I had an interesting question from a reader recently. I’ll share it here to illustrate the kind of information that is in two of my book genres (hyperinflation/depression and real estate investment). The reader got it out of my book How to Protect Yourself from Hyperinflation & Depression, 2nd edition. But it is a topic also covered in my real estate investment books
In the hyperinflation book, I said owing a high loan-to-value ratio, non-recourse mortgage would be a great investment for protection against both inflation and deflation (depression). It would be a you-can-win-but-you-can’t-lose-much investment.
The whole idea is borderline legally impossible, but it is unlikely you would encounter anyone knowledgeable enough to recognize that.
In one Tax Court case, the court said a high loan-to-value ratio non-recourse mortgage turns the deal into a call option, not a mortgage-financed purchase. (Franklin 64 TC 752)
Stated in stock-market terms, such a combination of asset and liability would arguably be a call option in substance, not a purchase. During normal times—no inflation or deflation—you can make UNLIMITED PROFITS from a call option. Furthermore, with a high loan-to-value ratio, leverage would MULTIPLY your unlimited profits.
Walk away if depression/deflation
Furthermore furthermore, in deflation, you could and should WALK AWAY from it if the property value fell below the mortgage balance. With a high LTV ratio, that would happen quickly.
Is that immoral? No, although a lot of people are ignorant enough to think it is. I said it was a non-recourse mortgage. That means the lender can only foreclose on the real estate pledged as security for the loan. They cannot also go after your income or other assets if the foreclosure proceeds are less than the mortgage balance.
In a non-recourse mortgage, the lender agreed to that. Some will try to shame you into paying the loan off for moral purposes. That is valid in the case of RECOURSE mortgages. You do have both a moral and a legal duty to pay those off in full. But if you were managing someone else’s money and you paid off a non-recourse mortgage with their funds other than the foreclosure proceeds, you could go to jail or lose your financial guardian license for incompetence.
There are some pertinent AT-RISK RULES in income tax law. You cannot deduct losses on loans where you did not have money “at risk” in a limited partnership. [IRC Sec. 465(a)(1)]
You right to walk-away was the agreed-to deal from day one
Recourse means recourse and non-recourse means non-recourse. What is immoral is for a lender to agree to non-recourse, then try to shame the borrower into behaving as if the mortgage were recourse.
According to economic theory, the borrower should be paying a higher interest rate for a non-recourse mortgage than for a recourse mortgage on the same property. You gotta be pretty dumb to pay extra to get non-recourse, then pay out of pocket after foreclosure as if you have NOT paid extra to get non-recourse.
In short, you get to keep ALL THE PROFITS if the property goes UP in value, but you only lose your EQUITY if it goes DOWN in value and the mortgage is non-recourse. YOU CAN WIN BUT YOU CANNOT LOSE—MUCH with a high LTV, non-recourse mortgaged property. Hell of a deal.
In hyperinflation, you make out like a bandit
Now add hyperinflation to the mix. In hyperinflation, the building will roughly retain its purchasing power. For example, if the building cost the same as ten Lexus 500 LSs before the hyperinflation, it will still be worth the same as ten Lexus 500 LSs during and after the hyperinflation.
The MORTGAGE, however, will become WORTHLESS to the lender during hyperinflation. That kills the lender, but is a fabulous gift to the borrower. In effect, the hyperinflation pays off the mortgage for the cost of a candy bar. For example, suppose you have a $900,000 mortgage. In hyperinflation, $900,000 could be the cost of a candy bar that currently sells for $1.25. Really. Look at Venezuela.
So in hyperinflation, you get to keep your ten Lexus 500 LSs, but the $900,000 loan you took on to buy them becomes as easy to pay off as it is to buy a candy bar today. In terms of purchasing power, before hyperinflation you owned ten Lexus 500 LSs that had purchasing power of $1,000,000 in today’s dollars, but you also owed $900,000 on them giving you equity of $100,000 in them. AFTER hyperinflation, you still have the ten Lexus 500 LSs, but the DEBT DISAPPEARS, giving you equity of $1,000,000, a.k.a., making out like a bandit.
It is a “heads you win unlimited, tails your lender loses $900,000 and you lose $100,000” situation. (Actually, the lender would probably get more than zero but it would not matter to you if they got zero.)
