The classification of debt as recourse or nonrecourse is important for borrowers in two ways. First, the classification affects the borrower’s personal liability for unpaid loan amounts after assets have been sold by the lender. Second, the classification determines whether the borrower must report ordinary income from debt forgiveness and recognize a gain from the foreclosure or repossession. Speak to a tax professional to understand the consequences of recourse and nonrecourse debt before defaulting on a loan.
Recourse is a legal means for lenders to seize assets when borrowers default on debts. As the Investopedia website notes, debt can have full or limited recourse. With full recourse, the borrower is liable for the full loan amount without exception, and the lender can sell the borrower’s personal assets until the debt is satisfied. With limited recourse debt, however, the lender can claim only the specific assets the borrower pledged in the loan documents. For example, a borrower might secure a personal loan for $500 by pledging a television. If the borrower defaults, the lender can sell the television to recover as much of the outstanding debt as possible.
Nonrecourse debt is secured by the asset financed. The lender can seize only the financed asset if the borrower defaults. If the asset value is insufficient to cover the debt, the borrower has no personal liability for the debt. Nonrecourse debt is typically used to finance long-term, high-value loans.
Tax Impact of Recourse Debt
Recourse debt can have two tax consequences for borrowers. First, a borrower must recognize ordinary income if the lender forgives any portion of the debt. For example, if a borrower owes $5,000 on a repossessed car that the lender sells for $4,000, the remaining $1,000, if forgiven, is considered taxable ordinary income to the borrower. Second, a borrower must report a gain or loss if the borrower’s basis in the asset, usually the original loan amount, differs from the amount recognized from the asset sale. For example, if the original car loan was $10,000, the borrower subtracts the $4,000 realized from the sale to arrive at a nondeductible loss of $6,000.
Tax Impact of Nonrecourse Debt
Because lenders must be satisfied with the proceeds from an asset’s sale for nonrecourse debt, there is no debt to forgive and no affect on ordinary income for the borrower. However, borrowers must report a gain or loss for tax purposes, using the debt outstanding minus the asset’s fair market value at the time of repossession. For example, if a borrower defaults on a nonrecourse loan with a balance of $50,000 and the asset’s fair market value at the time of repossession was $55,000, the borrower reports a taxable realized gain of $5,000.
Gain and Loss Clarification
Borrowers must recognize gains and losses for the tax year in which the foreclosure or repossession occurred. Gains are included as income and are considered when tax liability is calculated. Losses, however, cannot be deducted from income.