Nonrecourse debt

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Nonrecourse debt or a nonrecourse loan (sometimes hyphenated as non-recourse) 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 can seize and sell the collateral, but if the collateral sells for less than the debt, the lender cannot seek that deficiency balance from the borrower—its recovery is limited only to the value of the collateral. Thus, nonrecourse debt is typically limited to 50% or 60% loan-to-value ratios, [1] so that the property itself provides "overcollateralization" of the loan.

Contents

The incentives for the parties are at an intermediate position between those of a full recourse secured loan and a totally unsecured loan. While the borrower is in first loss position, the lender also assumes significant risk, so the lender must underwrite the loan with much more care than in a full recourse loan. This typically requires that the lender have significant domain expertise and financial modeling expertise.

Recourse debt

Recourse debt or recourse loan is a debt that is backed by both collateral from the debtor, and by personal liability of the debtor. [2] This type of debt allows the lender to collect from the debtor and the debtor's assets in the case of default, in addition to foreclosing on a particular property or asset as with a home loan or auto loan. Nonpayment of recourse debt allows the lender the right to collect assets or pursue legal action. While mortgages in the US are typically nonrecourse debt, a foreclosure or bankruptcy can trigger the loan to become recourse debt at the request of the lending institution. [3]

Classification

Recourse debt can either be full or limited recourse debt. A full recourse debt gives the granter the right to take any and all assets of the debtor, up to the full amount of the debts. The lender will sell the seized assets, including the asset acquired through the original loan. [4] Limited, or partial recourse debt, relies on the original loan contract, where named assets are the extent to which a lender may take action. [5]

Consumer finance

In Europe, mortgage loans secured by personal residences are usually recourse loans. [6] Most states in the United States also permit recourse for residential mortgages, but antideficiency statutes in a minority of states require nonrecourse mortgages. Around 13 states can be classified as nonrecourse states, depending on a researcher's classification standards. [7] [8]

Self-directed IRA investors who choose to purchase investment real estate are able to leverage their purchase with a nonrecourse loan. Due to Internal Revenue Service regulations, it would be deemed a violation of the qualified retirement account status to personally guarantee any loan on real estate owned by a self-directed IRA.

A property assessed clean energy (PACE) loan, used by some states to fund residential energy improvements, is an example of a loan that is nonrecourse to the borrower. [9]

Commercial lending

Nonrecourse debt is typically used to finance commercial real estate, shipping, or other 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. Since most commercial real estate is owned in a partnership structure (or similar tax pass-through), nonrecourse 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 nonrecourse debt of $30 billion was issued to JPMorgan Chase by the Federal Reserve in order to purchase Bear Stearns on March 16, 2008. The nonrecourse loan was issued with Bear Stearns's 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.

The legal financing industry provides nonrecourse financial products used to provide financial assistance to plaintiffs involved in a contingency-based lawsuit like a car accident. The funds are provided to the consumer on the potential settlement amount. This money is true nonrecourse funding, if the case is lost, one does not owe the company funding the lawsuit anything. This is a purchase of an asset and not a loan.

Characterization in corporate finance

Nonrecourse debt is usually carried on a debtor company's balance sheet as a liability, and the collateral is carried as an asset. 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 nonrecourse debt already attached, or whether the taxpayer took out the nonrecourse debt after acquisition of the property, and the relative relationships between fair market value and purchase price and disposition price. 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. [10]

The adjusted basis is the sum of the following:

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. [11] 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, as follows:

As an example, suppose:

  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 nonrecourse example, let's assume, contrary to the 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. [12] 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.

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. [13]

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, [14] 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, Crane v. Commissioner , [15] subsequent borrowing is not. Woodsam Associates, Inc. v. Commissioner. [16] Subsequent borrowing proceeds reinvested in a depreciable property thereby avoid Woodsam and take advantage of Crane.

See also

Related Research Articles

<span class="mw-page-title-main">Debt</span> Obligation to pay borrowed money

Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.

<span class="mw-page-title-main">Loan</span> Lending of money

In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay interest for the use of the money.

A mortgage is a legal instrument of the common law which is used to create a security interest in real property held by a lender as a security for a debt, usually a mortgage loan. Hypothec is the corresponding term in civil law jurisdictions, albeit with a wider sense, as it also covers non-possessory lien.

