Are Non-Recourse Loans Taxable?

Are Non-Recourse Loans Taxable?

Non-recourse loans are not taxable and are treated differently by the IRS from recourse loans.

Non-recourse loan tax consequences will be different from those of recourse loans. 

Depending on the type of loan, you may still owe taxes on part of it even if you default.

When a non-recourse loan defaults, is canceled, or is forgiven, the borrower is free from potential taxes.

In other words, the amount canceled or forgiven will not be taxed. While there may be specific exceptions, generally, non-recourse loans are tax-free. 

On the other hand, if you default on a recourse loan and the debt is forgiven or canceled, the debt amount can still be considered taxable income on your 1099-C.

The tax implications of a non-recourse loan are one reason they are attractive to borrowers.

What Does "Non-recourse Loan" Mean?

A non-recourse loan does not hold the borrower personally responsible for the debt. In the event of default, the lender can only pursue the loan's collateral, not the borrower's personal assets, even if the collateral is insufficient to satisfy the defaulted amount.

For example, if you default on a non-recourse mortgage loan, the lender can only use that house to satisfy the debt.  The lender cannot seek additional money from the borrower's other assets or income, such as other property, wage garnishment, and more. 

Non-recourse debts have many advantages for the borrower, including forgiving tax implications.

However, they pose a greater risk to the bank or lender than a recourse debt. If the property's resale value decreases and the borrower defaults, the lender is bound to the value of that property.

Lenders can pursue the borrower's other assets for recourse loans to satisfy the remaining balance. Because non-recourse loans are riskier to the lender, they often charge higher interest rates and have a stricter application process. They typically require higher credit scores to qualify.

Twelve states allow recourse and non-recourse loans, including Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington. 

To determine whether a loan is recourse or non-recourse, you must look at the language of the debt instrument or loan documents.

Non-Recourse Debt Examples

Here are two everyday examples of how non-recourse debt works. Suppose you default on your home mortgage and owe $500,000, but when the bank forecloses on and sells your home, it is only worth $400,000.

If you have a non-recourse loan, the bank cannot seek that $100,000 balance from your other assets. They are bound to only seek the property value of the home and nothing more. 

Another prime example is a car loan. Generally, cars lose their value from the date of purchase. If the auto lender provides a $40,000 car loan based on the new car's value, but at the time the borrower stops making payments, the car is only worth $25,000, but they still owe $30,000.

This leaves the lender looking for the difference. With a non-recourse loan, the buyer will not be personally liable for the remaining balance.

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