Recourse and nonrecourse liabilities differ in terms of responsibility for the loss if the borrower defaults on the loan. With recourse debt, the lender can sue the borrower to be made whole for the loss. Any debt that is not recourse is nonrecourse.
This difference between recourse vs nonrecourse debt matters for taxes because losses by partners and sole proprietors may not be deductible if they are not personally responsible for the repayment of nonrecourse debt. A few other tax considerations include debt cancellation income and gain or loss on the transfer of property repossessed as collateral.
Recourse Loans | Nonrecourse Loans | |
|---|---|---|
Risk Profile | Higher risk for borrowers | Higher risk for lenders |
Borrower Liability | Have personal liability for outstanding debt | Have no personal liability for outstanding debt beyond the property offered as collateral |
Interest Rates | Generally lower | Generally higher |
Credit Rating Requirements | Generally lower | Generally higher |
Collateral Required | Usually | Yes |
What Happens to Debt After Sale of Collateral? | Lender can sue for outstanding debt or forgive the debt | Lender absorbs loss |
Borrower Benefit | Cheaper debt | Less liability if there is a default |
Cancellation of Debt Income | Generally yes | No |
Gain or Loss on Repossession of Property | Generally yes | Generally yes |
Key takeaways
- Recourse loans give creditors the right to go after personal assets and future income if the loan defaults and the collateral (if any) is insufficient.
- Nonrecourse loans limit creditors to repossession of the collateral property and nothing more.
- Partners and sole proprietors cannot count nonrecourse loans as part of their investment in their company.
- Gain or loss may be recognized upon default with both recourse and nonrecourse debt.
- Default of a recourse loan may result in cancellation of debt income.
- Recourse loans are riskier to the lender than nonrecourse loans and may result in higher interest rates for the borrower.
- Loan documents should state whether the debt is recourse or nonrecourse. These agreements should conform to state law, which may dictate whether certain loans are required to be categorized as either recourse or nonrecourse.
What Is Recourse Debt?
With a borrower defaulting on their loan, recourse debt permits a lender to:
- Foreclose or repossess any property offered as collateral (if any)
- Sue for a claim to a defaulted borrower’s personal assets if the collateral is insufficient
Recourse debt often includes collateral. Examples of recourse debt with collateral are home and auto loans. Meanwhile, samples of recourse debt that generally exclude collateral are lines of credit and credit card loans.
What Is Nonrecourse Debt?
Generally, with nonrecourse debt, the following applies:
- Loan is guaranteed by property like a building or equipment
- Lender has limited options upon default beyond repossession of the property
- Lender takes on the vast majority of the risk of the loan
- Banks tend to lend fewer nonrecourse loans than recourse loans
To further mitigate risk, interest rates on nonrecourse loans are often higher, and higher credit scores are often expected. This means that a borrower with a nonrecourse loan may end up with higher payments than they would with a recourse loan.
What Is Qualified Nonrecourse Debt?
Qualified nonrecourse debt follows the same rules as regular nonrecourse debt for liability purposes. The lender’s restorative action is limited to the repossession of property and does not extend to the borrower’s personal assets.
This debt is specific to real estate and can only be issued by certain kinds of lenders. Qualified lenders include banks, persons active in the business of lending money, and federal, state, or local government entities.
Qualified nonrecourse debt differs from regular nonrecourse debt in how it affects a business owner’s ability to deduct losses. It can be included in the borrower’s investment in their business, while regular nonrecourse debt is excluded.
Why Does Recourse vs Nonrecourse Debt Matter for Taxes?
Knowing the difference between recourse and nonrecourse liabilities matters for taxes because:
- Taxpayers are subject to different amounts of gain or loss depending on the type of debt
- Partnerships have unique basis considerations, which are also impacted by the nature of the debt
- Pass-through entities must consider the at-risk rules that come into play depending on if the liability is recourse or nonrecourse
Special Partnership Debt Rules
The IRS has special rules regarding how partnership debt impacts a partner’s basis. Basis is a complicated topic, but in its simplest form, it can be thought of as a partner’s investment in the partnership. Basis is extremely important because partners can only take tax-free distributions and deduct losses to the extent that they have basis:
- A partner’s share of partnership recourse debt and qualified nonrecourse debt is included in the partner’s basis
- Nonrecourse debt is excluded from a partner’s basis
At-risk Rules
Another set of rules that can limit the deductibility of losses for partners, sole proprietors, and even rental property owners is the at-risk rules. Total deductible losses cannot exceed the taxpayers’ investment for which they are at risk of losing.
- Business and rental investments financed with recourse and qualified nonrecourse debt are at risk.
- Investments financed with nonrecourse debt are not at risk.
