Foreclosure Home News and Opinion Recourse vs. Non-Recourse Loans

Recourse vs. Non-Recourse Loans

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Some 12.8 million borrowers in the United States are underwater on their home loans, meaning they owe more on their mortgage loan than their homes are worth. For many of these underwater borrowers it will be years before they see any equity in the property. Others will succumb to foreclosure and lose their property to the bank.

But what happens when you walk away from a mortgage loan?

It depends on what state you live in and what kind of loan you have — a recourse loan or a non-recourse loan.

Non-Recourse Loans
In a non-recourse state, borrowers are not held personally liable for the outstanding loan amount — at least not with the lender. Lenders may recoup some of its cost through foreclosure, but the lender can’t sue the borrower for additional funds (known as a deficiency judgment). If the foreclosure sale does not generate enough money to satisfy the loan, the lender must accept the loss. In non-recourse states, you can turn over the keys and walk away, free and clear.

But the Internal Revenue Service (IRS) considers debt forgiveness as income. Therefore, you might owe the federal government money. A law passed in 2007 makes that forgiven mortgage debt not taxable by the federal government, but that law is set to expire at the end of this year. Also, your credit score will take a hit, but you can rebuild it over several years.

Each non-recourse state has its own anti-deficiency statutes that prohibit lenders from seeking judgments. In some states— such as California — non-recourse laws apply only to “purchase money” loans (i.e. original home loans that are used to purchase a property). Mortgage refinances do not constitute “purchase money” loans. So, if you refinance a “purchase money” loan, it becomes a recourse loan.

Recourse Loans
Recourse loans are different. Recourse borrowers owe the full amount of the mortgage — even if they deed the property back to the bank. The lender can foreclose on a delinquent borrower, sell the property for less than the mortgage, and come after the borrower for all the rest — plus real estate selling commissions, legal fees, carrying costs and other expenses.

Moreover, refinanced loans, second mortgages, and “cash out loans like home equity lines of credit (HELOC loans) are generally recourse loans. Here’s some help tax advice from the IRS and the California Franchise Tax Board.

Talk to a real estate attorney before making a walk away decision, and show your lawyer the mortgage contracts.

Readers what do you think? Should non-recourse borrowers walk away from underwater properties to avoid a foreclosure? Or is walking away from mortgage debt illegal and immoral? What are your thoughts?

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Octavio, walking away does not avoid foreclosure. A Deed-in-lieu could avoid foreclosure, but I don't know i=of anyone recommending that option. So, I'll answer a slightly modified question: Should non-recourse borrowers walk away from underwater properties to [eliminate severe negative equity]? If the bank refuses to negotiate a fair loan modification, it is very clear the answer is YES. In the research, "severe" negative equity is a homeowner with a combined loan-to-value ration (LTV or CLVT) of 125% or more. I think a better metric is if it would take 5 years or more to get back to positive equity when paying the minimum allowed on the loan. If that is the case, it is hard to imagine they would not be much MUCH better off after strategic default (assuming the lender won't or can't modify). Another good rule of thumb (IMHO) is if the negative equity is $100K or more. For even the richest family, receiving a $100K post-tax bump to their family's assets would be life changing. At the very least, it would radically improve their retirement, child's education attainment, or the family's safety-net. Walking away from $100K or more of negative equity *IS* a $100K tax-free bump to their assets. On your moral question, there have been many many discussions. I think each family has a moral obligation to do the best they can to provide for their family. If someone is $20K or $50K underwater, they should probably just stay-and-pay. But, if they are sacrificing 5 years of their family's wealth building years to be moral, if they are jeopardizing their own retirement and making it likely they will need to lean heavily on government programs for their housing and health care in their later years to be moral... In those circumstances, I have a very hard time seeing the morality of being financially derelict with your family's finances. Mark Moore HomeLiberty Posted: September 2, 2012 by: HomeLiberty

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