With the many types of loans available to borrowers, nonrecourse loans remain popular because they can shield borrowers from personal liability. But lenders will try to add “carveouts” to minimize that protection. If borrowers violate carveouts in the loan document, they may be left with full liability. Both lenders and borrowers will negotiate nonrecourse loan carveouts, with borrowers looking to minimize personal liability.
How Does a Nonrecourse Loan Work?
In a nonrecourse loan, the lender agrees not to hold the borrower personally liable on the loan. In the case of default, the lender’s only “recourse” lies in the collateral — generally real estate. Thus, your lender’s only recourse is to seize the property that secured the loan. When the borrower surrenders the property, the transaction is generally treated as a sale to the lender equal to 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 $2 million and your tax basis is $1.5 million, your taxable gain would be $500,000. A discharge of nonrecourse debt doesn’t result in any taxable cancellation of debt income, because the lender has no right to pursue other corporate or personal assets.
What Types of Carveouts are Common in a Nonrecourse Loan?
Carveouts are specific exceptions lenders may include when negotiating nonrecourse loans. Such carveouts nullify the personal liability restriction. The scope of carveouts has expanded over the years, but some possible common ones include:
Fraud or waste by the borrower,
Intentional destruction of property,
Misapplication of insurance proceeds,
Failure to pay mechanics’ liens or real estate taxes, and
Proceed with caution, however. Not many courts 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 keep in mind that each state may interpret nonrecourse loans and their carveouts differently.
What to Watch Out for When Negotiating Carveouts
Before entering into 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. 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. Limit such guarantees to intentional acts, excluding mere negligence or mistake. For example, limit a carveout for waste to intentional waste only.
Ideally, try to limit liability under both springing guarantees and carveouts to only damages caused by the prohibited act, rather than 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.)
The leading reason to enter into nonrecourse loans is to protect yourself from personal liability. But before entering into a nonrecourse loan, review the loan and its carveouts with both your attorney and financial advisor. Identify each carveout and do the math. This should help you estimate — and minimize — damages in the unfortunate event there’s a breach of a loan carveout provision.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.