Recourse vs. Non-Recourse Debt: Which is Best for Your Real Estate Investments?

As a real estate investor, you’re likely well aware that debt offers a powerful form of leverage to grow your investment portfolio. Securing financing against your properties allows you to invest a smaller percentage of your own (or your investors’) capital in each asset, enabling you to acquire more assets with the capital at your disposal.

But while debt undoubtedly helps you grow faster, it’s also a double-edged sword with a lot of risk. Exactly how much depends on whether it’s recourse or non-recourse debt. This important distinction has implications not only for your personal liability in the event of foreclosure but also for the deductibility of losses.

Understanding the different types of debt available to you as a real estate investor is key to making the right choices for your portfolio. This is especially true in recent years as interest rates and construction costs have climbed higher. This has left many real estate investors with less room for error than ever before.

We’ve broken down the key differences between recourse and non-recourse debt, including everything real estate investors need to understand to make the best choice for their portfolio.

The Different Types of Debt in Real Estate

There are three tax classifications of debt in real estate: recourse debt, qualified non-recourse debt, and non-recourse debt.. Here are the key differences between each of these forms of debt.

Recourse Debt Definition

Recourse debt is any loan for which the borrower provides a personal guarantee.

In the event of a default on the loan, the guarantor of the loan is responsible for making the lender whole. The lender will first seize the collateral associated with the loan (i.e., the property which is being borrowed against). But if the value of that asset isn’t sufficient to cover the balance of the debt, the borrower will be responsible for repaying the difference from their personal assets.

Qualified Non-Recourse Debt Definition

Qualified non-recourse debt in real estate investing is a form of financing in which the lender’s only recourse in case of default is the property itself, not the borrower’s personal assets.

Most mortgages on real estate investments would be considered qualified non-recourse debt. Qualified non-recourse debt is riskier for lenders since they can only seize the collateral used to secure the loan. For that reason, they tend to be harder to qualify for. Loan to value (LTV) ratios will likely be lower for qualified non-recourse debt, and interest rates may be higher, although this is not always the case.

To be eligible for qualified non-recourse debt, investors typically need to show a strong track record and project a debt service coverage ratio (DSCR) above certain thresholds determined by the lender. Remaining in compliance with these debt covenants is vital.

Non-Recourse Debt Definition

Non-recourse debt is any other kind of debt in real estate. This typically includes items such as accounts payable and any other form of debt that does not include a personal guarantee.

Note: Many people refer to qualified non-recourse debt simply as non-recourse debt. In most instances, this simplification works fine, since the real distinction is between recourse and non-recourse debt.

Key Considerations for Real Estate Investors

All else being equal, when it comes to choosing between recourse and non-recourse debt, real estate investors typically opt for non-recourse debt since it comes with no personal liability. However, if you’re early in your career, entering a new market or investing in a new asset class, recourse debt might be all you qualify for.

Regardless, it’s important that investors understand the key distinctions between recourse and qualified non-recourse debt. This is particularly true in partnerships such as real estate funds, where the type of debt can have significant implications for the tax strategies of partners in the fund.

Personal Guarantees

As outlined above, one of the major distinctions between recourse and non-recourse debt is the requirement for the borrower to provide a personal guarantee. If the borrower breaches the loan covenants or defaults on the loan, the lender may seize the collateral through a foreclosure action.

If that’s insufficient to cover the outstanding balance owed on the loan, the lender will then pursue the guarantor’s personal assets. At this point, settling the debt is a negotiation between the borrower and the lender.

Generally speaking, investors should avoid making a personal guarantee on a loan if they can. But this isn’t always possible.

Deductibility of Losses

Another key distinction, particularly for investors operating with partners, is the deductibility of the losses. Investors must pass three tests to be eligible to deduct their losses:

1. Basis Limitations: An investor’s ability to deduct losses is limited to the tax basis that they have in the partnership. Qualified non-recourse debt is included in this tax basis, meaning that investors often have a greater tax basis than economic basis.
2. At Risk Limitations: Qualified non-recourse and recourse activities give investors risk. Partners may deduct losses up to the amount that they have “at risk” in the investment.
3. Passive Activity Loss Limitations: Finally, investors have to consider passive activity rules and know they can only use these passive activity losses to offset passive income.

The way that losses are allocated is also driven by the nature of the debt. Recourse debt is allocated to the individuals who have personally guaranteed the debt. Non-recourse debt, on the other hand, is allocated among all partners based on their ownership percentage.

Here’s a simple example. Four people invest together in a real estate partnership: Joe, Jack, Jane and Jake. If the partners take out recourse debt which Joe alone guarantees, only Joe may deduct losses against the debt once their capital has been exhausted. If they instead took out non-recourse debt, the debt would be allocated according to all four partners’ ownership percentages.

There are additional ways for real estate funds to work around these limitations using special allocations. However, these must have substantial economic effect to be considered valid in the eyes of the IRS. For more information, read Special Allocations and Basis Limitations: A Guide for Real Estate Funds.

James Moore: Specialized Real Estate CPAs

In today’s market, real estate developers are facing more challenges than ever. With costs continuing to rise and interest rates remaining high, it’s difficult to find the leverage needed to make bold investments that deliver results for investors.

So it’s vital to understand the different forms of debt available — and the implications of each on both your personal financial situation and the tax strategies of your investors. Allocating losses among investors in particular demands a sophisticated understanding of IRS regulations and the internal financial infrastructure of a real estate fund.

At James Moore, our real estate CPAs provide support to real estate investors and fund managers, helping them navigate the complexities of real estate accounting and tax strategy. To learn more about how we can help you, contact an advisor today.

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