forgiveness or cancellation of debt.

The gain or loss on foreclosure or repossession is determined the same way as for a sale or exchange – the difference between the amount realized and your adjusted basis in the property.

In a foreclosure situation, the selling price used for tax purposes isn't immediately clear because there's no escrow statement and no mutually agreed upon selling price. However, there is still a "selling price" for tax purposes: it is either the fair market value of the property or the outstanding loan balance immediately prior to the foreclosure.

A recourse loan (usually refinanced and home equity loans) is a loan where the borrower is personally liable for the debt, and the lender can pursue repayment even after the property has been repossessed. For recourse loans, the figure used as the selling price is the lower of

A non-recourse loan (used to acquire a house), is a loan where the borrower is not personally liable for repayment of the loan; in other words, once the lender repossess the property used to secure the loan, the loan is satisfied and the lender cannot pursue the borrower for further repayment. For non-recourse loans, the figure used as the selling price is the outstanding loan balance immediately before the foreclosure. You are considered as selling the house to the lender for full consideration of the outstanding debt.

With a recourse loan the borrower may have cancelled debt income arising from the foreclosure, while with a non-recourse loan there is no cancelled debt income because the lender is prohibited by law from pursuing the borrower for repayment.

The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt (up to $2 million for married filing jointly) on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in calendar years 2007 through 2012.

Form 1099-A, Acquisition or Abandonment of Secured Property, is issued by the bank after a real estate has been foreclosed, and reports the date of the foreclosure, the fair market value of the property, and the outstanding loan balance immediately prior to the foreclosure. You will need this information when reporting any capital gain income related to the foreclosure.

Form 1099-C, Cancellation of Debt, is issued by the bank after the bank has canceled or forgiven any debt on a recourse loan. The form will indicate how much debt was canceled.

Your adjusted basis in the property is the same as it would be in the case of a sale or exchange – your original basis (cost or other basis, depending on how you acquired the property), plus any additions or improvements, and less any depreciation claimed on the property, casualty losses, or other adjustments.

If there is a gain, it could be:

If it is a loss, it could be:

Tax form 1040 Schedule D is a form used to report capital gains and losses for the purpose of income tax. A capital gain is any profit made from the sale of an investment for more than the purchase price.

For tax purposes, the purchase price of your main home includes a number of things, like upkeep costs, purchase costs, sale costs, minus accumulated depreciation. You can also exclude up to $250,000 of profit if you’ve lived in the home for two or more years.

If the real estate is not your primary residence, such as a second home or vacation home, the real estate is treated as a short-term or long-term capital gain, depending on how long you have owned the house.

Short-term capital gain income from property held one year or less is taxed at the ordinary income tax rates in effect for the year, ranging from 10% to 35%.

If the foreclosed property was mixed use (was your primary residence at one time, and was a secondary residence at another time), then you'll need to utilize the modified rules for calculating your gain or loss.

Unfortunately losses from selling a personal residence are not deductible.

IRS Form 4797 is used to report the sale of property used for business.

Form 4797 can be used by individuals, sole proprietorships, partnerships, corporations, and S-corporations to report gains and losses from sales, exchanges, and involuntary conversions of depreciable and amortizable property used in a trade or business. 

If you have a property that is a business or rental property and the property is sold at a loss, you can claim that loss as a deduction under most circumstances. If, however, the property began as your primary residence and was then converted to a business or rental property and the adjusted basis was higher than the fair market value of the property at the time of conversion, it may limit how much you can deduct.

As with anything having to do with the IRS it is wise to consult with tax professionals to discuss the potential tax liability in the event of any foreclosure situations.