I hadn't thought of it in terms of a foreclosure, whre the bank loses money in the subsequent sale. Still it's the same concept as a short sale or a settlement of any debt for less than owed.
The difference between the amount of debt and what is paid or otherwise recovered is seen as what's called imputed income to the person "getting off the hook." A couple of folks touched on the concept of how the taxes work. Bank loses $40K in the transaction you described. They deduct it. The guy who lost his farm gets taxed on it as income.
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