Nonrecourse Debt: Basis, At-Risk Limits, and Partnership Rules

Nonrecourse debt receives a distinctive federal tax treatment: the full loan amount is included in your cost basis in the financed property, but the same debt generally does not count toward the “at-risk” amount that governs how much loss you can actually deduct. Real estate gets a large exception to that at-risk rule, partnerships and S corporations handle the debt very differently, and when the property is foreclosed the outstanding loan balance is treated as your sale price no matter what the property is worth. Those four points, taken together, are the framework.

Nonrecourse Debt Counts Fully Toward Basis

Buy a $1,000,000 commercial building with $200,000 cash and an $800,000 nonrecourse mortgage, and your depreciable basis is the full $1,000,000, not just the cash you put in.¹ The larger basis produces larger annual depreciation deductions.

The rule comes from the Supreme Court’s 1947 decision in Crane v. Commissioner, which held that “property” for tax purposes is the whole asset rather than the owner’s equity net of the mortgage.² The Court extended the principle in Commissioner v. Tufts (1983), ruling that when property subject to nonrecourse debt is disposed of, the full outstanding loan balance is included in the amount realized even if the property is now worth less than the debt.³ Fair market value drops out of the calculation. That principle drives both the basis rule at acquisition and the gain rule at foreclosure.

Why High Basis Doesn’t Automatically Mean High Deductions

Internal Revenue Code Section 465 caps deductible losses from an activity at the amount you have “at risk” in it. The at-risk amount is roughly the money you could genuinely lose: cash and the adjusted basis of property you contribute, plus amounts you borrow for the activity if you are personally liable or have pledged separate property as security.⁴

Nonrecourse debt does not, as a general matter, add to that at-risk amount, because you have no personal liability for the loan. In the $1,000,000 building example, basis is $1,000,000 but the initial at-risk figure is only the $200,000 of cash. Losses in excess of the at-risk amount are not lost forever. They are suspended and carried forward until the at-risk amount rises, whether from additional contributions, income from the activity, or conversion of the debt to recourse.⁴ The at-risk rules apply broadly, including to equipment leasing, farming, energy, and film activities.

The Real Estate Exception: Qualified Nonrecourse Financing

Section 465(b)(6) treats certain nonrecourse loans secured by real property as at-risk amounts. This is the reason leveraged real estate investors can deduct losses far in excess of their cash contribution. To qualify, the financing must meet every one of the following:⁵

The loan is secured by real property used in the activity of holding real estate. Incidental personal property and related services are included; mineral property is not.
The lender is a bank, credit union, insurance company, pension fund, or another entity actively engaged in the business of lending money. Federal, state, and local government loans and government-guaranteed financing also qualify.
No person is personally liable for repayment.
The debt is not convertible into an ownership interest in the property.⁶

Seller financing generally does not qualify, and neither does financing from a party who receives a fee tied to your investment. A loan from a related party can qualify if the terms are commercially reasonable and substantially similar to what an unrelated lender would offer.⁵

The Full Stack of Loss Limitations

Even after basis and at-risk are satisfied, two more limits sit above the deduction. The full sequence applied to a pass-through loss runs in a fixed order:⁷

Basis limitation. Losses cannot exceed your basis in the investment (partnership interest, S corporation stock, or the property itself).
At-risk limitation. Of the losses surviving the basis test, only the portion up to your at-risk amount is deductible in the current year.
Passive activity limitation. Losses from activities in which you do not materially participate can only offset passive income.
Excess business loss limitation. For noncorporate taxpayers, remaining business losses above the annual threshold ($256,000 for single filers and $512,000 for joint filers in 2026) are deferred and treated as a net operating loss carryforward.

Qualified nonrecourse financing solves the at-risk problem for real estate but does nothing about the passive activity limit. Most rental property owners are passive participants, so their losses commonly get blocked at that third step. Suspended passive losses carry forward until you generate passive income to absorb them or dispose of the entire activity in a taxable transaction. The real estate professional rules in Section 469 provide an escape from the passive category, but they set a high bar: more than 750 hours of qualifying services and more than half of all personal services performed across all trades and businesses.⁸

Partnership Treatment: Debt Flows Through to Partner Basis

The reason most leveraged real estate is held in a partnership or an LLC taxed as one comes down to Section 752. An increase in a partner’s share of partnership liabilities is treated as a deemed cash contribution by that partner, which raises the partner’s outside basis. A decrease is treated as a deemed distribution and reduces basis, potentially triggering gain if it exceeds remaining basis.⁹

Treasury Regulation 1.752-3 allocates partnership nonrecourse liabilities among the partners in three tiers:¹⁰

Tier 1 allocates each partner’s share of partnership minimum gain associated with the nonrecourse debt, determined under the Section 704(b) regulations.
Tier 2 allocates the Section 704(c) gain that would be triggered if the partnership sold all property subject to nonrecourse debt for the debt amount and nothing more. This tier captures built-in gain from contributed or revalued property.
Tier 3 allocates whatever remains based on the partners’ shares of partnership profits, with some flexibility for the partnership agreement to specify those shares or to tie them to the way related deductions are shared.

