Rama Mehra
San Ramon Real Estate Specialist
A non recourse loan is a loan with no personal or business responsibility.
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If the loan is not paid off, the lender can not go after the borrower. At most, the lender can keep the collateral pledged as a warranty for the loan. A non recourse loan is usually a secured loan in which the borrower offers stocks or bonds as collateral for the loan. The lender needs to have some type of warranty because it can not go after the individual or business in case the borrower does not pay off the home. The most a lender can do is to keep the provided collateral In addition, a nonrecourse loan is usually a non purpose loan. A non purpose loan is a type of loan in which the individual or business can spend the proceeds of the business for any purpose. |
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Also, a non recourse loan offers much better terms than a traditional loan. It usually offers shorter application processes, lower rates and more flexibility in the duration of the loan. Rates are usually between 2 and 5 points lower than in a traditional loan.
The essential difference between a recourse and non-recourse loan has to do with which assets a lender can go after if a borrower fails to repay a loan. As a matter of principle, borrowers almost always favor non-recourse loans, while lenders almost always favor recourse loans.
In both types of loans, the lender is allowed to seize any assets that were used as collateral to secure the loan. In most cases, the collateral is the asset that was purchased by the loan. For example, in both recourse and non-recourse mortgages, the lender would be able to seize and sell the house to pay off the loan if the borrower defaults.
The difference comes if money is still owed after the collateral is seized and sold. In a recourse mortgage, the lender can go after the borrower's other assets or sue to have his or her wages garnished. In a non-recourse mortgage, however, the lender is out of luck. If the asset does not sell for at least what the borrower owes, the lender must absorb the difference and walk away.
While potential borrowers might find it attractive to hold out for non-recourse loans, it is important to remember that they come with higher interest rates and are reserved for individuals and businesses with the best credit. Additionally, failure to pay off a non-recourse debt may leave other assets unharmed, but the borrower's credit score will be affected in the same way as a failure to repay recourse debt.
California Law
Deficiency Judgment
Lenders may not seek a deficiency judgment if (1) the foreclosure is non-judicial or if (2) foreclosure is on a purchase money obligation. The same rules do not apply to guarantee or later lien holders. The lenders may seize alternative collateral. If the lender forecloses by filing a lawsuit, then the lender can obtain both a foreclosure sale order and a judgment against the borrower for a deficiency after the court-ordered sale, but only for the difference between the judgment and the fair value of the security.
Most common form of foreclosure in California is Non-judicial foreclosure.
A nonrecourse debt or non-recourse debt or nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral. If the property is insufficient to cover the outstanding loan balance (for example, if real estate prices have dropped), the lender is simply paid out the difference. Thus, non-recourse debt is typically limited to 80% or 90% loan-to-value ratios, so that the property itself provides "overcollateralization" of the loan. The purpose of non-recourse debt is to require lenders to underwrite their loans on a sustainable and prudent basis since the lender is in the first-loss position with these loans, not the borrower.
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Common uses
Non-recourse debt is typically used to finance commercial real estate and similar projects with high capital expenditures, long loan periods, and uncertain revenue streams. It is also commonly used for stock loans and other securities-collateralized lending structures. Because most commercial real estate is owned in a partnership structure (or similar tax pass-through), non-recourse borrowing gives the real estate owner the tax benefits of a tax-pass-through partnership structure (that is, loss pass-through and no double taxation), and simultaneously limits personal liability to the value of the investment.
A non-recourse debt of $30 billion was issued to JPMorgan Chase by the Federal Reserve in order to purchase Bear Stearns on March 16, 2008. The non-recourse loan was issued with Bear Stearns less liquid assets as collateral, meaning that the Federal Reserve will absorb the loss should the value of those assets be below their collateralized value.
Characterization
Non-recourse debt is usually carried on a company's balance sheet as a liability, and the collateral is carried as an asset.
Tax consequences of disposition of property encumbered by nonrecourse debt
For U.S. Federal income tax purposes, the interaction among the concepts of (1) the "amount realized" upon a disposition, (2) the amount of nonrecourse debt, and (3) the amount of adjusted basis in the property is fairly complex. The tax consequences of a disposition depend on whether the taxpayer acquired the property with the non-recourse debt already attached, or whether the taxpayer took out the non-recourse debt after acquisition of the property, and the relative relationships between fair market value (FMV) and purchase price and disposition price.
Basic concept: Computing gain or loss on a disposition
Upon a sale or other disposition of property under U.S. income tax law, a taxable gain generally results where the amount realized upon the sale or other disposition of property exceeds the amount of the taxpayer's adjusted basis in that property.
Generally, the amount realized is the amount of cash and other consideration received by the taxpayer. The amount of any loan forgiven or discharged is generally part of that consideration.
The adjusted basis is the sum of the following:
- the amount of the original cost incurred by the taxpayer when the property was acquired, including the amount of any non-recourse debt assumed by the owner/taxpayer as part of the acquisition (also known as "original basis"),
- plus the costs of improvements (if any) made by the taxpayer to the property,
- less the amount of depreciation (or similar) deductions allowed (or allowable) to the taxpayer on that property.
