What Is Qualified Nonrecourse Financing?

Nonrecourse financing is a loan secured by the property itself, which acts as collateral. If a borrower defaults, the lender can seize the property. The defining characteristic is that the borrower is not personally liable for any loan balance that remains if the property’s value is insufficient to cover the debt, limiting their potential loss to the amount invested.

The Role of At-Risk Rules in Limiting Losses

The Internal Revenue Service (IRS) establishes at-risk rules that affect how much in losses an investor can deduct. These rules state that an investor’s deductible losses from an activity are limited to the amount they have “at risk.” An investor’s at-risk amount is calculated as the sum of their direct cash contributions, the adjusted basis of any property they contributed, and any funds borrowed for which they are personally liable.

This presents a challenge for investors using traditional nonrecourse financing. Because standard nonrecourse debt does not hold the borrower personally liable, it is not included in the at-risk calculation. This means an investor might have significant economic losses from factors like depreciation but be unable to deduct them on their tax return.

For example, if an investor contributes cash but the property is primarily financed through a standard nonrecourse loan, their at-risk amount would be limited to their cash contribution. Any tax losses generated by the property exceeding that cash amount would be suspended. These suspended losses cannot be deducted in the current year but may be carried forward to future years if the investor’s at-risk amount increases.

Defining Qualified Nonrecourse Financing

An exception to the at-risk rules is “qualified nonrecourse financing” (QNF). This category of financing is treated as an amount at risk for tax purposes when used for holding real property, allowing investors to increase their at-risk amount by their share of the QNF. The primary function of QNF is to bridge the gap created by the at-risk rules for real estate investors.

By including the loan amount in the at-risk calculation, investors can deduct losses, such as depreciation deductions, that would otherwise be disallowed. This aligns the tax treatment of the financing more closely with the economic reality of the investment. Without this exception, many tax incentives for investing in real estate would be greatly diminished.

Requirements for Financing to be Qualified

For a loan to be recognized as qualified nonrecourse financing by the IRS, it must satisfy several criteria. These tests are designed to confirm the loan’s connection to real property and the legitimacy of the lending relationship.

Use of Funds

The financing must be borrowed specifically for the “activity of holding real property,” which includes funds used to acquire, construct, or reconstruct property. The loan must be secured by the real property used in the activity. The financing can still qualify if it is secured by other property, as long as the fair market value of that other property is less than 10% of the fair market value of all property securing the loan.

Source of Financing

The loan must originate from a “qualified person” or be a loan from or guaranteed by a federal, state, or local government entity. A qualified person is an individual or entity that is actively and regularly engaged in the business of lending money, such as a bank or credit union. The person from whom the taxpayer acquired the property, or a person related to the seller, is not considered a qualified person.

Related Party Financing

There is an exception regarding the source of financing. A loan from a person related to the borrower can be considered QNF if the financing is “commercially reasonable” and on substantially the same terms as loans involving unrelated parties. This provision allows for flexibility in financing structures while maintaining safeguards against arrangements that lack genuine economic substance.

Nature of the Debt

Two conditions relate to the nature of the debt. First, no person can be personally liable for the repayment of the loan. If a portion of the financing does carry personal liability, only the part for which no one is personally liable can be treated as QNF. Second, the debt cannot be convertible into an ownership interest in the property.

Tax Implications for Partners and Investors

When a partnership obtains QNF for its real estate activities, each partner is allowed to increase their individual at-risk amount by their allocable share of that debt. A partner’s share of the QNF is determined according to their share of the partnership’s liabilities. This increase can directly translate into larger deductible losses.

Consider a partner who contributes $50,000 in cash to a real estate partnership that secures a $950,000 standard nonrecourse loan. The partner’s at-risk amount is limited to their $50,000 cash contribution. If the partnership generates a loss and the partner’s share is $80,000, they could only deduct $50,000 in the current year, and the remaining $30,000 loss would be suspended.

Now, assume the $950,000 loan meets the criteria for QNF. The partner’s at-risk amount would include their $50,000 cash contribution and their share of the $950,000 QNF. This expanded at-risk amount would cover their entire $80,000 share of the partnership’s loss, allowing the partner to deduct the full amount on their personal tax return.