Title 11 of the United States Code sets forth the statutes governing the various types of relief for bankruptcy in the United States. Chapter 13 of the United States Bankruptcy Code provides an individual with the opportunity to propose a plan of reorganization to reorganize their financial affairs while under the bankruptcy court's protection. The purpose of chapter 13 is to enable an individual with a regular source of income to propose a chapter 13 plan that provides for their various classes of creditors. Under chapter 13, the Bankruptcy Court has the power to approve a chapter 13 plan without the approval of creditors as long as it meets the statutory requirements under chapter 13. Chapter 13 plans are usually three to five years in length and may not exceed five years. Chapter 13 is in contrast to the purpose of Chapter 7, which does not provide for a plan of reorganization, but provides for the discharge of certain debt and the liquidation of non-exempt property. A Chapter 13 plan may be looked at as a form of debt consolidation, but a Chapter 13 allows a person to achieve much more than simply consolidating his or her unsecured debt such as credit cards and personal loans. A chapter 13 plan may provide for the four general categories of debt: priority claims, secured claims, priority unsecured claims, and general unsecured claims. Chapter 13 plans are often used to cure arrearages on a mortgage, avoid "underwater" junior mortgages or other liens, pay back taxes over time, or partially repay general unsecured debt. In recent years, some bankruptcy courts have allowed Chapter 13 to be used as a platform to expedite a mortgage modification application.

<span class="mw-page-title-main">Foreclosure</span> Legal process where a lender recoups an unpaid loan by forcing the borrower to sell the collateral

Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments to the lender by forcing the sale of the asset used as the collateral for the loan.

<span class="mw-page-title-main">Second mortgage</span> Additional loan

Second mortgages, commonly referred to as junior liens, are loans secured by a property in addition to the primary mortgage. Depending on the time at which the second mortgage is originated, the loan can be structured as either a standalone second mortgage or piggyback second mortgage. Whilst a standalone second mortgage is opened subsequent to the primary loan, those with a piggyback loan structure are originated simultaneously with the primary mortgage. With regard to the method in which funds are withdrawn, second mortgages can be arranged as home equity loans or home equity lines of credit. Home equity loans are granted for the full amount at the time of loan origination in contrast to home equity lines of credit which permit the homeowner access to a predetermined amount which is repaid during the repayment period.

Repossession, colloquially repo, is a "self-help" type of action in which the party having right of ownership of a property takes the property in question back from the party having right of possession without invoking court proceedings. The property may then be sold by either the financial institution or third party sellers.

In finance, a security interest is a legal right granted by a debtor to a creditor over the debtor's property which enables the creditor to have recourse to the property if the debtor defaults in making payment or otherwise performing the secured obligations. One of the most common examples of a security interest is a mortgage: a person borrows money from the bank to buy a house, and they grant a mortgage over the house so that if they default in repaying the loan, the bank can sell the house and apply the proceeds to the outstanding loan.

A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, and if the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower. An example is the foreclosure of a home. From the creditor's perspective, that is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

<span class="mw-page-title-main">Mortgage</span> Loan secured using real estate

A mortgage loan or simply mortgage, in civil law jurisdictions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

A deficiency judgment is an unsecured money judgment against a borrower whose mortgage foreclosure sale did not produce sufficient funds to pay the underlying promissory note, or loan, in full. The availability of a deficiency judgment depends on whether the lender has a recourse or nonrecourse loan, which is largely a matter of state law. In some jurisdictions, the original loan(s) obtained to purchase property is/are non-recourse, but subsequent refinancing of a first mortgage and/or acquisition of a 2nd are recourse loans.

Mortgage underwriting is the process a lender uses to determine if the risk of offering a mortgage loan to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C's of underwriting: credit, capacity and collateral.

Crane v. Commissioner, 331 U.S. 1 (1947), was a case heard before the United States Supreme Court concerning the value, for tax purposes, of inherited property with a nonrecourse mortgage encumbering it. According to Boris I. Bittker, Crane "laid the foundation stone of most tax shelters."

Taxpayers in the United States may have tax consequences when debt is cancelled. This is commonly known as cancellation-of-debt (COD) income. According to the Internal Revenue Code, the discharge of indebtedness must be included in a taxpayer's gross income. There are exceptions to this rule, however, so a careful examination of one's COD income is important to determine any potential tax consequences.

<i>Zarin v. Commissioner</i> Court of Appeals case

Zarin v. Commissioner, 916 F.2d 110 is a United States Third Circuit Court of Appeals decision concerning the cancellation of debt and the tax consequences for the borrower for U.S. federal income tax purposes.

Commissioner v. Tufts, 461 U.S. 300 (1983), was a unanimous decision by the United States Supreme Court, which held that when a taxpayer sells or disposes of property encumbered by a nonrecourse obligation exceeding the fair market value of the property sold, the Commissioner of Internal Revenue may require him to include in the “amount realized” the outstanding amount of the obligation; the fair market value of the property is irrelevant to this calculation.

