Non-Recourse Debt

The tax law counts non-recourse debt at face value, whatever the property is worth.

Reg. section 1.1001-2 says the amount realized on a sale or other disposition includes liabilities you are discharged from, and that a property value below the debt does not prevent the full amount from counting. Its Example 7 is a nonrecourse $19,000 note on property worth $15,000: the amount realized is $19,000.

The Supreme Court reached the same result in Commissioner v. Tufts in 1983, holding that when property encumbered by a nonrecourse obligation larger than its value is disposed of, the outstanding obligation is included in the amount realized and the fair market value is irrelevant. Section 7701(g) writes the point into the Code: fair market value is treated as not less than the nonrecourse debt on the property.

Recourse debt is split differently. Example 8 of the regulation transfers a $6,000 asset to settle $7,500 of debt the owner is personally liable for: the amount realized is $6,000 and the other $1,500 is income from discharge of indebtedness, which follows its own rules.

Carve-outs make non-recourse less absolute than the name suggests.

The OCC's Commercial Real Estate Lending handbook describes nonrecourse loans as ones where the lender may look only to the collateral, and notes that a guarantee is usually signed with carve-out provisions. Those carve-outs make the guarantor liable for losses caused by bad acts such as fraud or misrepresentation, voluntary bankruptcy, environmental issues, unapproved liens, waste, prohibited transfers and diverted funds, and certain carve-outs make the whole loan full recourse. The handbook also notes that loans placed in commercial mortgage-backed securities are commonly nonrecourse.

In an exchange the Form 8824 instructions treat a nonrecourse liability as generally assumed by the party that takes the property subject to it. Nonrecourse debt on the property you sell is therefore debt relief, and nonrecourse debt on the replacement, including your share of a trust loan, is debt taken on. What the trust's lender documents say about carve-outs is covered in DST lender documents and carve-outs.

It bites in a foreclosure and when the replacement must carry matching debt.

Hypothetical figures: your adjusted basis is $300,000, the nonrecourse balance is $900,000 and the property is worth $700,000 when the lender forecloses. Your amount realized is $900,000 and your gain is $600,000, even though you receive no cash. Had the loan been recourse and the lender forgiven the shortfall, the split would be $700,000 of amount realized, $400,000 of gain and $200,000 of discharge income. Run your own numbers with your CPA.

Because the whole balance counts, a heavily leveraged seller needs replacement debt to match, or must add cash. A trust interest supplies allocated nonrecourse debt without a loan application, as explained in does a DST loan count as replacement debt; the wider planning is in 1031 options for highly leveraged owners.