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

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.