Hamill: Words that hurt? Recourse and nonrecourse debt

Robert Fulghum wrote a popular book, “All I Really Need to Know I Learned in Kindergarten.” There is much merit in his book. We now know that cold milk is not good for everyone, but the basics of the book remain true.

I suppose I was ahead of my time, for I learned important things from a TV show while still a preschooler. Romper Room’s Miss Nancy taught me to be a Do-Bee and not to be a Don’t-Bee.

A song told us to be car sitters and not car standers. Important in days before mandatory seat belts and child car seats.

I confess to being a match toucher, one of the Don’t-Bee traits. Both Fulghum and Miss Nancy taught us to be kind to others.

Some kids were not kind. They might say, “Your mother wears army boots.” Today, with so many women serving in the military, a Do-Bee could say he is proud that Mom wears army boots.

But then we were told to say, “Sticks and stones may break my bones, but words will never hurt me.”

Well imagine my shock when I grew up, took on a career as a tax adviser, and discovered that I had not learned everything in kindergarten. Moreover, I learned words can hurt.

More specifically, the meaning of words can hurt. Particularly those words that were just a bit beyond our reach in kindergarten.

Two such words are recourse and nonrecourse. These words are applied to debt. Tax people define them in two ways, which can be confusing.

First, anyone who prepares a partnership tax return must include each partner’s share of recourse and nonrecourse debt on the form K-1 used to report tax items.

The regulations under section 752 of the tax law explain how to do this. Those regulations were just revised in 2019 to deal with some Don’t-Bees who were abusing the definition.

There are many partnership tax returns filed each year, so most tax preparers know the section 752 definitions of recourse and nonrecourse.

Another definition is found in the section 1001 regulations. The purpose of this definition is to determine gain or loss on disposition of an asset.

The section 1001 definitions become important when a debtor does not repay the full amount of the funds borrowed.

The act of borrowing money is not a taxable event. This is because the borrowings must be repaid based on the loan terms.

But what if things don’t go as planned? If some of the debt is cancelled, the tax law says the borrower may have income.

Cancellation of debt (COD) income is ordinary and taxed at the highest rate that applies to the borrower. But the law also has exceptions to grant relief from reporting COD income.

Relief is available if the borrower is insolvent, if the discharge occurs in bankruptcy, or if the debt is “qualified” farm, real property, or principal residence debt.

But COD occurs only if the debt is recourse. If the debt is nonrecourse the lender takes the secured property, and the borrower must treat that property as having been sold.

The IRS has said that section 1001 treats debt as recourse if the lender may recover from all the borrower’s assets. Nonrecourse means the lender can only take the secured asset.

This is not the same definition as is found in section 752. That is not an accident. The two provisions serve different purposes.

Yet many tax advisers do not know the two different meanings. Many lenders also do not know their definitions.

If a debt is nonrecourse and the creditor takes the secured property, that property is deemed sold for the unpaid debt.

If that debt exceeds the tax basis, a gain is reported. That gain may be tax-favored capital gain. But it cannot be reduced or eliminated using the COD relief rules.

Lenders must separately report debt cancellation and acquisitions of secured assets. Both forms used (1099-A and 1099-C) have a box to indicate if the debt was recourse.

You may lose the most favorable treatment if your preparer does not know the proper definition. Your lender may also not report the transaction properly. Yes, words can hurt you.