Non-Recourse Loan

A non-recourse loan is a loan secured by collateral where the lender's recovery is limited to that collateral. If the borrower defaults, the lender can foreclose on or repossess the property, but the borrower is not personally liable for any balance the property fails to cover. The IRS, which spells it "nonrecourse," draws the line by personal liability alone: "Debt for which you are personally liable is recourse debt. All other debt is nonrecourse debt."

The contrast is a recourse loan, where the borrower promises to repay personally. On a recourse loan the lender can take the collateral and then, subject to state law, pursue the borrower for the deficiency. Whether a loan is non-recourse depends on its terms and on any statute that limits the lender's remedies; the name a lender or seller uses does not settle it.

Where consumers meet it. Three settings come up for households.

• Federally insured reverse mortgages. The statute behind the FHA-insured Home Equity Conversion Mortgage requires that the homeowner not be liable for any difference between the loan balance and what the lender recovers from the sale or the insurance, which is why neither the borrower nor the estate owes a shortfall. A proprietary reverse mortgage has to be read for its own terms.
• Pawn loans that meet the federal definition. The CFPB's payday rule excludes a non-recourse pawn loan, one where the lender holds the item for the whole term and its only remedy is keeping it. A pawn loan that leaves anyone personally liable for the shortfall does not qualify.
• State anti-deficiency rules. Some states limit or bar a deficiency judgment after foreclosure on certain residential loans, which can make a loan behave as non-recourse even though its note contains a personal promise to pay. The rules differ by state and by type of loan and foreclosure, and the deficiency balance page explains the general picture.

The tax consequence. IRS Publication 4681 treats a foreclosure, repossession or abandonment differently depending on liability. For a non-recourse debt, "the entire amount of the nonrecourse debt is treated as an amount realized on the disposition of the property," even if the property is worth less, and the foreclosure "doesn't result in ordinary income from the cancellation of debt." For a recourse debt, the amount realized is the property's fair market value, and if the lender forgives the excess, "the cancellation of the excess debt may result in ordinary income" unless an exclusion applies. So a non-recourse borrower can have a gain or a loss on the disposition but no cancelled-debt income, while a recourse borrower may have both.

One exception survives. A non-recourse borrower who keeps the collateral can still have cancelled-debt income. The publication says that a borrower who is not personally liable has no such income "unless you retain the collateral and either" the lender discounts the debt for early payment or agrees to a modification that reduces the principal.

If the borrower keeps paying, a non-recourse loan works like any other secured loan. The difference appears only on default: the lender takes the collateral, sells it or keeps it, and that ends the matter between them.

For example: Andrés bought a home for $300,000. When the lender forecloses, he owes $280,000 and the home is worth $230,000.

If the loan is non-recourse, the lender keeps the home and absorbs the $50,000 shortfall ($280,000 − $230,000). For tax purposes his amount realized is the full $280,000 balance, so he has a $20,000 loss on the home ($300,000 basis − $280,000), and no cancelled-debt income. A loss on a personal residence is not deductible.

If the loan is recourse and state law allows a deficiency, the lender can pursue him for the $50,000. If it forgives the $50,000 instead, his amount realized is the home's $230,000 value, giving a $70,000 nondeductible loss ($300,000 − $230,000), and the $50,000 forgiven is cancelled-debt income that he must report unless an exclusion such as insolvency applies.

Pros

• The borrower's exposure is capped at the collateral, so a fall in its value cannot follow the borrower to other assets or wages.
• A foreclosure or repossession produces no cancelled-debt income for tax purposes.
• On an FHA-insured reverse mortgage, neither the borrower nor the estate owes more than the home brings.

Cons

• Whether a loan is non-recourse turns on its documents and on state law, which a borrower may not look into until a default.
• A pawn loan or other product described as having no recourse may not meet the definition; the documents decide.
• A non-recourse borrower who keeps the collateral can still have cancelled-debt income on a discount or a principal reduction.
• Losing the collateral still has consequences: a foreclosure or repossession can appear on credit reports.