What Is Recourse Debt in a Partnership?

Debt provides capital for business operations, growth, and expansion. Understanding different types of debt is important for business owners. Recourse debt is a specific category of financing that assigns liability for repayment.

Understanding Recourse Debt

Recourse debt represents a financial obligation where the borrower is personally responsible for repayment. If the borrower defaults, the lender can pursue not only the collateral securing the loan but also the borrower’s personal assets to recover any outstanding balance. Lenders have various legal avenues available, such as garnishing wages or levying bank accounts, to collect the amount owed if the collateral is insufficient. This type of debt offers greater protection to lenders because they have a broader pool of assets to draw from in the event of a default.

In contrast, non-recourse debt limits the lender’s recovery solely to the specific collateral pledged for the loan. If the borrower defaults on a non-recourse loan, the lender can seize and sell the collateral, but they cannot seek any deficiency balance from the borrower’s personal assets, even if the sale proceeds are less than the outstanding debt. For example, if a property secured by a non-recourse mortgage is foreclosed upon and sells for less than the loan amount, the lender cannot pursue the borrower for the difference. This distinction means that non-recourse loans carry higher interest rates due to the increased risk for the lender.

The determination of whether a debt is recourse or non-recourse depends on the specific language within the debt instrument and applicable state law. Lenders will indicate on Form 1099-C if a canceled debt was recourse, which impacts the borrower’s tax obligations. Recourse loans offer more flexible terms to borrowers because the lender has additional security beyond just the collateral.

Recourse Debt in Partnerships

The general principles of recourse debt apply distinctly within partnership structures, directly affecting the personal liability of partners. In a general partnership, state laws dictate that all general partners are personally liable for the partnership’s debts, unless those debts are explicitly non-recourse. This means that if the partnership cannot repay a recourse mortgage, the general partners would be obligated to cover any shortfall from their personal assets. The economic risk of loss is central to understanding recourse debt in this context.

For limited partnerships, general partners also bear personal liability for recourse debts. Limited partners enjoy protection from personal liability for the partnership’s unpaid debts, except to the extent they have specifically agreed to a deficit restoration obligation or personally guaranteed a debt. This distinction allows limited partners to cap their financial exposure to their investment in the partnership.

Members of a Limited Liability Company (LLC) that is taxed as a partnership are treated similarly to limited partners under state law, meaning they have limited personal liability for the LLC’s debts. Consequently, LLC liabilities are allocated in a manner resembling non-recourse liabilities for tax purposes, unless a member personally guarantees the debt or has a financial obligation to make contributions that are available to creditors. This structure provides a layer of protection, as lenders cannot pursue the personal assets of LLC members if the business defaults on its debts.

Partner Basis and At-Risk Rules

Recourse debt significantly impacts a partner’s tax basis and their “at-risk” amount, which are important for determining the deductibility of partnership losses. A partner’s tax basis represents their investment in the partnership, adjusted for contributions, distributions, and their share of the partnership’s income and losses. When a partnership incurs recourse debt, a partner’s share of that liability directly increases their tax basis. This increase is important because it allows partners to deduct a greater amount of partnership losses than they might otherwise be able to.

The “at-risk” rules, found in Section 465 of the Internal Revenue Code, further limit the amount of losses a partner can deduct. These rules permit a partner to deduct losses only to the extent they are considered “at risk” in the activity. For recourse debt, the amount for which a partner is personally liable or has pledged property as security is included in their at-risk amount. This means that if a partner personally guarantees a partnership’s recourse debt, their at-risk amount increases, which can enable them to deduct more losses.

While both recourse and certain types of non-recourse debt can increase a partner’s tax basis, only recourse debt and qualified non-recourse financing for real estate count towards the at-risk amount. Losses that exceed a partner’s basis or at-risk amount are suspended and carried forward to future years when sufficient basis or at-risk amounts are available. Understanding how recourse debt contributes to both basis and at-risk amounts is important for managing the tax implications of partnership investments.

Allocating Recourse Debt Among Partners

The allocation of recourse debt among partners for tax purposes is governed by specific principles, primarily focusing on who bears the “economic risk of loss” for the liability. Treasury Regulations under Section 752 of the Internal Revenue Code dictate that a partner’s share of partnership recourse liabilities corresponds to the extent they would be obligated to pay a creditor if partnership assets became worthless and the debt became due. This means the debt is allocated to the partner who would ultimately have to pay it from their personal funds if the partnership defaulted, without a right of reimbursement from another partner.

Partners may bear this economic risk through various arrangements. For example, a partner who directly lends money to the partnership or personally guarantees a partnership debt will be allocated that portion of the recourse liability. Similarly, if a partner provides an indemnity or agrees to a deficit restoration obligation that would require them to contribute additional capital to cover partnership debts, they would bear the economic risk of loss. These arrangements directly determine how recourse debt is assigned to individual partners for tax reporting.

Recent final regulations under Section 752 provide further guidance on allocating recourse liabilities, particularly in situations where multiple partners or related parties share the economic risk of loss for the same debt. These regulations employ a proportionality rule to determine each partner’s share when there is overlapping risk. The allocation of recourse debt directly impacts a partner’s tax basis and at-risk amount, which in turn affects their ability to deduct partnership losses, highlighting the importance of these allocation rules.