Non-recourse Debt

A non-recourse debt or non-recourse debt or non-recourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender’s recovery is limited to the collateral. If the property is insufficient to cover the outstanding loan balance (for example, if real estate prices have dropped), the lender is simply out the difference. Thus, non-recourse debt is typically limited to 80% or 90% loan-to-value ratios, so that the property itself provides "over collateralization" of the loan.

Non-recourse debt is typically used to finance commercial real estate and similar projects with high capital expenditures, long loan periods, and uncertain revenue streams. Because most commercial real estate is owned in a partnership structure (or similar tax pass-through), non-recourse borrowing gives the real estate owner the tax benefits of a tax-pass-through partnership structure (that is, loss pass-through and no double taxation), and simultaneously limits personal liability to the value of the investment.

Non-recourse debt is usually carried on a company’s balance sheet as a liability, and the collateral is carried as an asset.

A lender of non-recourse debt depends crucially on an accurate assessment of the credit of the borrower, and a sound knowledge of the underlying technical domain as well as financial modeling skills.

Tax Consequences of Disposition of Property Encumbered by Non-recourse Debt

The interaction between non-recourse debt and taxable basis in the property is fairly complex. It depends on whether the taxpayer acquired the property with the non-recourse debt already attached, or whether the taxpayer took out the non-recourse debt after acquisition of the property, and the relationship between fair market value (FMV) and purchase price and disposition price.

When a debtor surrenders the collateral in exchange for the cancellation of the non-recourse debt (for example, at foreclosure), the excess of the cancelled debt over the adjusted basis of the surrendered property is gain from the disposition of property. It does not matter if the debt exceeds the FMV of the property.

When a taxpayer sells or disposes of property encumbered by a non-recourse obligation exceeding the fair market value of the property sold, the "amount realized" includes the outstanding amount of the obligation; the fair market value of the property is irrelevant to this calculation. Commissioner v. Tufts, 461 U.S. 300 (1983). On sale of the asset, the amount of non-recourse debt is included in amount realized by taxpayer upon sale, despite fact that non-recourse debt protects taxpayer from suffering down-side, because the seller is relieved of indebtedness. Crane v. Commissioner of Internal Revenue, 331 U.S. 1 (1947) A non-recourse mortgage on property that has appreciated while in the borrowers hands is not a realization event, and there is no step-up in basis, just unrealized appreciation. In the event of a default and a tax write-off of a bad loan, the tax loss is limited to the current basis of the loan - that is, the original loan proceeds advanced less depreciation. At sale, foreclosure or other disposition, non-recourse debt incurred as part of the financing of the acquisition, and money extracted from an investment by mortgaging out are treated the same: both are taxable realization when the property is disposed of. Estate of Levine v. Commissioner, (a non-recourse mortgage debt is a debt of the property owner since he is, in reality, a quasi-obligor on the debt, notwithstanding the fact that the debt is owed by the property.); Woodsam Associates, Inc. v. Commissioner,  (the excess of the face amount of the debt over the adjusted basis of the property is gain, and will be treated as capital gain, subject to the rules on depreciation recapture), even if at time of disposition the property is worth less than the amount of the mortgage. Initial borrowing included in basis (Crane), subsequent borrowing is not (Woodsam), but subsequent borrowing proceeds reinvested in a depreciable property thereby avoid Woodsam and take advantage of Crane.