4C — May 21 - June 17, 2021 — Owners, Developers & Managers — M id A tlantic Real Estate Journal


O wners , D evelopers & M anagers By Kelly Lopez Portillo, CPA, WITHUM Understanding Prepayment Penalties and Defeasance Fees


very active market, combined with low interest rates, gener-

fixed-rate mortgages often come with prepayment pen- alties if the owners choose to pay off the debt ahead of its specified maturity date. These types of mortgages have generally been securi- tized and sold to investors as Commercial Mortgage Backed Securities (“CMBS”). CMBS rely on a stable pay- ment stream through the original maturity date of the mortgage bundle. Thus, fixed-rate mortgages rep- resent a more volatile in- vestment because, in the event that a loan is repaid

early, there is a risk that the resulting funds will be reinvested at a lower rate, resulting in an economic loss to investors. To counter the risk, lenders will often require the receipt of pre- payment penalties. In some cases, the borrower will be required to pay the entire remaining interest on the note at the time that the debt is repaid. However, in many instances, the terms of the loan will call for a de- feasance, which is effectively a prepayment penalty, but that can offer some flexibility

to the borrower. A defeasance is a transac- tion that allows the borrower to replace the collateral on the loans with assets that provide the same cash flow stream to the lender as the original loan. Generally, the new col- lateral is a portfolio of govern- ment securities, such as Trea- sury bonds. In exchange, the lender releases the real estate from the lien of mortgage. The terms of the defeasance will likely require a successor bor- rower to acquire the note and related collateral to assume the borrower’s obligation on

the loan. This is beneficial to the lender because they main- tain the same cash flow, and their investment is backed by lower-risk collateral, among other factors. Whether a defeasance is advantageous to a borrower depends greatly on current interest rates. If interest rates are low and the rate on the debt exceeds the average rate on government securi- ties, the borrower’s cost to acquire the securities will exceed the principal on the loan, since enough securi- ties have to be purchased so that they yield the necessary income to service the debt. This is a defeasance premi- um, and can be quite costly. In addition, the borrower will incur other expenses, such as accounting and legal fees, consultant fees, as well as loan servicers, successor bor- rower fees, etc. Even in those circumstances, the overall costs of the defeasance may still be lower than a regular prepayment penalty. From a tax standpoint, prepayment penalties, as well as the premium and expenses related to the de- feasance, are deductible. However, in the case of a defeasance transaction, the timing of the deduction will depend on whether the bor- rower’s liability has been fully discharged. If the bor- rower retains any liability on the original note, then all expenses will be deduct- ible over the remaining life of the note. However, if the debt is fully discharged, the borrower can claim the de- duction in the year that the defeasance occurs. Understanding the factors and intricacies of prepay- ment penalties and defea- sance transactions is very important when negotiating the terms of a loan, and when analyzing the profit - ability of a sale or a refi- nance. With the appropriate planning at various stages of the transaction, real estate owners can achieve their investment goals while mini- mizing their costs. Due to the complexities of the above, it is prudent that any potential borrower seek professional advice before finalizing any transactions. Kelly Lopez Portillo, CPA is senior manager at Withum. MAREJ

ates tremen- dous oppor- tunities for commercial real estate owner s t o sell or refi- nance their properties. However, the early ex-

Kelly Lopez Portillo

tinguishment of debt can come with additional com- plications. Commercial real estate investments that have

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