Nonrecourse loans draw many borrowers because the arrangements can shield them from personal liability. But they don’t always provide that protection. If borrowers violate carveouts in the loan document, they may be left with full liability. Here’s how to use negotiations to handle nonrecourse loan carveouts and to minimize personal liability.
Nonrecourse Loans in a Nutshell
Under a nonrecourse loan, the lender agrees not to hold the borrower personally liable on the loan. The result: The lender’s only “recourse” in the case of default lies in the collateral — generally real estate.
In other words, your lender’s only recourse is to seize the property that secured the loan. When you surrender the property, the transaction is generally treated as a sale to the lender for the amount of debt.
Your capital gain or loss equals the difference between the amount of outstanding debt and your adjusted tax basis in the property. For example, if outstanding debt is $1 million and your tax basis is $700,000, your taxable gain would be $300,000. A discharge of nonrecourse debt doesn’t result in any taxable cancelation of debt income because the lender has no right to pursue other corporate or personal assets.
When negotiating a nonrecourse loan, the lender may include specific exceptions — known as “carveouts” — that will nullify the personal liability restriction. Common carveouts include:
- The borrower’s fraud,
- Misapplication of insurance proceeds,
- Waste, or
- Intentional destruction of property.
These are just some of the carveouts used today; the scope of carveouts has expanded over the years. Carveouts can also include bankruptcy filings, the failure to pay mechanic’s liens or real estate taxes, and environmental damages.
Proceed with caution, however: Few court cases have directly tackled the enforceability of carveouts in nonrecourse loans or the lender’s ability to accelerate foreclosure and recover the full amount of the loan where a party violates a carveout. And remember that each state may interpret nonrecourse loans and their carveouts differently.
So what should you do before entering a nonrecourse loan? Evaluate and negotiate any carveouts in the loan documents. Look for overly broad language and negotiate to make it as narrow as possible. Make sure to clearly define potential causes of default.
Also watch out for “springing guarantees.” These trigger a guarantor’s obligations to pay the full amount of debt, as opposed to only the damages proximately caused by a breach of a carveout. You’ll want to limit such guarantees to intentional acts, excluding mere negligence or mistake. For example, limit a carveout for waste to intentional waste only.
Ideally, you’ll want to try to limit liability under both springing guarantees and carveouts to only damages caused by the prohibited act, instead of the entire debt deficiency. Finally, negotiate for the inclusion of notice and cure periods to secure the opportunity to take corrective action before acceleration and foreclosure.
Once you close on the loan, avoid taking actions that could violate carveouts, especially those that might affect the value of the collateral securing the loan. If you sell the property and the buyer assumes the loan, negotiate a release from liability so you aren’t exposed to potential liability for the buyer’s acts. (Note that nonrecourse agreements frequently include a carveout requiring written consent from the lender before transferring mortgaged property.)
Review with Your Advisors
So what should you do to protect yourself from personal liability before entering into a nonrecourse loan? First, review the contract and identify each carveout with your attorney. It’s also advisable to consult your accountant to crunch the numbers. This will help you estimate damages in the event of a loan carveout provision breach.
For more information or discussion, contact Kevin Carney.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this publication should be taken only after a detailed review of the specific facts and circumstances.