When you’re part of a partnership or LLC, how your debt is classified—recourse or nonrecourse—can affect your taxes in big ways. This guide will break it down so you can understand what these two types of debt mean and how they impact things like tax deductions, gains, and losses.
What’s the Difference Between Recourse and Nonrecourse Debt?
- Recourse Debt:
- At least one partner or member personally guarantees the debt.
- If the business can’t pay, the lender can go after the partner’s personal assets.
- Example: A bank loan with a personal guarantee.
- Nonrecourse Debt:
- The loan is backed only by the business’s assets, not anyone’s personal assets.
- If the business can’t pay, the lender can take the asset but can’t pursue individual partners.
- Example: A real estate loan where the lender can only foreclose on the property.
How Does This Affect Your Taxes?
1. How Debt Increases Your Tax Basis
- Tax Basis: Think of this as your “investment value” in the partnership or LLC. It determines how much of the losses you can deduct and how gains are taxed when you sell your interest.
- Recourse Debt:
- The portion of the loan you personally guarantee gets added to your tax basis.
- A higher basis means you can deduct more losses from the business.
- Nonrecourse Debt:
- The debt gets split among all partners based on their ownership percentage.
- This still increases your tax basis, but not as much as a guaranteed recourse loan.
2. Impact on Loss Deductions
- Recourse Debt:
- Since you’re personally on the hook, you get a bigger tax basis and more room to deduct losses.
- This can be helpful in the early stages of a business when losses are common.
- Nonrecourse Debt:
- Everyone shares the debt for tax purposes, but no one takes personal responsibility.
- You might get fewer loss deductions because the increase to your tax basis is smaller.
3. What Happens When the Debt is Forgiven or the Asset is Sold?
When the partnership or LLC’s debt is forgiven (or an asset is foreclosed on), the IRS looks at whether the debt was recourse or nonrecourse to decide how the gain or loss is taxed.
- Recourse Debt:
- If the business defaults and the lender forgives more than the asset’s value, the excess is counted as taxable income (called Cancellation of Debt Income).
- Example: You owe $500,000 on a loan, but the asset is only worth $400,000. The $100,000 difference is taxable.
- Nonrecourse Debt:
- The lender can only take the asset, and no taxable income arises from the forgiven amount.
- However, the entire loan amount is treated as if you sold the asset for that amount, which could result in a capital gain.
- Example: If you owe $500,000 and the lender forecloses, it’s treated like you sold the property for $500,000, even if the asset was worth less.
Which Type of Debt is Better for Your Taxes?
- Recourse Debt:
- Good for partners who want to maximize their loss deductions, but it comes with personal liability.
- Useful in early-stage businesses that expect losses and need bigger deductions.
- Nonrecourse Debt:
- Safer for partners, since no one is personally liable, but offers fewer tax benefits.
- Popular in real estate deals, where the asset itself secures the loan.
Choosing the right kind of debt depends on your business goals and personal risk tolerance. If you want bigger tax deductions, recourse debt might be the way to go. But if you prefer less personal liability, nonrecourse debt offers peace of mind—even if it comes with fewer tax perks.
If you have questions contact Paragon today!
