Recourse debt makes you personally liable for the full loan balance, so if the collateral doesn’t cover what you owe, the lender can come after your income and other assets for the shortfall. Nonrecourse debt limits the lender to the collateral itself; whatever the property sells for is the end of the story. That is the core difference between recourse and nonrecourse debt, and it controls three things that matter to you: what a lender can seize after a default, how the IRS taxes any forgiven balance, and, if you’re an investor, how much of a loss you can deduct.
The Core Distinction
With a recourse loan, you guarantee repayment with everything you own. If you default and the lender sells the collateral for less than your outstanding balance, that shortfall is called a deficiency. The lender can ask a court to convert it into a judgment, and once granted, the lender becomes an ordinary creditor with access to bank levies, liens on other property, and wage garnishment.
Nonrecourse debt flips the risk. The lender’s only remedy is to take back the collateral. If the property sells for less than the loan balance, the lender absorbs the loss. Your bank accounts, investments, and wages stay untouched.
Lenders price these risks differently. Recourse loans usually carry lower interest rates, higher loan-to-value ratios, and easier approval, because the lender has more ways to get paid. Nonrecourse loans typically require larger down payments and stronger underwriting, and the rates run higher, because the lender is betting on the collateral alone.
Which Loans Are Which
Most consumer debt is recourse. Credit cards, auto loans, home equity lines of credit, and personal loans all carry personal liability. Small business loans almost always require a personal guarantee from the principal owners, which converts what looks like a business obligation into personal recourse debt.
Residential mortgages are recourse in most states. Roughly a dozen states have anti-deficiency statutes that block lenders from pursuing a deficiency judgment on purchase-money mortgages for a primary residence, but the protections vary. Some apply only to the original purchase loan and not to refinances or home equity lines, some only to owner-occupied homes, and some only after certain types of foreclosure. Living in one of these states is not the same as being fully protected.
Nonrecourse debt dominates large commercial real estate financing, where lenders underwrite the loan based on the property’s cash flow rather than the borrower’s personal balance sheet. This is the standard structure in commercial mortgage-backed securities. Federally insured Home Equity Conversion Mortgages (reverse mortgages) are also nonrecourse by design: the borrower or their estate will never owe more than the home’s value at the time of repayment, regardless of how much the loan balance has grown.1U.S. Department of Housing and Urban Development. Home Equity Conversion Mortgages Handbook 4235.1 REV-1
What Happens if You Default
On a recourse loan, the lender first takes back and sells the collateral. If the sale doesn’t cover the balance, the lender can petition a court for a deficiency judgment, which is a new unsecured claim against you for the remaining amount. That judgment opens the door to garnishment, levies, and liens.
Federal law caps how much of your paycheck a creditor can take on an ordinary debt like a deficiency judgment: the lesser of 25 percent of your disposable earnings or the amount by which your weekly disposable pay exceeds 30 times the federal minimum wage ($7.25 per hour, or $217.50 per week).2Office of the Law Revision Counsel. 15 USC 1673 – Restriction on Garnishment Earn less than $217.50 per week in disposable income, and your wages are fully protected. Some states set tighter limits.
Lenders face a deadline for pursuing a deficiency after the foreclosure sale. The window ranges from as little as 30 days to several years depending on the jurisdiction. Miss it, and the lender loses the right to chase the shortfall.
On a nonrecourse loan, the process ends when the lender takes back the collateral. If you owe $500,000 and the property sells for $350,000, the lender writes off the $150,000 difference. No lawsuit, no judgment, no garnishment, assuming no carve-out has been triggered (more on that below). The debt is legally satisfied by the transfer of the collateral. That predictability is a real advantage in a down market when property values have fallen below loan balances.
How the IRS Taxes Forgiven Debt
Canceled debt is generally income. Under Section 61 of the Internal Revenue Code, any discharge of debt counts as gross income, whether or not you receive a Form 1099-C.3Office of the Law Revision Counsel. 26 US Code 61 – Gross Income Defined Lenders must file a 1099-C when they forgive $600 or more.4Internal Revenue Service. About Form 1099-C, Cancellation of Debt But the tax treatment splits along the recourse line.
Recourse: Ordinary Income
When a lender forgives a recourse deficiency, the forgiven amount is cancellation-of-debt (COD) income, taxed as ordinary income. A waived $50,000 deficiency lands on your return as $50,000 of ordinary income, stacked on top of your other income at your marginal rate.
