You lose both. You'll notice the biggest weight lost after fasting for a while as fat goes first, which weighs less than muscle, followed by muscle which ways alot more than fat but is alot better for you than fat.

Fat is evil, it doesn't like heat.

Go for a run, doing cardio to keep your heart moving and the fat will be gone and muscles intact.

A pound of muscle weighs the exact same as a pound of fat. Pound for pound it weighs the same. Hence the term 'pound'. Muscle looks better. Muscle is better for your metabolism. You don't want to lose muscle. The more muscle you lose, the less calories you burn. The less calories you burn,the more you will hold on to those calories, thus resulting in weight gain of the fatty variety (unless you are living weights and working out to promote muscle).

You should eat a balanced diet and do cardio to lose fat.

Yeah, a pound of feathers and a pound of iron weigh the same but the size is completely different. A pound of fat will be larger in quantity than muscle. I.E, 10 pounds of fat = beer belly etc, 10 pounds of muscle = abs etc.