With the many types of loans available to borrowers, nonrecourse loans remain popular with borrowers because they can shield them from personal liability. Even if you own your business through a limited liability company, banks may not be willing to lend funds without recourse. Lenders will try to add “carve outs” to minimize that protection. If borrowers violate carve outs in the loan document, they may be left with full liability. Both lenders and borrowers negotiate nonrecourse loan carve outs, while most borrowers are looking to minimize personal liability.

What Are Nonrecourse Loans?

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, especially with real estate.  Your lender may have limited recourse to attack the property that secured the loan. When a borrower surrenders the property, the tax treatment is generally a sale to the lender with proceeds 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 adjusted tax basis is $1.5 million, your taxable gain would be $500,000.  A discharge of nonrecourse debt does not result in any taxable cancellation of debt (COD) income because the lender has no right to pursue other corporate or personal assets.

How Do You Carve Out Exceptions?

Carve outs are specific exceptions that lenders may include when negotiating nonrecourse loans. Such carve outs nullify the personal liability restriction. Common carve outs include fraud or waste by the borrower, intentional destruction of property or misapplication of insurance proceeds.  Additional carve outs include bankruptcy filings, the failure to pay mechanics’ liens or real estate taxes and environmental damages. The scope of carve outs has expanded over the years, and these are just some of the possibilities.

Not many courts have directly tackled the enforceability of carve outs in nonrecourse loans or the lender’s ability to accelerate foreclosure and recover the full amount of the loan where a party violates the carve out.  If any legal issues arise, each state may interpret nonrecourse loans and their carve outs differently.

What Should You Consider When Negotiating?

Before you enter into a nonrecourse loan, try to evaluate and negotiate any carve outs in the loan documents. Beware of overly broad language and restructure it to make it as narrow as possible. Be proactive by clearly defining potential causes of default.

Also beware of “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 carve out. Some guarantees are unilateral, which are too easy to trigger, even when they are unintentional. Try to limit guarantees to intentional acts, excluding mere negligence or mistake.

The ideal choice is to limit liability under both springing guarantees and carve outs to only damages caused by the prohibited act, rather than the entire debt deficiency. Finally, consider if you can 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 carve outs, 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 are not exposed to potential liability for acts of the buyer. (Note that nonrecourse agreements frequently include a carve out requiring written consent from the lender before transferring mortgaged property.)

Minimize Your Exposure

The intent of entering into nonrecourse loans is to protect yourself from personal liability. But before entering into nonrecourse loans, review the loan and its carve outs with both your attorney and financial advisor. Identify what are potential carve out issues and consider the math and risk. This should help you estimate (and minimize) damages if there is a breach of a loan carve out.

For more information, contact Tom Kosinski at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.

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