Common Examples of Nonrecourse Liabilities

A nonrecourse liability is a type of debt where the lender’s claim in a default is limited to the specific asset pledged as collateral. If the borrower fails to repay the loan, the lender can seize and sell the collateral. However, the lender cannot pursue the borrower’s other assets to cover any remaining loan balance if the sale of the collateral is insufficient.

Defining Nonrecourse Liabilities

For the lender, the risk profile is elevated compared to other financing. Their sole remedy is to take possession of the pledged asset. If the market value of that asset has declined below the outstanding loan amount, the lender must absorb the financial loss on the difference, known as a deficiency. Lenders cannot initiate further legal action to compel the borrower to pay this shortfall. This limitation often leads lenders to require lower loan-to-value ratios or higher interest rates to compensate for the increased risk.

Common Examples of Nonrecourse Liabilities

A prevalent example of nonrecourse financing is found in commercial real estate. Consider a developer who forms a limited liability company (LLC) to purchase an office building for $10 million. The developer secures a $7 million nonrecourse loan, using the building as the sole collateral. If an economic downturn causes the property’s value to plummet to $6 million, the LLC may default. The lender can foreclose on the building but cannot pursue the developer’s other holdings for the $1 million deficiency.

Partnerships also frequently use nonrecourse liabilities, which have specific tax accounting implications. Imagine a partnership obtains a nonrecourse loan to acquire manufacturing equipment, with the equipment as the only security. For tax purposes, under Internal Revenue Code (IRC) Section 752, this debt is allocated among the partners and increases each partner’s outside basis in the partnership. This increased basis allows partners to deduct partnership losses that might otherwise be disallowed, even though their personal assets remain protected from the lender.

Tax Implications and At-Risk Rules

The Internal Revenue Service (IRS) established the “at-risk” rules under IRC Section 465 to prevent taxpayers from deducting losses in excess of their economic investment in an activity. These rules limit a taxpayer’s deductible losses to the amount they personally stand to lose. This amount includes cash contributed, the adjusted basis of property contributed, and amounts borrowed for which the taxpayer is personally liable.

Nonrecourse financing does not increase a taxpayer’s amount at risk because the borrower is protected from loss beyond the collateral pledged. For example, if a sole proprietor purchases $50,000 of equipment entirely with a nonrecourse loan, their initial at-risk amount is zero. If the business generates a $10,000 loss, the proprietor cannot deduct that loss against other income. The loss is suspended and can only be used in future years if the at-risk amount increases.

The Qualified Nonrecourse Financing Exception

A significant exception to the at-risk rules exists for certain real estate investments, known as Qualified Nonrecourse Financing (QNF). This provision allows taxpayers to treat specific nonrecourse loans as an amount at risk for the activity of holding real property. This treatment enables real estate investors to include this debt in their at-risk calculation, which can permit the deduction of losses that would otherwise be suspended.

To be considered QNF, the financing must meet several criteria.

• The money must be borrowed for the activity of holding real property.
• The loan must be secured by the real property used in that activity.
• The financing must be borrowed from a “qualified person,” which includes a bank, savings and loan, or other institution in the business of lending money.
• No person can be personally liable for repayment, and the debt cannot be convertible to equity.

By including QNF in their at-risk amount, real estate investors can deduct operating losses from the property, such as depreciation and interest expenses, against other income. For a partnership, a partner’s share of QNF is determined based on their share of the liability under partnership rules. This exception is specifically targeted and does not apply to activities other than holding real property.