IRS would treat it as a sale. You would compare your basis in the goods at the time of sale, to what you "received" from the sale. Basis is the amount of value left in the goods for tax purposes, generally cost less depreciation. What you "received" is the amount of reduction of the loan (plus excess funds, if it sold for more than was owed). If the stuff brought more at the sale than its basis, you're on the hook for capital gains tax on the difference.
The "imputed income" situation that Scotty brought up only came into play when you turned over the equipment or real estate in full satisfaction of the debt. They, you would be taxed on the amount of loan forgiveness that was above and beyond the fair market value of the stuff. Some exceptions generally kept folks out of that situation- if you were insolvent, or in bankruptcy, it didn't apply, and many were in that situation by the time such drastic measures as foreclosure occurred.
Even though this seems unfair (kicking you while you're down, so to speak), it was generally advantageous from a financial standpoint. If you had a loan of $100,000, and bank accepted R/E worth $75,000 in full satisfaction, you'd owe tax on $25,000- lets say, 4 grand. However, if bank just did a sale and applied the proceeds, you'd still owe 25 grand.
The most cruel application of the rule is when you tried to be a good guy and give the bank a "deed in lieu of foreclosure" voluntarily, instead of making them go through the foreclosure process. Thanks for doing the right thing, and by the way, Surprise! You owe some tax!
Happy to say, the "imputed income" rule has been suspended by IRS, beginning in 2007, and on into the forseeable future (translation- until economy gets back on its feet, and they can resume taxing the daylights out of us).
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Today's Featured Article - Women and Tractors - More Views From the Farmer's Wife - by Teri Burkholder. The top ten reasons why the judges wouldn't let you participate in the stock antique tractor pull: Hey, this is stock! It came with that V8 in it! That "R" on my tires stands for "really old" not radial! Blue gas? We thought it was a pretty color! What wire hooked to my throttle?
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