Nonrecourse: Capital Gain
The IRS doesn’t treat a nonrecourse shortfall as COD income at all. Instead, under Treasury Regulation 1.1001-2, the full outstanding loan balance is treated as the amount you received for the property, even if the property was worth far less.5eCFR. 26 CFR 1.1001-2 – Discharge of Liabilities The property’s fair market value at foreclosure doesn’t factor in. Your gain or loss is the difference between that deemed sale price and your adjusted basis. Owe $400,000 on a nonrecourse loan with a $300,000 adjusted basis, and you have a $100,000 capital gain. Long-term capital gains are taxed at lower rates than ordinary income for most taxpayers, which cuts both ways: the rate is friendlier, but the exclusions below don’t reach capital gain.
The Exclusions That Can Wipe Out COD Income
For recourse debt, Section 108 of the Internal Revenue Code offers several exclusions.6Office of the Law Revision Counsel. 26 US Code 108 – Income From Discharge of Indebtedness The two most commonly used are the bankruptcy exclusion, which fully excludes debt discharged in a Title 11 case, and the insolvency exclusion, which lets you exclude COD income up to the amount by which your total liabilities exceeded the fair market value of your total assets immediately before the discharge.
A separate exclusion for qualified principal residence indebtedness allowed homeowners to exclude up to $750,000 of forgiven mortgage debt on a primary residence. It applied to discharges before January 1, 2026, or under written arrangements entered before that date.7Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness Unless Congress extends it, it isn’t available for 2026 discharges.
Claiming any of these exclusions requires filing IRS Form 982 and reducing certain tax attributes, such as net operating losses and capital loss carryovers, dollar-for-dollar against the excluded amount.8Internal Revenue Service. Instructions for Form 982 The exclusion is really a deferral: today’s tax bill shrinks, but so does the pool of future deductions.
None of these exclusions helps with nonrecourse debt. Because the IRS treats the transaction as a sale rather than a cancellation, the gain is a capital gain, and the insolvency exclusion doesn’t offset capital gains.
Nonrecourse Carve-Outs: When “Nonrecourse” Isn’t
Very few nonrecourse loans are truly unconditional. Most commercial nonrecourse agreements include contractual exceptions called carve-outs, sometimes known in the industry as “bad boy” guarantees. They were designed to punish deliberate misconduct, but in practice the triggers are often broader than borrowers realize. Common ones include:
- Fraud or material misrepresentation on the loan application or in ongoing financial reporting.
- Voluntary bankruptcy, or consenting to an involuntary filing against the borrowing entity.
- Breach of environmental representations or contamination of the property.
- Waste, meaning physical deterioration or stripping the property of value.
- Misapplying funds such as insurance proceeds, security deposits, or rental income.
- Violating entity covenants, like commingling funds or failing to keep the borrower as a properly capitalized special purpose entity.
The last one catches even sophisticated borrowers. Many nonrecourse commercial loans require the borrower to operate as a special purpose entity that exists solely to own and manage the property. Commingling funds, sloppy record-keeping, or letting the entity become undercapitalized can trigger full recourse liability for the entire loan. Once triggered, many carve-outs are irrevocable; fixing the problem later doesn’t undo the personal liability that already attached. Read the carve-out language before signing, not after a default notice arrives.
The At-Risk Rule for Investors
If you’re a real estate investor, the recourse question also affects how much of a paper loss you can actually deduct. Under Section 465, you can only deduct losses from an activity up to the amount you have “at risk” in it.9Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk Money borrowed on a recourse basis counts as at-risk because you’re personally on the hook. Nonrecourse borrowing generally does not, because you can walk away. So if depreciation generates tax losses on a nonrecourse-financed property and you have no other skin in the deal, you can’t use those losses against your other income.
Real estate gets an important exception. “Qualified nonrecourse financing” secured by real property counts as at-risk even though no one is personally liable, provided the loan comes from a bank, a government entity, or another qualified lender and isn’t convertible debt.10Office of the Law Revision Counsel. 26 US Code 465 – Deductions Limited to Amount at Risk Most institutional commercial real estate loans qualify, so the at-risk rule usually doesn’t block depreciation deductions in a typical deal. Seller-financed loans or loans from related parties may not qualify, which can limit your ability to use those losses.