I would like to find out in regards to distributing money from an IRA , will the participant still have to pay taxes if they have lost principle?
I realize that IRA's are tax-deferred accounts, but the money that went in was aprox $ 40,000 and now the account is worth $26,000 and I thought maybe there was some sort of special handling/taxe issue for losses when the money gets distributed to the participant.

If the $40,000 that went into the account was comprised of entirely tax-deductible amounts (this assumes the IRA is a traditional IRA), then the balance is taxable income to the participant, regardless of the amount in the account. Whatever is in there is untaxed dollars. Any non-deductible contributions, however, can be used to raise the basis in the account.