IRS Recourse vs. Nonrecourse Debt

IRS Recourse vs. Nonrecourse Debt
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According to the IRS, a recourse debt holds the borrower personally liable to repay the debt. All other debts are called nonrecourse. In a recourse loan, should the borrower default (i.e., fail to pay), creditors can seize the borrower’s property even after taking the collateral. When a nonrecourse loan defaults, a creditor can take the collateral securing the loan, but cannot sue the borrowers for other property.

The consequences of whether a loan is a recourse vs. nonrecourse debt affects the creditor, the borrower and possibly the borrower’s business. It also can affect whether a borrower must pay taxes on forgiven debt.

Understanding Debt Basics

Individuals, partnerships, limited liability companies, C corporations and S corporations and are among the entities that can borrow money. When an entity takes a nonrecourse loan, it maintains certain rights should it default on a loan. Generally, only the collateral named in the nonrecourse loan agreement can be used to satisfy the debt.

Collateral might be real property, such as land or a building. It also can be the ownership interests in an entity, such as shares of a partnership, C corporation, S corporation or LLC. In fact, collateral can be whatever the loan agreement specifies, subject to legal limitations.

Treatment of Cancelled Recourse Debt

Should the collateral prove insufficient to repay a recourse loan, the creditor can sue the lender in court to collect additional money and property. The lender can levy the borrower’s accounts and garnish wages. Certain types of property, such as retirement accounts, are exempt from collection to satisfy a defaulted recourse loan.

For recourse loans, the shortfall is considered _cancelled deb_t, and in most cases, the borrower must treat cancelled debt as taxable income. However, borrowers who are insolvent and/or enter into Chapter 11 bankruptcy do not have to include the cancelled debt in their taxable income. Also, certain types of student loans and farm indebtedness are exempt from the cancelled debt rules.

The difference between the collateral property’s fair market value and the borrower’s cost basis (i.e., the amount spent to buy and renovate the property) will be a gain or loss to the borrower. For example, if the repossessed property is auctioned for less than the borrower’s cost basis, the borrower will have a deductible capital loss on the difference between the cost basis and the sale proceeds.

Treatment of Cancelled Nonrecourse Debt

The situation is vastly different for nonrecourse loans. A lender foreclosing a loan can sell the collateral to help repay the nonrecourse loan. Even if the collateral falls short of full repayment, the lender cannot go to court to collect more money.

The proceeds of the collateral sale are its fair market value. If they are less than the amount due, the borrower does not have to treat the shortfall as taxable income. Any proceeds from the collateral sale that exceed the loan amount due are returned to the borrower. The borrower will have a taxable capital gain or loss on any difference between the collateral sale proceeds and the borrower’s cost basis in the property.

Introduction to Partnership Debt

A general partnership is one in which at least one general partner has personal liability for the partnership’s debts. In a limited partnership (or an LLC that chooses to be taxed as a partnership), no partner has personal liability, even for recourse loans.

Partnerships employ a concept known as tax basis. Generally, tax basis is a measure of how much an investor spends and/or earns on an investment. Partners measure tax basis by tallying how much cash a partner contributes to the partnership and/or how many shares (or participation units) a partner purchases.

  1. The inside basis: This refers to a partnership’s tax basis in individual assets. It is the sum of the fair market values of contributions from partners.
  2. The outside basis: This is each partner’s after-tax investments in a partnership. It includes contributions, distributions, allocation of profits and losses and non-contribution costs to acquire partnership interests. The outside basis affects the tax impact of some transactions, such as taxation of a distribution that exceeds accumulated investment. 

If a partner contributes property to a partnership, the partnership’s inside basis increases by the fair market value of the contribution. However, the outside basis of the contributing partner increases by only the cost basis of the contribution, not its fair market value.

Partners can seek to increase their outside bases in a partnership. Their motivations to do so include:

  • To increase the amount of gain (or loss) they recognize on the sale of their partnership interests
  • To increase the amount of partnership losses, credits and expenses they can claim on their personal income tax return
  • To decrease the extent to which distributions from the partnership are taxable

A partner can increase nonrecourse debt basis by lending money to the partnership, by guaranteeing the partnership’s debt or by taking on certain debt-related agreements.

Recourse vs Nonrecourse for Partnerships

General partners are liable for all recourse liabilities of the partnership that can’t be allocated to limited partners. “Exculpatory liabilities” are debts that are secured by all partnership property (as opposed to specific collateral), but not by partner personal liability.

Thus, they are recourse for partnership assets but nonrecourse for partner liabilities. Limited partners and limited liability company members are not liable for partnership liabilities unless they specifically offer a debt guarantee, even if the liabilities are recourse.

Limited partners might have a payment obligation for the partnership recourse debts they guarantee. However, if the state doesn’t consider the guarantee legally binding, then the partner does not have a payment obligation.

IRS Issues New Rules

The IRS introduced rules in 2016 concerning “bottom dollar guarantees.” A bottom dollar guarantee is provided by a partner establishing a payment obligation for some portion of a partnership debt, but only if the lender collects less than a guaranteed minimum amount. It was a way for a partner to increase outside basis without guaranteeing the full amount of a loan.

For example, suppose a limited partnership takes out an $8 million nonrecourse mortgage on a $10 million property it wants to build. Partner X, a limited partner, extends a $1 million guarantee on the $8 million debt. This is a bottom dollar guarantee by Partner X, since it only pays a portion ($1 million) of the partnership’s $8 million debt.

Thus, the loan is recourse with respect to Partner X. Subsequently, the partnership repays only $0.9 million of the debt and then defaults on the balance, rendering the property (which was also the collateral) worthless. Partner X is on the hook for $0.1 million, which is the guaranteed amount ($1 million) minus the amount the lender already collected ($0.9 million). The lender ends up collecting only $1 million and taking a $7 million loss (because the collateral became worthless).

The new IRS rules state that Partner X would not increase her outside basis if the bottom dollar guarantee was issued after October 4, 2016. As of that date, bottom dollar guarantees are now considered nonrecourse. Partnerships can issue interim rules to ease in the new regulation over a period ending on October 4, 2023.