The Tax Implications of Non-Recourse Loans

Non-recourse loans have become an increasingly popular financing option, especially for real estate investments. While they provide more protection for borrowers in some ways, non-recourse loans also have unique tax implications that borrowers need to understand. In this comprehensive guide we’ll break down what non-recourse loans are, how their tax treatment differs from recourse loans and key factors that impact how canceled debt is treated for tax purposes.

What is a Non-Recourse Loan?

A non-recourse loan is a loan where the borrower is not personally liable for repayment If the borrower defaults, the lender can only seize the collateral securing the loan – they have no recourse to pursue other assets belonging to the borrower

This differs from a recourse loan, where the borrower is personally responsible for the debt. With a recourse loan, the lender can take legal action to garnish wages or put liens on other property if the borrower defaults.

Non-recourse loans are most common in commercial real estate financing and business lending scenarios where the lender relies on the property or business assets alone as collateral. Residential mortgages are almost always recourse loans.

The Tax Advantage of Non-Recourse Loans

The key tax advantage of non-recourse loans is that canceled debt is generally not treated as taxable income, while it often is with recourse loans. Here’s an overview of the difference:

Recourse Loans:

• If the lender forgives or cancels part of the debt, the canceled amount is treated as taxable income to the borrower.

• The borrower will receive a 1099-C form reporting the canceled debt amount as income.

Non-Recourse Loans:

• Because the borrower is not personally liable, canceled debt is not treated as taxable income.

• The borrower will not receive a 1099-C reporting canceled debt income.

This can be a major advantage as it avoids owing taxes on potentially large canceled debt amounts. However, non-recourse status does not guarantee the canceled debt is tax-free. There are important exceptions covered next.

When Canceled Non-Recourse Debt Becomes Taxable

While the general rule is that canceled debt on a non-recourse loan is not taxable, there are two important situations where it can trigger taxes:

1. Debt forgiven in bankruptcy: If the debt is forgiven while the borrower is in bankruptcy, the canceled amount is treated as taxable income even on a non-recourse loan. This applies to Chapter 7, 11, 12, or 13 bankruptcy.

2. Debt exceeding asset value: If the outstanding debt amount exceeds the fair market value of the asset securing the loan, the difference is treated as taxable canceled debt income.

For example:

• Original Loan Amount: $1,000,000
• Current Property Value: $700,000
• Loan is forgiven when property is worth $700,000

In this case, the $300,000 difference between the value of the property and the original debt amount would be taxable as canceled debt income.

These exceptions remove some of the tax advantages of non-recourse loans. Borrowers need to be aware of them before assuming all forgiven debt is tax-free.

Other Factors Impacting Tax Treatment of Canceled Debt

Beyond whether a loan is recourse or non-recourse, there are other important factors that can determine if canceled debt gets treated as taxable income:

Insolvency exclusion: If the borrower is insolvent (liabilities exceed assets) immediately before the debt is forgiven, the canceled amount is excluded from taxable income. This applies to both recourse and non-recourse loans.

Principal residence exclusion: Up to $2 million in canceled mortgage debt is excluded from income if the loan was used to buy, build or substantially improve the borrower’s principal residence. This normally applies only to recourse loans, unless the non-recourse loan exception above is triggered.

Purchase price reduction: If the lender reduces the original sales price for an asset, the reduced debt is not taxable as canceled debt income.

Deductible business debt: If the forgiven debt would have been fully tax deductible as a business expense if the borrower had paid it, the canceled amount is not taxed.

Gift or bequest: Debt canceled as a gift, bequest, devise or inheritance is not taxable income to the borrower.

The Bottom Line on Non-Recourse Loan Taxation

The most important thing to remember is that non-recourse loans generally avoid taxation on canceled debt, while recourse loans do not. However, non-recourse loans can still create tax liability for forgiven debt in certain situations – namely bankruptcy and debt greater than asset value.

Borrowers should consult a tax professional to fully understand how both recourse and non-recourse loans may be treated for tax purposes when all factors are considered. With proper planning, non-recourse loans can provide tax advantages while limiting personal liability.