Recourse

A recourse is a legal agreement which gives the lender the right to pledged collateral in the event that the borrower is unable to satisfy the debt obligation. Recourse refers to the legal right to collect.

Recourse lending provides protection to lenders, as they are assured to have some sort of repayment, either in cash or liquid assets. Companies that issue recourse debt have a lower cost of capital, as there is less underlying risk in lending to that firm.

Recourse provides the legal means for a lender to seize a borrower's assets if he 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. In most cases, the lender may obtain a deficiency judgment to seize unpledged assets, levy bank accounts or garnish wages.

Recourse loans are distinct from non-recourse loans, which limit the lender to claiming only the specific asset pledged as collateral. Recourse debt is the more common form of debt because it is less risky for lenders, while non-recourse debt is usually limited to longer-term loans placed on stabilized and performing assets, such as commercial real estate.

Recourse debt has two tax implications for borrowers that translate into recognizing taxable ordinary income and reporting a loss or gain. Any part of the debt that is forgiven by the lender must be reported as ordinary income. 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, 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.

Most loans are issued with recourse language included in the loan document. The language specifies the recourse actions that may be taken 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 cannot exceed the fair market value (FMV) of the property.

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 $50,000, which is the difference between the FMV and the amount owed on the loan. In some states, such as Arizona, California and Oregon, lenders are prohibited from obtaining deficiency judgments.