Gain or Loss on a Foreclosure Transfer
When collateralized property is surrendered to a lender, the transfer is treated by the borrower as a sale of the property—and a gain or loss is realized. The amount of the sale, or “amount realized” in tax jargon, depends upon whether the loan is recourse vs nonrecourse:
- Nonrecourse loan: The borrower has no obligation to repay any outstanding debt that might remain after the collateral is sold, meaning the transfer of collateral wipes out the entire outstanding debt. Therefore, the amount realized on the transfer of the collateral is the total amount of the outstanding debt—regardless of whether it is more than the value of the collateral.
- Recourse debt: Because the borrower of a recourse loan is still liable for any outstanding balance after the sale of collateral, the amount realized on the exchange is limited to the fair market value (FMV) of the collateral.
Cancellation of Debt
- Generally, there is no cancellation of debt income with a nonrecourse loan because, as stated above, a borrower’s obligation to pay is met by transferring the collateral.
- Cancellation of debt income can occur with recourse debt when the FMV of the collateral is less than the debt. If the lender gives up collecting the remaining recourse debt, then the borrower realizes cancellation of debt income Taxpayers may not have to recognize the cancellation of debt as income if they are insolvent before and after the cancellation. .
We’ll illustrate how recourse vs nonrecourse debt is treated differently for taxes by looking at a couple of simple scenarios.
Example 1: Let’s look at a sample where the FMV of the collateral is more than the outstanding debt:
- Adjusted basis of collateral: $100,000
- FMV of collateral: $120,000
- Outstanding debt: $90,000
Since the FMV of the collateral is greater than the outstanding debt, the transfer of the collateral satisfies the liability of both recourse and nonrecourse borrowers and either one would realize a $10,000 loss.
Nonrecourse & Recourse Debt | |
|---|---|
Amount Realized | $90,000 |
Adjusted Basis | ($100,000) |
Realized Gain (Loss) | ($10,000 |
There is no cancellation of debt income in this instance because the entire debt of the recourse borrower is satisfied by the collateral.
Example 2: Now, here’s a scenario where the FMV of the collateral is lower than the outstanding debt:
- Adjusted basis of collateral: $100,000
- FMV of collateral: $130,000
- Outstanding debt: $140,000
In this case, the $130,000 worth of collateral is not enough to satisfy the obligation of the recourse borrower. They will realize the $130,000 FMV of the collateral on the exchange but will still be liable for the $10,000 of debt remaining.
Nonrecourse Debt | Recourse Debt | |
|---|---|---|
Amount Realized | $140,000 | $130,000 (limited to FMV) |
Adjusted Basis | ($100,000) | ($100,000) |
Realized Gain (Loss) | $40,000 | $30,000 |
Cancellation of Debt | $0 | $10,000 |
Total Income | $40,000 | $40,000 |
If the recourse lender gives up on collecting the $10,000 of remaining debt, then the recourse borrower must recognize $10,000 of cancellation of debt income.
Notice that total income for nonrecourse and recourse borrowers are the same—only the type of income is different. This is important because the gain on the exchange might be taxed at capital gains rates and the cancellation of income will be taxed at ordinary rates.
Adverse Clauses in Nonrecourse Loans
Nonrecourse loans often contain “bad boy carve-outs” in the loan documentation. This language protects the lender by stating that if the borrower unlawfully represents themselves or falsifies information, then the loan immediately converts to a recourse loan. This conversion would expose the borrower’s personal assets to seizure in the event of a loan default.
Some examples of triggers for “bad boy carve-outs” include:
- Failing to pay property taxes
- Being insolvent (being unable to pay external debts) if the loan agreement states you must stay solvent
- Using loan proceeds in an unauthorized manner
While bankruptcy may be out of your control, a bad situation could become worse if you become personally liable for another debt that you can’t pay if you are considered insolvent. Before signing any documentation, you should examine the agreement for any “bad boy carve-outs” that might be buried in the fine print.
Frequently Asked Questions (FAQs)
Qualified nonrecourse debt is a nonrecourse loan made by a bank, government, or person in the business of providing loans where the loan is for the purchase of real estate. Seller-financed mortgages cannot be qualified nonrecourse debt.
Recourse debt holds the borrower liable for any remaining debt if the collateral is insufficient, whereas nonrecourse debt is secured by only the collateral. Borrowers of nonrecourse debt are only liable to the extent of the collateral.
Nonrecourse debt would be better for a borrower if there is a likelihood of default. However, recourse debt might be preferable if there is a low risk of default because the lender may offer the loan at a lower interest rate.
Bottom Line
Recourse debt provides the lender with loss recovery alternatives through suing for a claim to the personal assets of a borrower. Both recourse and nonrecourse debt may give rise to gain or loss when collateral is foreclosed or repossessed, although only recourse debt may result in cancellation of debt income.
