Commercial Mortgage Loan Workouts – Part One

Introduction

Nearly $1.5 trillion in commercial mortgages are coming due over the next three years.[1] Many of the borrowers may not be able to refinance as lenders are becoming increasingly reluctant to lend, a situation that poses problems not only for borrowers but for their existing mortgage lenders. According to the Wall Street Journal, “The CBRE Lending Momentum Index, a proxy for U.S. commercial real estate lending, fell 54% in the first quarter of 2023 compared with a year ago.”[2] As bank deposits shrink, banks “are stepping back until it is clear where real-estate values will settle.”[3] With a massive increase in maturing loans and a decrease in lending, loan delinquencies have also been increasing.[4]

When a borrower defaults on a commercial mortgage loan, the borrower will typically try to work out a loan extension or a settlement with the lender, and the lender may be willing to work things out with the borrower especially if market conditions, rather than the borrower’s decisions, precipitated the default. Possible settlements include: a modification of the loan terms, a loan payoff at a discounted amount, the purchase by the borrower or its affiliate of the loan from the lender at a discount, or a deed in lieu of foreclosure. When negotiations with the lender fail, the lender will generally foreclose resulting in the sale of the property to the lender or a third party at a public auction. As discussed below, foreclosure is the worst result for the borrower for a number of reasons and the goal of workout negotiations is the avoidance of foreclosure.

Foreclosure  

In most states, including California and Texas, the lender typically forecloses through a trustee’s sale, which may be scheduled for a date occurring a short time after the service of a notice of default: three months plus 21 days in California[5] and 41 days in Texas[6]. In other states, such as New Jersey, where the deed of trust has not supplanted the mortgage, trustee’s sales are not available, and foreclosure requires the filing of a lawsuit[7] and the court issuance of a judgment of foreclosure and writ of execution[8] followed by the scheduling of a foreclosure sale through the sheriff’s office[9]. In either case, at the foreclosure sale, the property is sold at public auction to the highest bidder for cash; however, the foreclosing lender may credit bid—offsetting its bid by cancelling all or part of the mortgage balance.[10] Generally, the purchaser at the foreclosure sale takes title to the property “free and clear” of all liens and encumbrances junior to those of the foreclosing lender but subject to any senior liens or encumbrances.[11] If there are any sales proceeds, they are distributed first to pay the costs of the sale; then to satisfy the debt of the foreclosing lender; next to pay any junior lienholders in their order of priority; then any surplus to the borrower.[12] The foreclosing lender often credit bids all or part of the unpaid balance of its loan at the foreclosure sale. If there are no higher bidders, the foreclosing lender will acquire the property at the sale in return for the satisfaction of its loan to the extent of its credit bid. Because a full credit bid is the equivalent of “a total satisfaction of the secured obligation,” it follows that the lender making a full credit bid gives up any right to pursue the borrower for a deficiency judgment, in cases where deficiency judgments are not prohibited by statute or judicial decision.[13] For this reason, if the mortgage loan is guaranteed by a solvent guarantor, the lender will credit bid only the amount necessary to win the auction.

Tax Consequences of Foreclosure

If the property is foreclosed upon or the borrower gives the lender a deed in lieu of foreclosure, the transaction is treated as a sale of the property for income tax purposes.[14] As a result, if the amount realized in the sale exceeds the borrower’s adjusted basis in the property, the borrower will realize a gain; if the amount realized is less than the borrower’s adjusted basis in the property, the borrower will realize a loss.[15]

From the lender’s perspective, if the property is sold at the foreclosure sale (to the lender or a third party) for less than the loan balance and all or part of the remaining debt is uncollectible, the uncollectible amount is deductible as a bad debt.[16] If the lender acquires the property by deed in lieu of foreclosure, the lender is entitled to a bad debt deduction for the difference between the lender’s basis in the loan (which is typically equal to the loan balance) and the fair market value of the property.[17]   

In future blogs, we will discuss foreclosure, its benefits and drawbacks, and persons affected, including tenants, guarantors and other creditors, secured and unsecured, as well as various foreclosure alternatives: a deed in lieu of foreclosure, loan modification, discounted payoff, and borrower’s purchase of the mortgage loan from the lender.

[1] Wall Street Journal, “Interest-Only Loans Helped Commercial Property Boom. Now They’re Coming Due. June 6, 2023.

[2] Wall Street Journal, “A Lifeline for Property is all Gummed Up”, June 4, 2023.

[3] Id.

[4] https://www.trepp.com/trepptalk/cre-loan-performance-higher-delinquency-rate-higher-risk-q2-2023

[5] See, Cal. Civ. Code §§2924(a)(2) and 2924f.

[6] See Tex. Prop. Code §51.002.

[7] N.J. Ct. R. §4:64.

[8] N.J. Rev. Stat §2A:50-36.

[9] N.J. Ct. R. §4:65-2.

[10] See, e.g., Cal. Civ. Code §§2924g-h.

[11] See, e.g., Streiff v. Darlington, 68 P. 2d 728, 729 (Cal. 1937).

[12] See, e.g., Cal. Civ Code §2924k(a).

[13] Cornelison v. Kornbluth, 542 P.2d 981, 992 (Cal. 1975).

[14] Helvering v. Hammel, 311 U.S. 504 (1941).

[15] I.R.C. §1001(a). We will discuss how to determine the “amount realized” in future blogs. 

[16] I.R.C. §166; Treas. Reg. §1.166-6(a). If the lender bought the debt at a discount and then receives more than its purchase price at foreclosure, the profit is taxed as ordinary income. Ogilvie v. Commissioner, 216 F. 2d 748 (6th Cir. 1954). If the lender is the purchaser at the foreclosure sale and the lender’s credit bid differs from the market value of the property, the lender also must recognize gain or loss measured by the difference between the loan balance and the market value of the property. Treas. Reg. §1.166-6(b)(1). However, absent clear and convincing proof to the contrary, the bid price in a foreclosure sale is presumed to be the property’s market value. Treas. Reg. § 1.166-6(b)(2).

[17] Commissioner v. Spreckels, 120 F. 2d 517 (9th Cir. 1941).