By Fred Matera, CIO, Redwood Trust A lack of affordability will lead to near-term weakness,…
Updated: March 14th, 2017
Depending on the stage and type of real estate financing, both a recourse and nonrecourse loan are used by different real estate finance lending companies. The non-recourse loan is very popular with real estate investors looking to borrow money for the new fix and flip projects.
Real estate secured loans can be broken down into either recourse and non-recourse loans. With a loan default, both of these loans use your personal assets as collateral that can be seized. In this article, we will look at what a nonrecourse loan is, its tax implications and a real life nonrecourse loan example.
In this article we’ll cover these topics related to Recourse and Nonrecourse Loans:
- What is a Recourse Loan
- What is a Non-Recourse Loan
- Bad Boy Guaranty with Non-Recourse Loans
- Difference With Recourse and Non-Recourse Loans
- Non-Recourse Loan Example
- Tax Consequences: Recourse and Non-Recourse Loans
What is a Recourse Loan
Seen as a more traditional loan, the recourse loan holds the real estate borrower accountable for repaying the outstanding balance. This is the case only if the loan liquidates due to a default of payments.
To be more specific, let us say a borrower defaults on a loan and the collateral used to secure the loan is not enough to cover the total that is still owed to the lender at the time. Then the lender can have the right to seek additional personal collateral of the borrower to cover the difference. Recourse loans are used mostly with very short term real estate financing and construction loans.
What is a Nonrecourse Loan
Used by more aggressive fix and flip real estate investors, the nonrecourse real estate loan allows the borrower not to be personally liable to repay the outstanding balance of his assets. Investor property lenders use this type of loan if they feel the borrower has a more long term track record of stabilized real estate assets.
If the collateral is insufficient to repay the loan, the lender incurs a loan loss. With a non-recourse loan, the principals of the borrower can transfer ownership of the loan collateral to the lender. They then can walk away from the debt without having to pay anything further to the lender.
Bad Boy Guaranty with Non-Recourse Loans
The bad boy guaranty is a provision that protects the nonrecourse lenders from events such as borrower fraud, misrepresentation, failure to pay taxes, committing a crime and failing to maintain required insurance.
With a non-recourse loan, the bad boy guaranty clause keeps the lender protected from bad business practices used by some borrowers. You should always have your loan document reviewed by a licensed and reputable real estate lawyer.
The difference comes if money is still owed after the collateral is seized and sold.
Difference With Recourse and Non-Recourse Loans
The main difference with recourse vs nonrecourse financing is whether or not a lender can go after the borrower’s assets if he/she defaults on their loan. Nonrecourse loan lenders would rather go after recourse loans. Borrowers are the ones who favor nonrecourse financing.
It’s important to note that in both nonrecourse and recourse loans, the lender will seize the assets labeled as collateral when the loan was secured. With real estate investments, the home or property is usually the asset that the loan purchased. If the borrower defaults on a nonrecourse real estate loan, then the lender would absorb the home and sell it to pay off any debt from the borrower on the initial loan.
With recourse financing, the lender will also go after the borrower’s additional assets by suing them in the court of law. With nonrecourse loans, the lender cannot. Nonrecourse loan lenders will have to take a net loss on the difference in debt value for what they borrower owes.
It may seem that all borrowers favor a non-recourse loan. However, these types of loans are higher in interest and demand high credit scores from the borrowers. Also, the borrower’s credit score will get dinged in just the same way as defaulting on a home mortgage loan. Nonrecourse financing doesn’t protect the borrower from credit protection.
When a borrower defaults on the recourse loan, the debt balance left over is called the deficiency balance. Usually, lenders will sue in court. When the debt comes from a nonrecourse loan, the lender is out of luck.
Nonrecourse Loan Example
Let’s take a look at a quick nonrecourse loan example. If you are taking out a loan for a car and about a year into the loan, you default and cannot make the car payment. There is $10,000 left on the loan. The lender takes your car and sells it for $7,000.00. So the $3000.00 difference in debt will then be accounted to the non-recourse loan lenders for a net loss.
Tax Consequences: Recourse and Non-Recourse Loans
Whether you have a recourse or nonrecourse loan, your tax implications will be different on what you have to pay after your seized asset has been sold off by the lender. With recourse loans, the tax is implied as the property was sold at fair market value. Qualified Nonrecourse real estate loans give debtors the impression that they sold their asset for the outstanding balance left on the seized loan.
Check If Non-Recourse Loans are an Option
While community banks sometimes have lower rates as a result of the exceedingly low rates at which they pay depositors, that low rate comes with a price – they are almost always full recourse. Borrowers need to think long and hard about this question because of the potential consequences of a recourse loan.
When recourse becomes an issue, typically investors’ asset values have also dropped leaving their portfolios and loans under water. There is significant downside risk to your personal balance sheet when signing personal guarantees to repay a loan. Especially if the proceeds from the collateral are insufficient to retire the debt.
My point is when given the option to sign recourse or non-recourse, saving a little money on rate or fee may be penny wise and pound foolish. The marginally less costly deal is not always the best deal in the long run.
Obtaining Non-Recourse Financing with CoreVest Finance
Our originations team consists of seasoned professionals with significant residential and commercial backgrounds with recourse and non-recourse loan financing. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how CoreVest can help grow your rental and rehab business, please call 844.223.2231 or submit our contact form.