I sold my primary residence to a family member in 2006 and financed the loan. Now in 2007 they decided not to pay for it and 'gave' it back to us. How do figure out my basis and capital gains for 2007. Also now we are going to rent the property until the market comes back and we can sell it. I am really confused how to record all of this on my taxes.

I assume that you got SOME type of down payment and that you received at least some monthly payments.

The down payment PLUS the principal payments and the interest on the monthly payments must be reported as income on Line #21, Form 1040.

You must originate a Form 1098 to account for the interest that you received. The Form 1098 is sent to the payer, the IRS and the state tax department where the payer lives.

The basis for your proerty has NOT changed. It is either what you paid for it plus all improvements made since you bought the property, or the Fair Market Value of the property when you convert to a rental property, whichever is LESS.

You will be depreciating the property while you rent. This is a fair routine calculation for a tax professional, but can be a little daunting for a layman. For this reason, I strongly recommend that you hire a tax professional to do your return while you are renting the house.

This can get a little tricky due to the sale to a related party. Did you file Form 6252 lInstallment Sale last year? The interest that was paid would be claimed on Schedule B. I also agree that you should seek professional help on this one. Here is a link to IRS Pub 537 that goes into detail as to how complicated this may be.
Publication 537 (2006), Installment Sales

The answer was thorough and actually confirmed the answer that I had found when researching this issue with the IRS. Thanks so much!

Since the property reverted back to the seller, the related-party problem is not really an issue.

I believe that Mobea means the interest received should be claimed on Schedule B. That IS correct.

Post the principal payment and down payment on Line #21.

A portion of the down payment should be considered a return of basis of the property. Therefore it would be consider tax-free according to IRS Publication 537 - How to figure installment sale income. Only the portion of the down payment that is considered capital gain on the property would be taxable and that would go on Sch D not Line 21 Other Income. I've done this calculation several times on installment sales for taxpayers and it can save a taxpayer taxes because the gain is spread out over a period rather than claiming in all in the year of the sale.
But... Rblum, did you claim the whole capital gain profit of the sale on your tax return in 2006? This will determine how to handle the reposession on your 2007 tax return.

Mobea may have a point.

However, since the property was returned and the basis restored to the original state BEFORE the sale, I do not see HOW the profit (down payment MINUS the return of basis) can be considered a capital gain, as no capital asset was effectively sold.

This is really a little more complicated than can be gotten into on this forum. Basis would be adjusted. (Original basis minus return of capital = new basis.)There may also be a capital loss that may be claimed depending on what had been claimed in 2006. For instance, if Rblum had claimed all of the profit of the sale in 2006, then they could recoup some of the taxes that they paid on the gain, because in reality they did not actually receive all of the gain because of the repo. It is a long formula that needs to be calculated as directed in Pulication 535. That is why a professional should be consulted.

The need for professional tax help?

There I totally agree with Mobea.

Of course.

Great minds think alike! :-)