What Is Non-Recourse Debt and Its Tax Consequences?
Learn how loans that limit a borrower's personal liability can still create a taxable event upon default, even without any cash proceeds.
Non-recourse debt is a type of loan where the borrower does not have personal liability. If the borrower fails to repay the loan, the lender’s only course of action is to seize the collateral that was pledged to secure it. This means the lender cannot pursue the borrower’s other personal assets, such as their savings or other properties, to satisfy the outstanding debt. This arrangement is common in commercial real estate financing.
The Role of Collateral in Non-Recourse Loans
In a non-recourse loan, the collateral is the sole security for the lender. For instance, in a commercial real estate transaction financed with a non-recourse loan, the property itself is the collateral. Should the borrower stop making payments, the lender can initiate foreclosure proceedings to seize the property.
Once the lender takes ownership of the collateral, they sell it to recover as much of the outstanding loan balance as possible. If the sale price is less than the amount owed, the lender must absorb that loss. The lender has no legal right to sue the borrower for this shortfall, known as a deficiency. The lender’s risk is confined to the value of the collateral, which is why lenders often require a lower loan-to-value ratio, perhaps 50% or 60%, to create a protective equity cushion.
Understanding Recourse Debt
Recourse debt presents a different level of liability for the borrower. Under a recourse loan agreement, the borrower is personally liable for the entire loan amount. The pledged collateral is the primary source of repayment in a default, but the lender has the right to pursue the borrower’s other assets if the collateral is insufficient to cover the debt.
In a default scenario on a recourse loan, the lender will seize and sell the collateral. If the proceeds from the sale do not cover the full outstanding balance, the lender can obtain a deficiency judgment from a court. This judgment gives the lender the legal authority to collect the remaining balance from the borrower’s other personal assets, which could include garnishing wages or levying bank accounts.
Tax Consequences of Default
When a borrower defaults on a non-recourse loan and the lender forecloses on the property, the Internal Revenue Service (IRS) treats the event as a sale of the asset. This “deemed sale” has tax implications. The amount realized from this sale is not the property’s fair market value at the time of foreclosure, but rather the full outstanding balance of the non-recourse debt. This rule applies even if the property’s value has fallen far below the loan amount.
To calculate the taxable gain or loss, the borrower must subtract their adjusted basis in the property from the amount realized. The adjusted basis is the original purchase price plus any capital improvements, minus any depreciation deductions taken. If the outstanding debt is greater than the adjusted basis, the borrower has a taxable gain, even though the borrower receives no cash from the foreclosure.
This situation can lead to what is known as “phantom gain.” For example, imagine a borrower has a property with an adjusted basis of $300,000 and an outstanding non-recourse loan balance of $500,000. If the borrower defaults and the lender forecloses, the amount realized for tax purposes is $500,000. The taxable gain would be $200,000 ($500,000 amount realized – $300,000 adjusted basis), and the borrower would owe capital gains tax on this amount despite losing the property.