What Is Recourse?
Let me explain what recourse means in lending. It's a legal agreement that grants the lender the right to take your pledged collateral if you can't meet your debt obligations. Recourse is essentially the lender's legal ability to collect what they're owed. This setup protects lenders because they know they'll get some repayment, either in cash or through liquid assets. If you're a company using recourse debt, you'll likely enjoy a lower cost of capital since there's less risk for the lender.
Key Takeaways
Here's what you need to know directly: Recourse is the lender's legal right to collect your pledged collateral if you don't pay your debt. With full recourse, the lender can seize other assets beyond the collateral to repay the debt. If you default on a recourse loan, the lender might go after your bank accounts or garnish your wages to cover the balance. In contrast, a non-recourse loan limits the lender to just the specific pledged asset in case of default. Also, recourse debt brings tax implications for you as the borrower, including recognizing taxable ordinary income and reporting any loss or gain.
Understanding Recourse
Recourse gives lenders a legal way to seize your assets if you default on a debt. If it's full recourse, you're liable for the entire debt amount, even if it exceeds the collateral's value. This means the lender can take other assets from you besides the collateral to repay the debt. Typically, the lender can get a deficiency judgment to seize unpledged assets, levy your bank accounts, or garnish your wages. They might even pursue other income sources like commissions, royalties, or investment income.
Recourse vs. Non-Recourse
You should understand how recourse loans differ from non-recourse ones. Non-recourse loans restrict the lender to claiming only the specific asset you pledged as collateral. If you default and the collateral's value doesn't cover what you owe, the lender can't go after your other assets to recover the balance. The lender's rights are limited to that pledged collateral. Because of this, recourse debt benefits the lender, while non-recourse debt benefits you as the borrower. Borrowers with non-recourse loans usually pay higher interest rates to compensate the lender for the extra risk. Recourse debt is more common since it's less risky for lenders, whereas non-recourse is often for longer-term loans on stable assets like commercial real estate.
Tax Impact of Recourse on Borrowers
Let's talk about taxes if you're a borrower with recourse debt. There are two main implications: you have to recognize taxable ordinary income and report a loss or gain. When filing taxes, you must report any forgiven debt as ordinary income. For instance, if a lender forecloses on a house for a $150,000 debt and sells it for $125,000, you still owe $25,000. If they forgive that, you report it as ordinary income. With non-recourse debt, forgiveness doesn't create taxable income because the lender can't pursue you personally. Regardless, you report a loss or gain based on the difference between the original loan and the sale amount—in the example, that's a $25,000 loss, but such losses from deficient asset sales aren't tax-deductible.
Special Considerations
Most loans include recourse language in the documents, specifying what actions the lender can take and any limits. Whether a loan is recourse or non-recourse often depends on the state where it originated. In most states, mortgage lenders have recourse, but it might be restricted—for example, deficiency judgments can't exceed the property's fair market value. Common recourse loans include credit cards, personal loans, and auto loans. Take a home with a $250,000 mortgage and $200,000 fair market value; if sold at auction for $150,000, the lender might only get a $50,000 deficiency judgment, which is the difference between FMV and sale price. Some states prohibit deficiency judgments entirely.
Example of Recourse
Consider Company ABC, a delivery firm needing to replace its old trucks. They buy five new ones for $250,000, paying $50,000 in cash and borrowing $200,000 from Bank XYZ as a recourse loan with the trucks as collateral. After three years, business is bad, and they can't pay; they still owe $125,000. Bank XYZ seizes the trucks, now worth only $75,000 due to depreciation, leaving a $50,000 shortfall. Since it's recourse, Bank XYZ goes after other assets, and they agree Company ABC hands over operating equipment worth $50,000 to settle the loan.
Questions & Answers
What is a non-recourse loan? It's a loan where, if you default and the collateral doesn't cover the debt, the lender can't pursue your other assets; banks avoid these to prevent losses. What recourse do you have against a home builder? If they've done poor work like faulty floors or cracked ceilings, check your contracts and warranties first; if not covered, it might be a breach or negligence, so file complaints with the BBB or FTC and consult a lawyer. What is recourse debt in a partnership? In a general partnership, partners can be personally liable for debts if collateral falls short, allowing lenders to seize personal assets; in an LLC, recourse is limited without touching personal assets. What is limited recourse debt? It's recourse with limits on which assets the lender can seize, as specified in the contract. What is full-recourse debt? It's unlimited recourse where the lender can seize any assets to cover the full outstanding debt, not just specific ones.
Other articles for you
The gross-income test is a key requirement for claiming dependents on US taxes, limiting their annual earnings.
Registered investment advisors (RIAs) are firms that provide fiduciary advice on investments and manage client portfolios while prioritizing client interests.
An error term in statistical models accounts for the unexplained differences between predicted and actual outcomes.
The bond market is a financial marketplace where governments and corporations issue and trade debt securities to raise capital.
Debt consolidation combines multiple debts into one loan to simplify payments and potentially lower interest rates.
William T
An organizational chart visually represents a company's structure, roles, and relationships.
The standard deduction is a fixed amount that reduces taxable income, offering a simpler alternative to itemizing deductions for US taxpayers.
National Insurance Contributions are taxes paid by UK employees and employers to fund social benefits like pensions and unemployment support.
A linked savings account connects to a checking or NOW account for easy fund transfers and better money management.