The Mortgage Forgiveness Debt Relief Act of 2007 was introduced in the United States Congress on September 25, 2007, and signed into law by President George W. Bush on December 20, 2007. This act offers relief to homeowners who would have owed taxes on forgiven mortgage debt after facing foreclosure. The act extends such relief for three years, applying to debts discharged in calendar years 2007 through 2009. With the Emergency Economic Stabilization Act of 2008, this tax relief was extended another three years, covering debts discharged through calendar year 2012. The relief was further extended until January 1, 2014, at Section 202 of the American Taxpayer Relief Act of 2012.

Loan modification is the systematic alteration of mortgage loan agreements that help those having problems making the payments by reducing interest rates, monthly payments or principal balances. Lending institutions could make one or more of these changes to relieve financial pressure on borrowers to prevent the condition of foreclosure. Loan modifications have been practiced in the United States since the 1930s. During the Great Depression, loan modification programs took place at the state level in an effort to reduce levels of loan foreclosures.

A strategic default is the decision by a borrower to stop making payments on a debt, despite having the financial ability to make the payments.

References

  1. ↑ "U.S. new and existing home sales move in opposite directions in April". Reed Construction Data. May 24, 2011. Retrieved 15 November 2013.
  2. ↑ "Recourse Loans vs. Non-Recourse Loan: What's the Difference?".
  3. ↑ Gotshal, Weil; Manges, LLP (November 1998). Reorganizing failing businesses. Section of Administrative Law and Regulatory. p. 22.9. ISBN   978-1-57073-626-1.
  4. ↑ "Recourse Loan". BusinessDictionary.com. Archived from the original on 2009-06-26. Retrieved 2009-07-18.
  5. ↑ Renz, Loren; Massarsky, Cynthia W. (1995). "Program-Related Investments: A Guide to Funders and Trends". The Foundation Center.{{cite web}}: Missing or empty |url= (help)
  6. ↑ Congressional Budget Office (2010). Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market. p. 49.
  7. ↑ Ghent, Andra C. and Kudlyak, Marianna, "Recourse and Residential Mortgage Default: Theory and Evidence from U.S. States" (July 10, 2009). Federal Reserve Bank of Richmond Working Paper No. 09-10. The authors classify eleven states (Alaska, Arizona, California, Iowa, Minnesota, Montana, North Carolina, North Dakota, Oregon, Washington, and Wisconsin) as nonrecourse. The authors also discuss the reasoning for this classification on a state-by-state basis. In several of the nonrecourse states some form of recourse is available but impractical due to lengthy and expensive judicial proceedings, jury trials, and extended redemption periods.
  8. ↑ "Comparison of State Laws on Mortgage Deficiencies and Redemption Periods". 29 July 2010. Retrieved 24 August 2013. The Connecticut Office of Legislative Research, relying on data from the National Consumer Law Center, concluded that at least 10 states can be generally classified as nonrecourse for residential mortgages.
  9. ↑ "Emerging Issues: Residential PACE Loans and Bankruptcy". natlawreview.com. 2018-02-08. Retrieved 2018-07-31.
  10. ↑ "Determination of amount and recognition of gain or loss", Taxalmanac.com.
  11. ↑ Discharge of liabilities
  12. ↑ Unless the $20,000 qualifies as being excludable under 26 U.S.C.   § 108.
  13. ↑ Commissioner v. Tufts , 461 U.S. 300 (1983); Crane v. Commissioner of Internal Revenue , 331 U.S. 1 (1947).
  14. ↑ Estate of Levine v. Commissioner , 72 T.C. 780, 792 (1979), aff'd, 634 F.2d 12 (1980) (a "nonrecourse mortgage debt is a debt of the property owner since he is, in reality, a quasi-obligor on the debt, notwithstanding the fact that the debt is owed by the property."); Woodsam Associates, Inc. v. Commissioner, 16 T.C. 649 (1951), aff'd, 198 F.2d 357 (2d Cir. 1952) (the excess of the amount of the debt over the adjusted basis of the property is gain, and will be treated as capital gain, subject to the rules on depreciation recapture).
  15. ↑ Crane v. Commissioner of Internal Revenue, 331 U.S. 1 (1947).
  16. ↑ Woodsam Associates, Inc. v. Commissioner, 16 T.C. 649 (1951), aff'd, 198 F.2d 357 (2d Cir. 1952).
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