Recourse vs Non Recourse Debt

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. That was held against the debt. Let us see more about the recourse vs non recourse debt.

Usually, debt or loan is secured against collateral, say ‘home’ in a home loan. Collateral is an asset for which one gets the loan. 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.

Example

Assume Mr. John and Mr. Donald have purchased a home with recourse debt and nonrecourse debt.

Under the situation of default:

Mr. John, who took recourse debt: Apart from 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). The lender will take over, but he is not liable to pay the debt with his personal assets.

Recourse-vs-Non-recourse-Debt

In other words, in Recourse Debt, the claim amount is over, and above the collateral value can one can realize 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 vs Non-Recourse Debt

Point of Difference Recourse Debt Non-Recourse Debt

Power

The lender has the power to seize the collateral. If the debt is not settled by selling off the collateral security, the lender can also claim the money from the borrower’s personal asset.

The lender’s powers are limited to pursuing debt through the collateral secured against the borrowed amount.

Market Conditions

When the credit market conditions are tough, and credit is not available easily, the lender generally has greater power and is able to impose tougher credit terms. One can secure lending under a recourse debt agreement in such a case.

Under a strong macro-economic backdrop, when the credit market conditions favor a buyer, the borrower and the lender generally end up settling for a non-recourse debt agreement.

Principal Amount

A lender might be more comfortable lending a higher amount of money under a 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 than recourse debt.

Interest Rate

Usually bears a lower interest rate than non-recourse debt, given that the borrower is personally liable under default.

A lender is generally willing to charge a higher interest rate on credit, considering the higher risk of repayment.

Tax Implications

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.

The 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. Suppose the borrower surrenders the collateral in return for the cancellation of non-recourse debt. In that case, any amount over the canceled debt and collateral’s adjusted basis is recognized as a gain from the disposal of such collateral or property.

Example

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 the bike as recognized on the books was $1500, and if the lender can make only $800 by the sale of the asset, the borrower would arrive at $700 as a non-deductible loss.

If $1000 is borrowed against an asset with a value of $1000 and then such an asset is disposed of for $1200, the borrower must record $200 as taxable gain.

Continue reading about Debt Financing.



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

Leave a Comment