Reprinted from Betty J. Boyd, To Prevent Adverse Tax Consequences, Make No Bones about the Classification of Your Loans, Business Law Today, November 2015. © 2015 American Bar Association. Reprinted with permission.
Recourse or nonrecourse: that is the question . . . for the IRS, when it comes to determining the tax consequences of a partnership loan agreement to the individual partners, upon the foreclosure of the partnership’s collateral property. Why does this matter? The bare bones answer is that, when the lender forgives all or part of the outstanding loan and forecloses upon the collateral property, the partnership is considered to receive income. Partners need to report this income on their tax returns. However, if the partnership loan is recourse, they may exclude the cancellation of debt income (and not pay tax on this income), to the extent of their respective insolvencies. We will call this the “insolvency exception.” On the other hand, if the partnership loan is nonrecourse, the partners may not use this insolvency exception.