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

74 Tax Lawyer 141 (2020)

24 Pages Posted: 3 Sep 2020 Last revised: 12 Dec 2020

Date Written: December 11, 2020

Abstract

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 to nonrecourse,
or vice versa, which rules will control? Examples of when debt
changes from recourse to nonrecourse, or vice versa, include bankruptcy discharges,
nonjudicial foreclosures in some states with deficiency statutes, some
short sales in deficiency states, and the operation of section 1111(b) of the
Bankruptcy Code.

The Cottage Savings regulations, Regulation section 1.1001-3, have specific
provisions designed to address what happens when debt changes from
recourse to nonrecourse, or vice versa. These regulations are sometimes helpful
to creditors (e.g. , elections under section 1111(b)(2) of the Bankruptcy
Code). 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 nonjudicial foreclosures
in deficiency states).

The Author believes that when recourse debt is converted to nonrecourse
debt by operation of a discharge in bankruptcy, there should be a discharge
of indebtedness event, and thereafter, the nonrecourse rules would apply, albeit
with the nonrecourse debt reduced by the amount of the debt discharged.
As a result, after discharge, the nonrecourse debt would be reduced to the fair
market value of the collateral. Upon a subsequent sale, the amount realized
by the debtor would be the fair market value of the property (or the new taxvalue
of the debt if the property declines in value). The current rule, with the
amount realized equaling the old face value of the debt, would no longer apply.
This change would put an end to the punitive gains resulting from the
current nonrecourse-sale rules. Unfortunately, this proposal is probably not
administratively feasible.

Suggested Citation

Weil, Kenneth, Recourse and Nonrecourse Debt: What Are the Federal Income Tax Consequences When the Character of Debt Changes (December 11, 2020). 74 Tax Lawyer 141 (2020) , Available at SSRN: https://ssrn.com/abstract=3660637 or http://dx.doi.org/10.2139/ssrn.3660637

Kenneth Weil (Contact Author)

Kenneth C. Weil Law Office ( email )

United States

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