Recourse

What Is Recourse?

A recourse is a legal agreement that gives the lender the right to pledged collateral if the borrower is unable to satisfy the debt obligation. Recourse refers to the lender's legal right to collect. Recourse lending provides protection to lenders, as they are assured of having some repayment, either in cash or liquid assets. Companies that use recourse debt have a lower cost of capital, as there is less underlying risk in lending to that firm.

Understanding Recourse

Recourse provides the legal means for a lender to seize a borrower's assets if the borrower defaults on a debt. If the debt is full recourse, the borrower is liable for the full amount of the debt even to the extent it exceeds the value of the collateralized asset.

Recourse debt allows the lender to take other assets from the borrower besides the collateral in order to repay the debt. In most cases, the lender may obtain a deficiency judgment to seize unpledged assets, levy bank accounts, or garnish wages. The lender may also go after other sources of income from the borrower, such as commissions, royalties, or investment income.

Recourse vs. Non-Recourse

Recourse loans are distinct from non-recourse loans, which limit the lender to claiming only the specific asset pledged as collateral. If a borrower defaults on a non-recourse loan and the value of the collateral does not cover the amount the borrower owes, the lender cannot attempt to recover the balance by seizing the borrower's other assets. The lender only has a legal right to the pledged collateral. Because of this distinction, recourse debt favors the lender, while non-recourse debt favors the borrower.

Recourse debt is the more common form of debt because it is less risky for lenders. Non-recourse debt is usually limited to longer-term loans placed on stabilized and performing assets, such as commercial real estate.

Borrowers who have non-recourse loans generally must pay higher interest rates than recourse loans in order to compensate the lender for undertaking the additional risk.

Tax Impact of Recourse on Borrowers

Recourse debt has two tax implications for borrowers that translate into recognizing taxable ordinary income and reporting a loss or gain. When filing their taxes, the borrower must report as ordinary income any part of a debt that is forgiven by the lender.

For example, if a lender forecloses on a house to recover a $150,000 debt and sells it for $125,000, the borrower still owes $25,000. If the lender forgives the $25,000, the borrower must report this amount as ordinary income for tax purposes. If the debt is non-recourse, the forgiveness of the loan does not result in taxable cancellation of debt income, since the terms of the loan do not give the lender any rights to pursue the owner personally in case of default.

Regardless of whether a debt is forgiven, the borrower must report a loss or gain based on the difference between the original loan amount and the amount realized in the sale of the asset. In the above example, the $25,000 must be reported as a loss. Losses incurred through the sale of deficient assets are not tax-deductible.

Special Considerations

Most loans are issued with recourse language included in the loan document. The language specifies the recourse actions the lender may take along with any limitations.

Generally, whether a loan is recourse or non-recourse depends on the state where the loan originated. Most states provide for recourse for mortgage lenders, but it may be restricted in some way. For example, in some states, the deficiency judgment the lender can obtain against the borrower cannot exceed the fair market value (FMV) of the property.

For example, consider a home that has a mortgage balance of $250,000 and a fair market value of $200,000. If the lender sells the home at auction for $150,000, it can only recover a $50,000 deficiency judgment against the borrower, which is the difference between the FMV and the amount the home sold for at auction. In some states, lenders are prohibited from obtaining deficiency judgments.