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The difference between recourse and non-recourse debt is that of personal liability. Under a recourse debt, the borrower is personally held liable whereas under a non-recourse debt the borrower is liable to the extent of the collateral. Thus, if a borrower defaults on a non-recourse debt, the lender can only come and seek the collateral held against the debt.
Usually a debt or loan is secured against collateral say ‘home’ in a home loan. Collateral is an asset that for which the loan is given. In case the borrower defaults, the lender or the bank has the right to recover the money from the collateral asset. The lender might or might not be able to recover his money fully with the collateral.
Assume Mr. John and Mr. Donald has purchased home with recourse debt and non recourse debt respectively.
Under the situation of default:
Mr. John, who took recourse debt: Apart from the home (i.e. the collateral in this case), he is also liable to pay the debt with his personal assets.
Mr. Donald, who took non-recourse debt: The home (i.e. the collateral in this case) will be taken over by the lender, but he is not liable to pay the debt with his personal assets.
In other words, in Recourse Debt, the claim amount over and above the collateral value can be realised from the borrower’s personal assets whereas in non-recourse debt, the borrower is not liable to pay anything over the given collateral.
Difference between Recourse and Nonrecourse Debt
|Point of Difference||Recourse Debt||Non-Recourse Debt|
|Lender has the power to seize the collateral and if the debt is not settled with selling off the collateral security, lender can also claim the money from borrower’s personal assets.||The lender’s powers are limited to pursuing debt through the collateral secured against the borrowed amount.|
|When the credit market conditions are tough and credit is not available easily, lender generally has greater power and is able to impose tougher credit terms. In such a case, one can secure lending under recourse debt agreement.||Under a strong macro-economic backdrop, when the credit market conditions favour a buyer, the borrower and the lender generally end up settling for non-recourse debt agreement|
|Lender might be more comfortable lending higher amount of money under recourse debt agreement, subject to the background check and credibility of the borrower.||The principal borrowing amount in question is usually lower under non-recourse debt compared to recourse debt|
|Usually bears lower interest rate as compared to non-recourse debt given that the borrower is personally liable under default.||Lender is generally willing to charge higher interest rate on the credit considering higher risk of repayment.|
|Tax implications are twofold. If the lender forgoes any outstanding portion of debt not paid by the borrower, the forgone portion becomes taxable for the borrower as income. The tax implication happens in the year in which the asset is foreclosed / sold. The gain is reported as income and loss cannot be deducted from income, so are non-deductible losses.
If you borrowed $1000 against a bike and if by selling the bike, the lender can make only $800, but still forgoes $200, $200 is taxable as benefit/gain for the borrower.
If the actual amount of bike as recognised on the books was $1500, and if the lender can make only $800 by sale of the asset, the borrower would arrive at $700 as non-deductible loss
|Ordinary income of a borrower remains unaffected in a non-recourse debt since the liability is restricted to the collateral. Thus, non-recourse debt tax implications are minimal for the borrower. If the borrower surrenders the collateral in return of cancellation of non-recourse debt, any amount over the cancelled debt and collateral’s adjusted basis is recognised as gain from disposal of such collateral or property
If $1000 is borrowed against an asset with value of $1000 and then such an asset is disposed for $1200, the borrower must record $200 as taxable gain.