What’s the catch? There is in income-tax law a doctrine called “substance over form.” It means simply that the courts will ignore what you CALL something and treat as what it actually is. In real estate, whether you own a property in substance is determined by answering the question who has the BENEFITS AND BURDENS OF OWNERSHIP, not whose name is on the deed.
The benefits and burdens of owning real estate include:
• who profits if it rises in value (owner)
• who loses if it falls in value (owner, but not call option owner)
So if your name is on the deed, but you do not lose if the property falls in value, you are, in substance, a CALL OPTION OWNER, NOT the property owner. Your profiting from the property going up in value is also consistent with either your being the owner of a call option or the owner of the property.
This issue also comes up when banks actually own a slum apartment building but pretend they are just the lender to avoid lawsuits and other trouble. Telltale signs like the “owner” having a rather distinct employee of the bank situation reveal the sham.
To state it in stock-market terms, owning a property with a high-LTV, non-recourse mortgage during hyperinflation is like owning a call option with a “strike price” (mortgage balance in this case) that starts at current market value of the underlying real estate, but then FALLS to zero in real terms during hyperinflation. Real terms means after adjustment for inflation.
A call option is the right, but not the obligation, to buy an asset for a certain price during a certain period of time. With a high-LTV, non-recourse mortgage, there would not be the usual time limit on the “call option.” Strike price is the market value at which the call option starts to have equity, a.k.a., be “in the money.”
What are the consequences of the purchase of the property including a high-LTV, non-recourse mortgage declared to be a call option by a court? The guy whose name is on the deed is not the owner. The seller is still the owner. Owner can depreciate and other things that call option owner cannot. You can’t sue the call option owner for property-management negligence.
Anti-deficiency judgment laws
Is it easy to find a high-LTV, non-recourse mortgage? It varies. In CA and AZ, they have ANTI-DEFICIENCY JUDGEMENT laws on conventional, purchase-money mortgages. Loans are available in 5% or 10% down versions, i.e., high loan-to-value ratios.
A deficiency judgment is a court finding that the foreclosure proceeds were not enough to pay off the mortgage and a license to go after the borrower’s other assets and income for the rest of the money owed. There are some similar or quasi-anti-deficiency judgment states that only permit ONE-ACTION—EITHER foreclosure OR going after other assets and income of the borrower.
Look at this table under “deficiency judgment allowed.”
There are a lot of articles on the Net about non-recourse, anti-deficiency judgment, and one-action states.
SELLERS can take-back mortgages that are non-recourse and have high LTVs and many are dumb enough to do so. Check state law on whether the non-recourse provision still works if the mortgage is a SELLER take back. Different laws apply to interest, basis, and capital gains taxes when it is a seller mortgage in income tax laws (Original Issue Discount rule—see IRS publication 1212).
Being INSOLVENT or BANKRUPT can, in effect, make recourse mortgages non-recourse if you have no other assets or income to go after. I do not recommend that as a strategy to pursue, but if you are already there, it should be taken into account.
FHA HECM loans are also non-recourse, but generally not high LTV.
I point out a whole lot of peripheral stuff here to show how states vary in how they treat the non-recourse issue. But this is basically a simple matter of buying a principal residence with 5% or 10% down and getting a purchase-money, conventional mortgage in a state with an anti-deficiency judgment statute. There are about 10 or 12 of them depending upon which web site you check. Thousands of people do this every day (almost all of them oblivious to the contents of this article).
It is a real estate asset/loan combination that allows you to win a lot if there is inflation but lose very little if there is deflation. And if there is neither, you do not suffer one whit. And you saved the $158,800 total cost of getting a Harvard MBA.
Let me contrast this to the most lauded hyperinflation hedge asset—gold. If you buy gold, and we have inflation, your gold falls in value. It does not make you richer in real (adjusted for inflation) terms. And if we have deflation, your gold will plummet in real terms making you poorer in dollar terms. Gold, like most hedges is just a bet on inflation. If we get no inflation or we get deflation, you lose. With a high LTV ratio, non-recourse mortgage, you are waging asymmetrical “warfare” on the financial world with a one-sided asset/debt combination. Most of the value of gold comes from fear of inflation. In deflation, fear of inflation disappears and along with it, the value of gold.
You can see my real estate books at https://www.johntreed.com/collections/real-estate-investment