My wife and I are really concerned that the IRS is going to tax us us for "foreclosing on business real estate property" ! After a year of pleading to the mortgage company to help modify my loan, and failing to do the short sale route, I ended up foreclosing on a house that I rented out. I lived in it a few years prior to moving out and renting it to some friends. My question is, what tax penalties do I have to pay? I paid $225,000 for it in 2005. When I stopped making my mortgage payments in January of 2011, I had a principle balance of $200,000. The mortgage company sold it later for $130,000. I filed for an extension this year so I can sort things out on what to do about this mess on the foreclosure. being that I first purchased the home as a primary residence, is it now considered business property because we only rented it for a couple of years?