If the amount realized exceeds the amount of adjusted basis, the taxpayer has realized a gain at the time of disposition. If the adjusted basis exceeds the amount realized, a loss has been incurred.
The Federal income tax effect of nonrecourse debt may be explained by first considering the tax effect of a disposition involving recourse debt (that is, a debt in which the property provides first security coverage, and the borrower/taxpayer is personally liable for any deficiency that may remain after the lender forecloses against the property), and then contrasting against similar facts involving nonrecourse debt.
Disposition of property subject to a recourse debt
Example:
1. The unpaid principal of the recourse debt is $100,000;
2. The fair market value of the property is $80,000;
3. The taxpayer's adjusted basis in the property is $45,000.
Assuming that the creditor forecloses on the property and that the $20,000 excess of the debt over the property's fair market value ($100,000 less $80,000) is contractually discharged (for didactic symmetry with the non-recourse example, let's assume, contrary to whole commercial point of a recourse loan, that the debt is outright forgiven by the creditor, with no actual payment), the taxpayer would realize the $20,000 amount as income from the discharge of indebtedness. That $20,000 of forgiveness would be taxable to the taxpayer as ordinary income even though the taxpayer received no "cash" at the time of the discharge.[1] The $35,000 excess of the fair market value over the adjusted basis ($80,000 less $45,000) would be treated as a taxable capital gain on the "sale or other disposition" of the property -- again, even though the taxpayer received no "cash" at the time of the foreclosure.
Disposition of property subject to a nonrecourse debt
Assuming the same facts except that the debt is nonrecourse, the result would be quite different. The taxpayer would realize zero taxable ordinary income from the discharge of debt. Instead, the entire $55,000 difference between the unpaid principal of the debt and the taxpayer's adjusted basis ($100,000 less $45,000) would be treated as a taxable capital gain on the "sale or other disposition" of the property -- again, even though no cash is received by the taxpayer at the time of foreclosure.[2]
At the sale, foreclosure or other disposition, nonrecourse debt incurred as part of the financing of the acquisition, and money extracted from an investment by mortgaging out, are treated the same: both are taxable realization only at the time of the property's disposition,[3] even if, at time of disposition, the property is worth less than the amount of the mortgage. Nonrecourse debt that is in place at the time of acquisition of the property is included in basis (the Crane case),[4] subsequent borrowing is not (Woodsam),[5] but subsequent borrowing proceeds reinvested in a depreciable property thereby avoid Woodsam and take advantage of Crane.
IRS
Home Foreclosure and Debt Cancellation
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Update Dec. 11, 2008 — The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition. The amount excluded reduces the taxpayer’s cost basis in the home. More details. Further information, including detailed examples, can also be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. The questions and answers, below, are based on the law prior to the passage of the Mortgage Forgiveness Debt Relief Act of 2007. 1. What is Cancellation of Debt? If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you. 2. Is Cancellation of Debt income always taxable? Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
3. I lost my home through foreclosure. Are there tax consequences? There are two possible consequences you must consider:
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Judicial foreclosure
An in-court foreclosure is called a judicial foreclosure, a lawsuit with specific parameters. Again the foreclosure laws will vary a great deal from state to state. A judicial foreclosure allows the lender to institute a lawsuit calling the entire note due and requesting a court ordered sale of the property to satisfy the note
When a judicial foreclosure permits the calling of the note due, taking the property may not be enough to satisfy your debt. The lender will gain a deficiency judgment against the borrower. A deficiency judgment demands that, if the lender does not receive all amounts due them from foreclosure sale of the property, the remaining balance of the debt should be paid by the borrower. The rules and requirements of both property types and borrower actions will vary greatly by state, so competent legal counsel is absolutely necessary.
Non judicial foreclosure
With an out of court process, or non-judicial foreclosure, the process is usually handled by an attorney or a foreclosure professional. In some states, the process allows the lender to re-take the property without getting any other compensation from the borrower. Other states will allow a deficiency judgment after the foreclosure process is completed. This type of foreclosure occurs when borrower has no other obvious assets or ability to pay, when the property is worth more than the loan outstanding, or when it appears that this is the only legal option.
In general the borrower has rights to bring payments up to date, in which case, the note may not have to be paid off. In many states the borrower may also have redemptive rights after the process has occurred.
Deed in lieu of foreclosure
Another way of dealing with a mortgage default that will require the cooperation of both the lender and the borrower is to transfer the property by means of a deed in lieu of foreclosure. Fast and inexpensive (legal fees), both parties agree to transfer the property to lender, avoiding the time and expense of foreclosure. Most importantly, the borrower may avoid the possibility of the lender pursuing them for a deficiency judgment.
Bankruptcy
The possibility always exists that declaring bankruptcy may be the last form of refuge in a loan default. Lenders will want to avoid such a situation as bankruptcy creates numerous delays at a considerable cost. Competent legal counsel should be sought in determining if this is the right avenue for you
With all of the alternatives discussed above, the specific rules applicable to your state will determine whether you would face the risk of having a deficiency judgment ordered on behalf of the lender. Utilize our site and the resources offered to make an educated decision as to how to proceed if you in financial distress, facing foreclosure or are in the midst of the process.
