There are a number of ways to finance a purchase or investment. Most of the common, available methods fall under equity or debt financing. With equity financing, the investor typically sells a portion of their equity (or shares) to a financier for cash. With debt financing, the investor accepts a loan from a financier and agrees to pay back the loan with interest over a certain term length.
Recourse vs nonrecourse debt
There are primarily two forms of debt:
- Recourse debt
- Nonrecourse debt
Both are simple to understand, a recourse debt holds the borrower (or investor) personally liable to the financier. This means that in the unfortunate circumstance that the investment or business fails, the borrower will be required to pay back the loan by liquidating whatever is left over from the investment. If the liquidation of their investment is not sufficient to fulfill the loan, then the borrower is required to pay back the financier from their personal property, which could mean the liquidation of their personal home or other assets.
So, What is qualified nonrecourse debt?
Qualified nonrecourse debt represents financing for which no one is personally liable for repayment. Instead, it represents a debt that is attached to some real property (real estate, automobile, etc.). In the vast majority of situations, nonrecourse debt is used to finance rental properties, as the financier can viably take the real estate.
Qualified nonrecourse financing is particularly important for partners in partnerships. A number of operating partnerships, especially within real estate, take on partnership liabilities in the form of nonrecourse debt. The items to consider on the K-1 are:
- Whether that debt is recourse; or
- Whether that is nonrecourse; or
- Whether it is qualified nonrecourse
What constitutes qualified nonrecourse financing?
- Secured by real property used in the activity;
- Not convertible from a debt obligation to an actual ownership interest, and
- Loaned or guaranteed by a government agency or borrowed from a qualified person. “A qualified person represents a person who is actively involved in and regularly engages in the business of lending money or providing financing. The most common example is a bank or savings and loan.
- Borrowed by the entity in connection with the activity of holding real property. Qualified nonrecourse financing offers interesting opportunities and consequences for determining your basis in a partnership. This will be covered more in-depth in Part 2 of this piece.
Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult your tax professional.