Non-recourse debt means that if the debtor defaults, the creditor cannot pursue the debtor personally. Instead, the creditor must seek recovery from the collateral securing the loan. The creditor can file a suit against the borrower if the collateral does not cover the debt. However, if the collateral covers the debt, the lender will likely agree to accept less than the total amount owed.

With recourse debt, the creditor can come after you and your assets if you fail to repay the loan. If you default, the creditor can seize your property, including any real estate you own and sell it to recover the amount owed. Non-recourse debt does not allow the creditor to go after you if you default on an obligation. Instead, the creditor can only get back what he paid for the asset. For example, if you bought a house using a mortgage, the bank cannot come after you for the unpaid portion of the mortgage. However, if you default on the mortgage, the bank can foreclose on the house and sell it to recover its losses.

Concerns when Obtaining Property Subject to Non-Recourse Debt

A second concern arises when considering acquiring property subject to a non-recoverable debt. You must first determine if the non-recourse liability is included in the purchase price. If so, you must also consider whether the non-recoverable responsibility is part of the sale proceeds. The cornerstone case for both of these questions comes from Crane v. Commissioner, 331 U.S. 1 (1947), which was decided in 1947 by the United States Supreme Court.

The basis of a property is the price paid for the property when you bought it. If you buy a house for $100,000, the basis is $100,000. You can deduct any increase in the value of the home during the year from your taxable income. For example, if you sell your house for $200,000, you get a capital gain of $100,000 ($200,000 – $100,000) and pay taxes on half of that gain ($50,000), leaving you with a $50,000 net profit. A higher basis means you can claim more significant deductions for depreciation, interest, and other expenses.

Non-recourse debt is usually considered when you buy a house. You must pay back the loan plus interest if you borrow money to buy a home. If you default on your loan, the bank may seize your assets. However, if you own your house free and clear, you won’t owe any money if you fail to repay the loan. You’ll still have to pay taxes on the gain, but there won’t be any penalties for failure to repay the loan.

In general, if you borrow money against your residence, the basis should be the property’s fair market value at the time of the loan. If you borrow money against your business real estate, then the basis should reflect the fair market value of your business real estate at the time of the borrowing. However, there are exceptions to this rule. You may be able to exclude certain types of debt from the basis of your property. For example, if you borrow money to pay for improvements to your property, the amount borrowed does not become part of the basis of the property. Similarly, suppose you borrow money to purchase an asset that is held primarily for sale to customers in the ordinary course of business. In that case, the amount borrowed is excluded from the basis of the asset.

Key Takeaways

A recourse loan is a type of credit instrument where the lender has recourse against the borrower if there is an event of default. A non-recourse loan is a type of loan where the lender does not have recourse against the borrower if the loan goes bad. Non-recourse loans are often associated with real estate lending because real estate is considered a safe asset. However, non-recourse loans are also used in other industries, including finance, manufacturing, and construction.

Non-recourse loans allow borrowers to borrow up to the value of the property. If the borrower defaults, the bank cannot pursue them for the remaining amount. As a result, banks charge higher interest rates on these types of loans to cover the increased economic risk. In the United States, loan-to-value ratios for residential mortgages are generally capped at 80%.

Special Considerations

Non-Recourse debt is an investment strategy involving borrowing money at low-interest rates and then investing those funds in projects that will generate returns later. These investments are made without guaranteeing that the borrower will repay the loan. If the project fails, the lender does not lose anything because they did not put any money down. On the other hand, if the project succeeds, the lender gets paid back plus interest.

For more information speak with a Denver business attorney at The McGuire Law Firm, call 720-833-7705.

Example: Jeff contributes property with an adjusted basis of $50,000 to a general partnership in exchange for a one quarter (1/4) interest in the general partnership.  At the time Jeff contributes the property, the partnership does not have liabilities outstanding and the property is subject to a recourse debt of $25,000.  The fair market value of the property is in excess of the $25,000 recourse debt.  After the contribution, Jeff remains personally liable to the creditor, Bank of Colorado and none of the other partners bear any of the economic risk for the $25,000 liability under state law or otherwise.  The partnership is treated as having assumed the $25,000 liability and as a result, Jeff’s individual liabilities have decreased by $25,000.  At the same time, Jeff’s share of the partnership liabilities has increased by $25,000.  Only the net increase or decrease in Jeff’s share of the partnership liabilities and Jeff’s individual liabilities are taken into account when applying Internal Revenue Code Section 752.  Thus, there is no net change for Jeff, and Jeff is not treated as contributing money to the partnership or receiving a distribution of property from the partnership.  Thus, Jeff’s basis in his partnership interest would be $50,000, which is the adjusted basis of the property Jeff contributed.

If you are partner in a partnership it is very important to have a general understanding of how contributions of property increase your partnership basis and how distributions of property decrease your partnership basis.  Moreover, it is very important to properly track your partnership basis from year to year and through certain transactions as they may occur in your business.  Your basis in the partnership can dictate the amount of gain (or loss) you may realize on the transfer or sale of your partnership interest or through the sale of the partnership.  Furthermore, your partnership basis allows you to pass through partnership losses.  Thus, your basis in the partnership must be tracked and should be considered and accounted for as you make certain business decisions.

You can speak with a tax attorney or business attorney at The McGuire Law Firm if you have questions related to your business.  A free consultation is offered to all potential clients, and The McGuire Law Firm has offices located in Denver, Colorado and Golden, Colorado.

www.jmtaxlaw.com

720-833-7705

John@jmtaxlaw.com