Does it matter for debt relief if the loan I paid off was recourse or nonrecourse?

A paid-off loan is debt relief whatever its recourse terms

Reg. Section 1.1001-2(a) puts 'the amount of liabilities from which the transferor is discharged' into the amount realized, and paragraph (a)(4) treats the sale of property securing either kind of loan as discharging you. The regulation's first two examples run the same sale with a recourse note and a nonrecourse note and reach the same $9,200 amount realized.

The exchange rules follow. Reg. Section 1.1031(d)-2 treats liabilities assumed by the other party, 'or of any liabilities to which the property exchanged by the taxpayer is subject', as money received. A loan wired off at closing is relief either way, and so is the requirement to replace it with new debt or added cash; see replace your mortgage or add cash.

When the buyer assumes the loan, the tests differ

Section 1031(d) uses section 357(d) to decide whether a liability was assumed. A recourse liability counts if 'the transferee has agreed to, and is expected to, satisfy such liability', whether or not you were released; a nonrecourse liability counts when the buyer takes 'any asset subject to such liability.'

The Form 8824 instructions repeat both tests for line 15. In practice an assumed recourse loan is still relief even if you stay secondarily liable, as Example 1 of Reg. Section 1.1001-2 shows. The commercial side of an assumption is in can the buyer assume my low-rate mortgage.

Underwater property is where the label changes the tax

For nonrecourse debt the value of the property is irrelevant. Reg. Section 1.1001-2(b) says the fact that value is below the debt 'does not prevent the full amount of those liabilities from being treated as money received', and Commissioner v. Tufts held the same. All of the excess shows up as gain on the sale.

For recourse debt the transaction splits. Under paragraph (a)(2), the amount realized does not include amounts that are income from discharge of indebtedness, and Publication 544 says the amount realized on a recourse foreclosure is the lesser of the debt or the property's value, with any forgiven excess treated as ordinary income from canceled debt.

Section 1031 defers gain on an exchange of property. Canceled-debt income is not gain on the property, so an exchange does not reach it. Section 108 offers exclusions instead, including qualified real property business indebtedness for taxpayers other than C corporations, elected on Form 982 and limited as Publication 4681 explains.

Worked example: an $850,000 loan on a $700,000 building

Hypothetical, round figures. Your building is worth $700,000, your adjusted basis is $400,000, the loan balance is $850,000, and the lender takes the property in full satisfaction.

Nonrecourse: the amount realized is the full $850,000 and the gain is $450,000, with no canceled-debt income. Recourse with the $150,000 shortfall forgiven: the amount realized is $700,000, the gain is $300,000, and $150,000 is ordinary canceled-debt income unless an exclusion applies. Total income is the same $450,000; the character and the available relief differ.

Either way there is no cash to reinvest, and the $700,000 or $850,000 of relief would need matching replacement debt or cash to stay out of boot. That is why selling at a loss or underwater and recapture with no cash are often the more urgent reading. Run your own numbers with your CPA.

On the replacement side, recourse does not matter at all

Reg. Section 1.1031(b)-1(c) offsets relief with any assumption of liabilities or receipt of property subject to a liability. A personally guaranteed bank loan and a nonrecourse share of a trust's mortgage count the same.

That gives an owner who is tired of guarantees a way to swap one for the other. In Rev. Rul. 2004-86 the trust's note is nonrecourse and no beneficial owner is personally liable, and a cash out DST is built on non-recourse financing so only the invested equity is at risk.