The purpose of this article is to understand the difference between financial recourse and nonrecourse debt. Furthermore, it discusses in depth the purpose of using qualified non recourse debt in partnerships.
Working in a partnership can be a risky venture. This becomes especially true when applying for a debt or loan. Many times, things can become unclear and paying off the loans can be a complicated process. There are many options available for people in a partnership to apply for a loan. The options are recourse, nonrecourse, and qualified nonrecourse debt.
Difference Between Recourse and Non-Recourse Debt
In order to further understand qualified nonrecourse debt, it is important to know the difference between recourse financial debt and non-recourse financial debt.
Recourse debts are those which need to be paid one or another. Recourse loans have a collateral with them. This makes it a secure form of debt. Any borrower who fails to live up to his word and pay back the debt will be held accountable by the lender. The lender can take away his property or any other asset in order to recover his debt. In worst case scenarios, the lender can sue the borrower if the loan is not returned on time.
Due to all these privileges given to the lenders, the position of lenders in the recourse debt is much stronger than that of the borrower. Through a recourse loan, the lender is safe to give money to a borrower. As the lenders have the upper hand in controlling the terms of recourse debt, they can lower the interest rates as well.
This further makes them look more attractive to the borrowers. When the economy is low and banks are unable to give out loans like usual recourse debts become very common.
Loans in the automobile industry are commonly recourse debts. In the scenario where the borrower is unable to pay the lender their money back, the automobile can be taken from the borrower by the lender. Then they can sell the automobile at full market value. But it is commonly known that the worth of an automobile reduces rapidly once it has been used. So apart from the automobile, the lender can go after whatever asset of the borrower that they want.
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As the name implies, it is the opposite of recourse debt. This means that if there is a loss in this scenario, the borrower will have zero liability. Furthermore, the lender has to bear the loss completely in case the borrower fails to pay up. No other assets of the borrower can be confiscated by the lender in such a scenario.
Since there is benefit for borrowers in this debt situation, borrowers prefer to take this kind of debt instead. But even though the borrower does not lose the assets when unable to return to the lender, it stays on the record and reflects a poor impression of the borrower in the longer run.
Since the risk is too high for lenders in non-recourse debt situation, the interest rate set by the lenders is high as well. Lenders opt for borrowers which are financially secure and have little to no risk attached in their returning the loan. This provides them with a safety net for minimal damage in case if things go wrong.
Non-recourse debts are taken when mortgage is applied for in traditional terms. The only collateral the organization can hold against the person is the house itself. Nothing else can be held liable by the lender and in case of a loss, nothing else can be confiscated apart from the house to repay the loan. Any remainder balance against the house cannot be recovered through any other assets. This creates a loss for the lenders which cannot be compensated by the borrower under any circumstance.
Qualified Non-Recourse Debt
A qualified nonrecourse debt is similar to a recourse debt. In easy words, qualified nonrecourse debt can be defined as the financing or debt for which no single person is liable for repayment. Mostly the debt acquired is used for the purpose of holding a real property.
Most of the times, this real property is held for the purpose of renting it out. The loan is mostly taken from either the state, government or a “qualified” person (as the name specifies). By the term qualified, it is implied that any person, bank, or business which is involved directly or indirectly in the business of lending money to other people.
Even pass through entities, a business structure used to reduce the effects of double taxation, are not liable to repay qualified nonrecourse debt. Qualified nonrecourse debt which secured through real property used in the activity of holding real property which is subject to at-risk rules is amounted to at-risk.
At risk-rules do not apply on all partners. It is applied on the individual partner level. Share in investments, assets, transactions, and liabilities nature considered as amount at risk are determined on the level of the partners individually. If a partner’s assets and amounts at risk suffers great losses, then it is suspended. It is then carried forward and can last indefinitely. During the sale of any partnership, losses can be used to balance any increases or expansions.
Requirements of Qualified Nonrecourse Debt
There are a few requirements which need to be followed in order to easily acquire the debt.
- It should be made secure by using real property in the activity.
- It cannot be converted from a debt obligation to a genuine owner interest.
- Loan is guaranteed from a person/agency/institute who is qualified enough to give out the loan. This can be banks or government agencies or individuals who are generally in the business.
Qualified nonrecourse debt plays an important role when going through at basis and at risk limitations. Both these limitations define whether a partner in a business can deduct a loss or not in the partnership. In order to ensure that the basis calculations are correct, it is important to keep an eye on the K-1.