Defeasance and Its Impact on Real Estate Transactions

By Michael McGivney, CPA, MSA, Cleveland

Editor: Anthony S. Bakale, CPA, M.Tax.

As the real estate market continues to show signs of improvement since the Great Recession and interest rates are starting to rise, many commercial real estate owners are refinancing or selling properties. Often, these properties have been financed by mortgages that were securitized and sold by lenders to investors as commercial-mortgage-backed securities, or CMBSs. When borrowers seek to either refinance or sell a property encumbered by such a mortgage, extinguishing the mortgage is not as simple as canceling the note with a prepayment funded by proceeds from the refinance or a sale. Rather, many borrowers must enter into a transaction to replace the payment stream on the mortgage. One way to do this is through a defeasance.

When handling the tax ramifications of a defeasance, a practitioner must first have a working understanding of defeasance and why it exists. When a mortgage is securitized, it is generally pooled with other investments of similar terms and risk. A credit agency, such as Moody's, issues a rating on the security, and investors price and purchase the CMBS from an originator based on its characteristics such as term, rating, and size. One desirable feature of a CMBS is that it has a predictable payment stream over the term of the note. Generally, investors in a CMBS prefer that underlying mortgage notes are not unexpectedly paid off, as this can affect the value of the CMBS and leave investors open to pricing manipulation. As a result, the underlying mortgage notes generally include some type of provision that prohibits the prepayment of principal. These noncancelable features can be particularly onerous on borrowers, so they are allowed to enter into a defeasance transaction.

In a defeasance transaction, a borrower substitutes new collateral in exchange for the lender's release of the old collateral. The new collateral is generally a portfolio of U.S. Treasury-backed obligations, such as Treasury notes, zero-coupon bonds, etc., which a broker will construct to generate a payment stream necessary to cover the periodic payments required under the original note. In addition, generally, the note and related collateral are assigned to a successor borrower, which steps into the shoes of the original borrower to guarantee performance on the loan. By stepping into the shoes of the borrower, the successor borrower generally relieves the original borrower of all obligations on the note (which is important from a tax perspective).

CMBS investors generally prefer borrowers to enter into defeasance transactions. As stated above, investors price a CMBS based partly on ratings issued by ratings agencies. When higher-quality collateral is substituted for the underlying real estate, the overall risk of the CMBS decreases. Depending on characteristics of the bonds and the number of underlying mortgages that are defeased, a credit agency may even upgrade the security's rating. Both the substitution of collateral and the credit upgrade will theoretically raise the price of such securities in the secondary market, thus benefiting investors.

For borrowers, the cost/benefit analysis is more complicated. Borrowers incur costs from two sources—the cost to acquire the substituted collateral and transaction costs to effectuate the transfer. If the interest rate on the mortgage is greater than current yields on substituted securities—which in today's economic environment is generally the case—the borrower incurs a premium based on the spread between the interest rate on the substituted collateral required to generate the cash flow necessary to pay off the note and the rate of interest on the defeased note. In addition, transaction costs can be substantial. Borrowers must pay legal fees, accountant fees, and successor borrower fees to commence a defeasance transaction. Generally, the borrower must weigh the costs of the defeasance against the benefits of a lower interest rate on the refinancing plus additional cash flow from the refinancing or proceeds from a sale and make an economic decision. This economic analysis should include the tax impact of the defeasance transaction.

While defeasance transactions can be costly, favorable tax treatment is generally available to borrowers. Regs. Sec. 1.1001-1(a) states that the gain or loss from the conversion of property (such as debt) into other property is recognized as sustained. The IRS acknowledged deductibility of the defeasance costs in Rev. Rul. 85-42, which addressed "in-substance defeasance." In this ruling, the IRS described a transaction in which a corporation transferred corporate bonds yielding 6% and U.S. government securities yielding 14% to an irrevocable trust where the corporation was the beneficiary and a commercial bank was the trustee. All parties fully expected the payment stream from the U.S. government securities to cover the obligations on the corporate bonds, but the transferor corporation remained liable on the notes in the event of default and retained a right to any amounts left in the trust account following final payoff of the bonds. The IRS concluded that because the corporation remained liable, it had not been fully discharged of its obligations, and, thus, any earnings of the trust were taxable to the corporation.

Had the interest yields been flipped, the corporation would have incurred a premium to acquire substituted securities, so instead of recognizing income on the trust activity, deductions equal to the net additional cost to the borrower would be available. While the IRS has not ruled directly on the character of the deduction, taxpayers can analogously compare currently recognized defeasance expenses to prepayment penalties. In Rev. Rul. 57-198, the IRS permitted the deductibility of prepayment penalties as interest expense under Sec. 163.

While a properly structured defeasance transaction can generate a significant deduction for taxpayers, taxpayers should consider the totality of the transaction when assessing the after-tax impact. For example, in a taxable sale of real estate, a transaction with a currently deductible defeasance expense will reduce income or increase loss generated from the sale of the property. However, the after-tax effect of transactions can be more complicated in a Sec. 1031 like-kind exchange. As stated above, the expense of a defeasance transaction is deductible as interest expense, so to the extent that proceeds of a sale are used to pay any expense associated with a defeasance (even transaction fees), those funds are likely considered taxable boot under Regs. Sec. 1.1031(a)-1(a)(2).

Another scenario that practitioners should assess is the original borrower's relationship to the successor borrower. Most defeasance transactions are structured for a successor borrower to step into the role of the original borrower. As stated above, the successor borrower is responsible for performing all obligations related to the note using the substituted collateral. If the original borrower retains any obligation on the note, then deductibility of all expenditures incurred will occur over the remaining term of the note as original issue discount, per Regs. Sec. 1.163-7(c). However, if the successor borrower assumes all obligations and the original borrower is fully released of all liability, current deductibility is likely available.

When practitioners have clients completing a defeasance transaction, it is important for them to understand the nuances of the documentation. Differences in the structure of these transactions can result in significantly different tax results, and to the extent taxpayers can properly plan to avoid any traps, they can accelerate deductions. In addition, when other factors are in play, such as a like-kind exchange, proper structuring is imperative to avoid unwanted surprises.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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