A recurring theme in our writings is managing risk in real estate investing. While most investors understand that debt can be a powerful tool to enhance returns, it is a “double-edge sword” that may increase the risk profile of an investment. However, a lesser understood risk of mortgage financing is its potential to increase losses beyond the amount of equity invested.
The Two Types of Mortgages
There is a bewildering array of loan options available for real estate, from bridge to permanent financing, to mezzanine loans, and so on. And, more often than not, the collateral used for your financing will be your property.
If you are unable to make your mortgage payments, your lender can seize the asset, sell it, and pocket the proceeds. But what happens if the sale proceeds are less than the value of the actual loan? Well, that depends.
- With a nonrecourse loan, the lender can’t come after you to make up the difference between sale proceeds and the loan amount. Your liability doesn’t go further than the actual value of the property.
- With a recourse loan, the lender can come after you, and seize additional assets, garnish your wages, and do just about anything else to make up that difference.
So, the obvious question is, why don’t all real estate borrowers hold out for nonrecourse loans? Well, for one thing, nonrecourse loans generally carry higher interest rates, and are typically reserved for borrowers with outstanding credit scores.
Additionally, a nonrecourse loan doesn’t mean you might be 100% off the hook, in the event of a default. If the lender can’t collect the entire amount owed, you, as the borrower, are subject to something called “Debt Forgiveness.” Despite its benign-sounding name, the concept isn’t very forgiving to the borrower. Debt forgiveness means the Internal Revenue Service (IRS) can treat any amount that is still owed following a foreclosure sale as actual, taxable income.
That’s right. So, if your property is foreclosed upon, and your lender seizes, sells and recovers less than what is owed, that difference can now be taxed as income. In other words, you’re still liable.
Can It Happen?
Certainly, no one invests in real estate planning to go through foreclosure proceedings down the line. However, during the past couple of decades, real estate long shots became reality.
Blockbuster declared bankruptcy in 2010, leaving behind empty big-box assets. The following year, Borders Group Inc., which owned and operated the Borders and Waldenbooks stores, collapsed. In its wake came swaths of empty real estate space. Then, there was the Great Recession of 2007-2009, made that much worse by the housing bust. Housing foreclosures hit an all-time high, and even as late as 2015, some of those cases were still making their way through the courts.
How to Protect Yourself
The takeaway from the above is that, as a real estate owner, you should protect yourself for any eventuality, by limiting your liability. You can do so in the following ways:
- Legal ownership. Rather than buying property as a sole proprietor, you’re better off forming a limited partnership (LP), limited liability company (LLC) or investing in a Delaware Statutory Trust (DST), which we’ll explain in more detail below. If you use one of these ownership formats for real estate investments, your personal assets are better protected, in the event your real estate goes belly up.
- Contractual arrangements. It’s very important to get your attorney on board when you first start contract negotiations. He or she can ensure damage caps be placed in the contract, that might limit your losses and impose time limitations on when a lender can collect.
- DST investments. We’ve written about these extensively. In a DST, the real estate and the related mortgage debt financing, if any, are held in a trust. The mortgage financing is nonrecourse to the DSTs beneficial interest owners. The DST also provides for real estate liability protections similar to that of LLCs.
The chances are pretty good that this article is detailing only the absolute worst-case scenario, and that you’ll never be at risk of default or foreclosure. However, it is always best to do what you can to protect yourself from any kind of liability, in the event that the worst-case scenario comes true.
At Realized 1031, we make it our job to understand both the obvious and hidden risks of utilizing a mortgage in your real estate investment. Contact us today at 877-797-1031 with any concerns you may have surrounding your next exchange.