You would've qualified to exclude $250,000 of your gain if you were single or head of household, and $500,000 of gain if you were married filing jointly. Any gain over that amount would be taxed as a long-term capital gains to you.
You could have owed capital gains tax even if you were foreclosed. For example, if you bought the home for $200,000, and it had a foreclosure value of $800,000, that would be a $600,000 capital gain. The fact that you might have taken out a second mortgage or home-equity loans that you could not pay would not change the fact that you have a capital gain.
The point of all of this, is that if you would have owed capital gains tax if you had sold the home for the adjusted price, or if you would have owed capital gains it on the foreclosure at the adjusted price, then the settlement is probably taxable as a capital gains. Because it would have been taxable if it had been part of the sale or foreclosure price. However, if you would not have owed capital gains tax, then the settlement is not taxable either.
We may need more facts and figures on the foreclosure of the house. Or, you may want to see a professional tax advisor.
There are two possible procedures on how to deal with the 1099 form that needs to be reported differently, but I'm not yet sure whether or how this should be reported.
