Defeasance of Debt in a Real Estate Transaction
October 25, 2022
By Dennis Mascali
A common assumption when real property that is collateralized by debt is sold is that the borrower will use the proceeds from the sale to pay off the existing principal balance of the debt prior to the maturity, which is usually the easiest option when a borrower wants to sell their property. However, prepayment with cash is not always the borrower’s most favorable option, especially when dealing with a fixed-rate loan, which often include large fees associated with prepayment. One alternative to cash prepayment is defeasance.
Defeasance of debt is a transaction in which a borrower replaces the collateral of a loan with new collateral that yields similar cash flows to the lender, often fixed-rate government bonds with maturities equal to the remaining term of the loan, to allow the lender to avoid the loss of income that would be associated with prepayment of the debt. The terms of defeasance, as well as any fees associated with prepayment, would typically be negotiated in conjunction with the initial debt agreement at the inception of the loan.
Defeasance is usually only seen as an option with fixed-rate loans, rather than debt with variable interest rates. This is due to the potential loss of income the lender may endure if interest rates decline as compared to the fixed rate of the loan, as the lender would use the funds from prepayment of the debt to lend out to a new borrower at a lower rate than what was being received from the fixed-rate loan. Lenders do not incur this reinvestment risk on variable rate loans as the rates associated with this debt will fluctuate with the current market.
Advantages of Defeasance
For the lender of a mortgage loan, defeasance is advantageous in most circumstances when compared to cash prepayment as the government-backed securities received as collateral to replace the lien on the property likely carry less risk than the mortgage. For instance, a borrower of mortgage debt is more likely to default on that debt due to disruptions in their business than the government agencies backing the bonds are to stop paying the yields on their bonds.
On the contrary, the borrower will likely have to calculate the costs of defeasance to weigh their options to determine if defeasance is more ideal for their situation than another prepayment option. This is dependent upon the borrower’s individual situation. In most cases, if market rates rise above the rate of the loan, it would benefit the borrow to enter into a defeasance transaction as the borrower would be able to spend less to purchase the securities required to yield returns similar to the loan for the lender, assuming the rise in rate is large enough for defeasance to cost less than prepayment of the outstanding balance and any penalties with cash.
Accounting for Defeasance
When the borrower sells a property collateralized by debt, defeasance has a similar accounting treatment as paying off the debt with cash, assuming it is a legal defeasance rather than an in-substance defeasance. According to ASC 405-20-55-9, in a legal defeasance, the creditor legally releases the debtor from being the primary obligor under the liability. Liabilities are extinguished by legal defeasances if the condition in ASC 405-20-40-1(b) is satisfied, which states the debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor. Assuming the borrower is legally released from their obligation, subsequent to the sale, the debt is no longer recorded on the borrower’s books and the costs of defeasance, similar to the costs associated with repayment, are used by the borrower to calculate the gain or loss on debt extinguishment recorded on the statement of operations. However, determining the cost of defeasance can be relatively complex as it involves determining the exact number of securities to be purchased, secured in the proper way to be transfer to the lender, as well as the potential required tax filings for the transaction. The best way to determine the cost, especially if the borrower doesn’t have past experience with defeasance, is usually through the use of an expert consultant.