Defeasance Deductibility in Commercial Real Estate

By Eduard Suleymanov  |  August 19, 2019

Refinancing is common in commercial real estate, as it allows investors to capitalize on equity and save money by lowering interest rates on a loan. However, commercial real estate owners who are interested in refinancing their loans must first determine if those loans are securitized, as a borrower with a securitized loan will need to defease the loan before selling or refinancing the property securing the loan. It is important for borrowers to be aware of the tax treatment associated with the costs related to a defeasance transaction. This article will explore the role of defeasance in commercial real estate transactions as well as the tax deductibility of a defeasance premium paid pursuant to a legal defeasance.

DEFEASANCE - A PRIMER

Conduit loans are pools of commercial mortgage- backed securities (CMBS), also referred to as securitized loans. CMBS loans are sold into securitization trusts that elect to be treated as a Real Estate Mortgage Investment Conduit (REMIC). The investors who invest in REMICs are enticed by the predictable payment stream offered by these investments. Due to the various restrictions imposed on REMICs by the tax code, prepayment of the underlying mortgages is generally not allowed, unless the collateral on those mortgages can be substituted with new collateral that guarantees the same payment stream to the investors as the old collateral.

This substitution and release of the old collateral for new collateral is referred to as a defeasance.

DEFEASANCE IN REAL ESTATE

In commercial real estate transactions, defeasance generally means that the original real estate securing a conduit loan is released as collateral and new collateral is substituted. (The new collateral is generally a portfolio of high-quality government securities, such as treasury notes, zero-coupon bonds, etc.) These substituted government securities must generate cash flows sufficient enough to cover the periodic payments required under the original loan. Costs to acquire the substituted collateral generally include transactional expenses, such as fees paid to attorneys, defeasance consultants and tax advisors, and may include a defeasance premium.

A defeasance premium is a function of the spread between the interest rate on the conduit loan and the yield on the government securities on the date the securities are purchased. A defeasance premium occurs when the interest rate on the substituted securities is lower than the interest rate on the original conduit loan.

Note: If the interest rate on the conduit loan is lower than the yield on the government securities, there is a defeasance discount.

A defeasance premium can be deducted immediately by the borrower so long as the transaction satisfies the definition of a legal defeasance.

A LEGAL DEFEASANCE

In a legal defeasance, the borrower is legally released from any continuing liability on the debt. The substituted

collateral purchased to defease the loan is treated as a repayment of the original loan. The loan is retired from the perspective of the borrower. A defeasance premium paid under a legal defeasance is deductible as a payment of interest in the year incurred.

A TYPICAL LEGAL DEFEASANCE

The transactional steps of a typical legal defeasance are listed below.

  1. In order to implement the defeasance, a conduit loan borrower borrows money and executes a defeasance promissory note from a new lender. The amount borrowed from the new lender is equal to the outstanding principal of the borrower’s existing conduit loan.
  2. The borrower is then required to use the proceeds of the new loan to purchase U.S. government securities to serve as collateral for the new loan. The purchased U.S. government securities must generate sufficient cash flow to make all remaining debt service payments of the existing conduit loan.
  3. The new lender then assigns its promissory note and its rights to the U.S. government securities serving as collateral for the new loan to the conduit loan lender.
  4. The conduit loan lender assigns the mortgage loan to the new lender and releases and discharges the borrower from all claims, liabilities and obligations under the conduit loan.

Following these steps, the borrower is able to sell or refinance the property subject to the promissory note and mortgage now owned by the new lender.

TIP: AVOID IN-SUBSTANCE DEFEASANCE

In an in-substance defeasance, the original borrower’s debt is not legally discharged, and the borrower remains legally liable to the lender to make required payments under the loan in the event there is a shortfall in cash flow generated by the substitute collateral. Thus, the borrower is not eligible for an immediate deduction of a defeasance premium attributable to an in-substance defeasance. Instead, the defeasance premium may only be deducted over the remaining term of the conduit loan.

CONCLUSION

Commercial real estate owners, borrowers and investors interested in refinancing their securitized loans should consider all the costs associated with a defeasance transaction as well as any possible tax deductions. If a defeasance is necessary, these individuals should consult with a defeasance consultant, their attorneys and especially their tax advisors to make sure a legal defeasance is achieved and the appropriate deductions are taken.


About Eduard Suleymanov

Eduard Suleymanov Linkedin Icon

Eduard Suleymanov, CPA, is a Director in the Real Estate Group at Marks Paneth LLP. In this role, Mr. Suleymanov provides accounting, tax planning and advisory services to commercial and residential real estate owners. His background includes preparing certiorari filings, operating escalation statements, as well as multi-state partnership tax returns.  With more than 12 years of experience in public accounting, Mr. Suleymanov brings additional experience in tax compliance for high-net-worth individuals and closely held businesses,... READ MORE +


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