Defeasance and its impact on real estate transactions.

• Author: McGivney, Michael R.

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).

...