The Tax Lawyer

Recourse and Nonrecourse Debt: What Are the Federal Income Tax Consequences When the Character of Debt Changes

Kenneth C. Weil

Abstract

When encumbered property is sold, the taxation of that sale is different if the sale involves recourse debt as opposed to nonrecourse debt. This difference raises an intriguing question: when debt changes from recourse debt to nonrecourse debt or vice versa, which rules will control? Examples of when debt changes from recourse to nonrecourse or vice versa include bankruptcy discharges, foreclosures in a state with anti-deficiency statutes, some short sales in deficiency states, and the operation of Bankruptcy Code section 1111(b).

The Cottage Savings regulations, Regulation section 1.1001-3, have specific provisions designed to answer the question what happens when debt changes from recourse to nonrecourse or vice versa. These regulations are sometimes helpful to creditors, e.g., elections under Bankruptcy Code section 1111(b)(2). Sometimes, they appear punitive to debtors, e.g., the mandatory conversion of recourse debt into nonrecourse debt in Chapter 11. And, sometimes, they do not provide an answer, e.g., short sales and foreclosures in some anti-deficiency states.

The author believes that when debt is converted from recourse to nonrecourse by operation of the bankruptcy discharge, there should be a discharge of indebtedness event, and thereafter, the nonrecourse rules would apply, though with the nonrecourse debt reduced by the amount of debt discharged. In other words, after discharge, the nonrecourse debt would be reduced to the fair market value of the collateral. Upon a subsequent sale, the amount realized to the debtor would be the fair market value of the property (or the new, tax-value of the debt, if the property declines in value). The current rule would no longer apply, i.e., the amount realized would not be the old face value of the debt thereby putting an end to punitive gains under the current nonrecourse-sale rules.