A limited partner in a real estate fund can therefore pick up outside basis from the fund’s nonrecourse mortgage, which is basis they need before they can deduct losses passed through to them.

S Corporations Are the Opposite Story

An S corporation shareholder’s deductible losses are limited to the sum of the shareholder’s stock basis and the adjusted basis of any loans the shareholder has made directly to the corporation.¹¹ Debt at the entity level, including a nonrecourse mortgage the S corporation itself borrows, does not increase shareholder basis. A shareholder guarantee of corporate debt does not count either; only a direct loan from the shareholder to the corporation does.¹²

If an S corp acquires a $5 million building with $4 million of nonrecourse financing and $1 million from shareholders, combined shareholder basis is capped at that $1 million. The same acquisition in a partnership would push each partner’s outside basis up by their allocated share of the $4 million. That single difference is often the reason to choose a partnership over an S corporation for leveraged real property.

Bad-Boy Carve-Outs and Whether They Blow Up Nonrecourse Status

Most commercial “nonrecourse” loans are not purely nonrecourse. Carve-out guarantees, or bad-boy clauses, impose personal liability if triggering events occur, typically including bankruptcy, fraud, misapplication of loan proceeds, or unauthorized transfers of the collateral. When triggered, the guarantee can create liability for actual damages or convert the whole loan to full recourse.

The IRS position is that a carve-out contingent on such acts does not reclassify the debt as recourse until a triggering event actually happens, on the reasoning that no rational borrower will intentionally commit the acts that would trigger personal liability. Under Treasury Regulation 1.752-2(b)(4), a payment obligation subject to contingencies making its discharge unlikely is disregarded for debt classification. Standard carve-outs therefore do not, by themselves, cost the debt its nonrecourse character or its status as qualified nonrecourse financing.

What Happens When the Property Is Foreclosed

Foreclosure of property secured by nonrecourse debt is treated as a sale, and your amount realized is the full outstanding balance of the loan regardless of what the property is currently worth.¹³ This is Tufts in operation.³

Take a property with an adjusted basis of $400,000, an outstanding nonrecourse mortgage of $600,000, and a current market value of $300,000. On foreclosure, taxable gain is $200,000: the $600,000 amount realized minus the $400,000 basis. You owe tax on the gain even though you walk away with nothing, and the property’s actual value is irrelevant to the math.

One advantage over recourse debt: the foreclosure is a single sale transaction, not a sale plus a separate cancellation-of-debt income event. There is no ordinary CODI to report. Gain or loss flows entirely through the disposition. For business or investment real estate, the transaction goes on Form 4797, and gain attributable to prior depreciation may be taxed at the 25% unrecaptured Section 1250 rate rather than the standard long-term capital gains rate.¹³

Timing depends on how the exit occurs. In a formal foreclosure, gain or loss is recognized when the redemption period expires, or when the foreclosure sale closes if the state provides no redemption period. Voluntary abandonment is recognized when the abandonment is complete, though regulatory guidance on what completes an abandonment is limited and state property law can control.

Reporting Requirements

When a lender takes secured property, the lender files Form 1099-A to report the acquisition or abandonment and sends the borrower a copy showing the acquisition date, the debt balance, and the property’s fair market value.¹⁴ The borrower uses that information to calculate gain or loss and reports business or investment property dispositions on Form 4797.¹³

For ongoing activities, file Form 6198 if you have amounts not at risk in an activity that generated a loss during the year. The form calculates the at-risk limitation and any suspended loss carryforward.¹⁵ Form 8582 tracks allowed and suspended passive losses when the passive activity rules also apply, and both forms feed the Schedule E that reports rental income or pass-through amounts from partnerships and S corporations.⁷

1
Office of the Law Revision Counsel. 26 USC 1012 – Basis of Property Cost
2
Library of Congress. Crane v. Commissioner, 331 U.S. 1 (1947)
3
Library of Congress. Commissioner of Internal Revenue v. Tufts, 461 U.S. 300 (1983)
4
Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk
5
GovInfo. 26 USC 465 – Deductions Limited to Amount at Risk
6
eCFR. 26 CFR 1.465-27 – Qualified Nonrecourse Financing
7
Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
8
Office of the Law Revision Counsel. 26 US Code 469 – Passive Activity Losses and Credits Limited
9
Office of the Law Revision Counsel. 26 US Code 752 – Treatment of Certain Liabilities
10
eCFR. 26 CFR 1.752-3 – Partners Share of Nonrecourse Liabilities
11
Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders
12
Internal Revenue Service. S Corporation Stock and Debt Basis
13
Internal Revenue Service. Publication 544, Sales and Other Dispositions of Assets
14
Internal Revenue Service. Instructions for Forms 1099-A and 1099-C
15
Internal Revenue Service. Instructions for Form 6198