I'll answer this two ways:
Schedule D would have been used for any installment sale reporting (see Form 4797) over the years. Your original basis in the property would have been eaten up slowly each year under the installment method.
When you reclaimed the property, you were no longer owed a debt. If anything, you would have owed the person who paid half your loan but didn't get the property, save that you could attribute their loan payments to rent given their use of the property, kind of like a rent-to-own contract were the property never gets owned, just rented.
Upon reclaiming the property, you would in theory undo the sale and be subject to all the additional income you retained as rent, given that is now the true nature of the transaction and there is no more cost of sales to you. If you were to do this and immediately sell again though, the effect would be a wash.
The correct treatment therefore, would be to just treat it like a sale in the year sold. Your gain is the purchase price less your basis. Your basis is your original purchase price less the percentage of your basis used to reduce gain on your installment sale in past years on the contract that didn't work out.
You have no forgiveness of debt income, no.
You sold a property originally. You did not use the installment method and recognized a full gain originally, even though you had received no money originally, just a note. The person then defaulted on the note. You reclaimed the property in satisfation of the note. Your basis in the property is now equal to your basis in the note. Again, there is no forgiveness of debt income if you take a property in full satisfaction of the note. Again, you should owe them if they lost their property after paying for half of it and after assuming title originally (you are allowed to secure their property for the purpose of resale generally speaking, where they keep the difference between what they owed you and what the house was sold for..).
If you reclaimed a house, sold it, and still couldn't get what was owed to you, then the remainder, finally, is a bad debt. I believe you have a non-business bad debt filed as a short term capital loss on Schedule D, in that case, unless you are in the business of developing or otherwise selling houses.
I'll continue to clarify if you need it.
Thank you for your question.
Edited by BK-CPA on 7/2/2010 at 6:36 PM EST