Nonrecourse debt
Encyclopedia
Non-recourse debt or a non-recourse 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 difference between the value of the collateral and the loan value becomes a loss for the lender. Thus, non-recourse debt is typically limited to 50% or 60% loan-to-value ratios, so that the property itself provides "overcollateralization" of the loan.
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.
In some states, "antideficiency statutes" provide that mortgages secured by personal residences are non-recourse against the borrower.
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'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.
Self-directed IRA investors who choose to purchase investment real estate are able to leverage their purchase with a non-recourse loan. Because of the IRS 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.
, the interaction among the concepts of (1) the "amount realized" upon a disposition, (2) the amount of non-recourse 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.
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:
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.
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 non-recourse 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 non-recourse debt, as follows:
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 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. 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.
on the "sale or other disposition" of the property—again, even though no cash is received by the taxpayer at the time of foreclosure.
At the sale, foreclosure or other disposition, non-recourse 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, even if, at time of disposition, the property is worth less than the amount of the mortgage. Non-recourse debt that is in place at the time of acquisition of the property is included in basis, Crane v. Commissioner
, subsequent borrowing is not. Woodsam Associates, Inc. v. Commissioner Subsequent borrowing proceeds reinvested in a depreciable property thereby avoid Woodsam and take advantage of Crane.
Secured loan
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...
(debt) that is secured
Security interest
A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets...
by a pledge of collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
, typically real property
Real property
In English Common Law, real property, real estate, realty, or immovable property is any subset of land that has been legally defined and the improvements to it made by human efforts: any buildings, machinery, wells, dams, ponds, mines, canals, roads, various property rights, and so forth...
, but for which the borrower is not personally liable. If the borrower defaults
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
, 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 difference between the value of the collateral and the loan value becomes a loss for the lender. Thus, non-recourse debt is typically limited to 50% or 60% loan-to-value ratios, so that the property itself provides "overcollateralization" of the loan.
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
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
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.
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.In some states, "antideficiency statutes" provide that mortgages secured by personal residences are non-recourse against the borrower.
A non-recourse debt of $30 billion was issued to JPMorgan Chase by the Federal Reserve in order to purchase Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
on March 16, 2008. The non-recourse 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.
Self-directed IRA investors who choose to purchase investment real estate are able to leverage their purchase with a non-recourse loan. Because of the IRS 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.
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 non-recourse debt
For U.S. Federal income tax purposesIncome tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...
, the interaction among the concepts of (1) the "amount realized" upon a disposition, (2) the amount of non-recourse debt, and (3) the amount of adjusted basis
Adjusted basis
In tax accounting, adjusted basis is the net cost of an asset after adjusting for various tax-related items.Adjusted basis is one of two variables in the formula used to compute gains and losses when determining gross income for tax purposes...
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
Adjusted basis
In tax accounting, adjusted basis is the net cost of an asset after adjusting for various tax-related items.Adjusted basis is one of two variables in the formula used to compute gains and losses when determining gross income for tax purposes...
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.
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.
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 non-recourse 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 non-recourse debt, as follows:
Disposition of property subject to a recourse debt
Example:- The unpaid principal of the recourse debt is $100,000;
- The fair market value of the property is $80,000;
- 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 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. 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 non-recourse debt
Assuming the same facts except that the debt is non-recourse, 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 gainCapital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
on the "sale or other disposition" of the property—again, even though no cash is received by the taxpayer at the time of foreclosure.
At the sale, foreclosure or other disposition, non-recourse 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, even if, at time of disposition, the property is worth less than the amount of the mortgage. Non-recourse debt that is in place at the time of acquisition of the property is included in basis, Crane v. Commissioner
Crane v. Commissioner
Crane v. Commissioner, 331 U.S. 1 , 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.”Justice Fred M...
, subsequent borrowing is not. Woodsam Associates, Inc. v. Commissioner Subsequent borrowing proceeds reinvested in a depreciable property thereby avoid Woodsam and take advantage of Crane.
See also
- FinanceFinance"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
- Mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
- Real estateReal estateIn general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
- Real estate appraisalReal estate appraisalReal estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
- Recourse debtRecourse debtRecourse debt is a debt that is not backed by collateral from the borrower. Also known as a recourse loan, this type of debt allows the lender to collect from the debtor and the debtor's assets in the case of default as opposed to foreclosing on a particular property or asset as with a home loan...
- Synthetic leaseSynthetic leaseA synthetic lease is a financing structure by which a company structures the ownership of an asset so that -* for financial accounting purposes , the asset is owned by a special-purpose entity and leased to the operating company under an operating lease...