Let’s start with your cost basis.
You bought the property for $123K and had $5800 in closing costs for an initial basis of $128,800. Add $16,587 to your basis for capital improvements which brings your basis to $144,787. Lastly subtract the $3650 in depreciation which gives you an adjusted basis of $141,137.
Your depreciation expense seems low for two years of ownership. Did you give us the total of all depreciation taken or just what you took in the past year? If you took more depreciation that $3650, then adjust the cost basis accordingly.
Now, let’s figure out your sale profit or loss.
You sold the property for the insurance settlement plus $2000, but then also got a deficiency judgement for $2563, so your net on the sale is $125,937 ($126,500 + $2000 - $2563).
It would appear that you have a capital loss on this property of $15,200. If you paid any settlement costs on the $2000 sale, then that amount would also be subtracted from your net on the sale, making your loss even greater.
Just how I see it. If I have it wrong, one of the CPAs on this board will correct the numbers.
I would challenge the mortgage lender on any prepayment penalty you had to pay. You did not sell the property or refinance it to pay off the loan, you had a casualty loss. I would hope that a prepayment penalty would not apply or that the mortgage lender would waive the prepayment penalty in your situation. If they rebate the prepayment penalty, then your deficiency judgement can go away, right?
If you don’t mind sharing more of your experience, why didn’t you use the insurance settlement to rebuild? The settlement should have been large enough to pay for reconstruction.