Defeasance vs. yield maintenance: What's the difference?

Real Estate Issues, Summer 2001 by Schonberger, Michael, Moliver, Donald M

PROCEDURAL STEPS

The following is a partial list of procedural steps that must be performed to execute a defeaseance in accordance with typical securitized mortgage documents.

1. Notice - At least 30 days prior to the intended defeasement date the borrower must deliver a defeasance request to the service.

2. Preparation of the Defeasance Security Agreement - The payee's attorney must prepare and review the Defeasance Security Agreement. Upon completion, these documents must be delivered to servicer.

3. Certificate from borrower's public accountant -- An accountant, acceptable to the servicer, must certify as to the adequacy of the defeasance collateral. In essence, adequacy means that the collateral will generate monthly payments equal to the cash stream required under the original note.

4. Opinion of counsel - Counsel must opine that the payee has a perfected first priority interest in the defeasance collateral, the defeasance security agreement is valid and enforceable, and the proposed substitution is in accordance with Treasury Regulation 1.860(g)-2(a)(8) and will not be treated as an exchange pursuant to Section 1001. The priority, validity, and enforceability are common issues that attorneys frequently opine to for a fee. The treasury regulation lists specific ways of handling a defeasance as to stay within the boundaries of a non-tax paying entity.

5. Written confirmation from the rating agency The rating agency that provided the REMIC with the original rating must provide a "no downgrade letter."12 This letter provides that the substitution of the defeasance collateral for the mortgaged property will not result in a downgrade, withdrawal, or qualification of the rating assigned to the REMIC. This process also serves as a means for the rating agency to conduct a final review to ensure that all of the documentation related to the above items is in proper order. There is no apparent credit issue when a mortgage secured by commercial real estate is being replaced by United States Treasury obligations. There is a possible issue with the integrity of the REMIC. If one particular REMIC were to substitute many of its loans or substitute one loan improperly, the IRS could claim it as a seller of real estate assets, thus placing its non-tax paying status in jeopardy. For now this possibility seems quite remote because the number of defeasance transactions is still rather low. The agencies typically do not charge borrowers a fee for a confirmation letter.

6. Mortgage recording tax - In some jurisdictions, for example New York, a tax is assessed for the recordation of a mortgage. The tax is calculated on a sliding scale based on the amount of the new mortgage debt. What many borrowers do in a refinancing is ask the new lender to take assignment of the existing mortgage and note and then record a modification reflecting the terms of the new loan. This way the tax is charged only the "new money." For example, a $10 million loan is made to refinance an $8 million existing loan. If the $8 million loan is terminated, the mortgagee must record a new $10 million mortgage and pay the recording tax based on that amount. If however, the mortgagee takes the existing note and mortgage by assignment and records a modification agreement the tax is charged on only the $2 million amount. For quite some time, many attorneys in New York were unsure of the proper recording tax given a defeasement transaction. The confusion surrounded the treatment of the original mortgage, which for defeasement purposes is terminated and for recording tax purposes is assigned. Recently, the State of New York Commissioner of Taxation issued an advisory opinion that, in effect, limits the applicability of the recordation tax to new indebtedness only regardless of whether the mortgage release is associated with a note termination or assignment.13