Pending legislation that would create tax incentives around the workout of commercial real estate loans could propel lenders and borrowers to move forward on working out troubled commercial real estate loans.
The bill, HR 5580, the Saving Our Mainstreet American Locations for Leisure and Shopping Act of 2023, aims to amend an existing tax code to allow noncorporate taxpayers to defer the tax incurred on loan reductions for troubled commercial real estate loans.
Essentially, the proposed legislation would defer discharges of debt secured by commercial real estate properties from being taxed as regular income in the year when the modification occurs. This means a reduction in the amount of a principal balance of a commercial real estate debt incurred during a loan modification or workout would not necessarily lead to immediately payable tax liabilities for borrowers, explained John T Duncan III, chair of the financial services division at Polsinelli’s Real Estate & Financial Services Department.
The bipartisan legislation, if approved, would apply to commercial real estate loans taken out before March 1, 2022 and canceled between December 31, 2022 and January 1, 2027. It would reduce some of the distress associated with an upcoming wave of commercial real estate loan maturities, estimated at more than $1.9 trillion over the next three years, per New York-based data provider MSCI.
“The bill is an attempt to make loan modifications involving the write-down of principal on loans more palatable for borrowers from a tax perspective,” Duncan said. He added that tax implications associated with loan write-down have been a barrier for borrowers to pursue that type of loan workout.
Ed Weil, co-leader of the national law firm Dykema’s CMBS practice, added the legislation is designed to eliminate a disincentive that currently exists for commercial real estate loans in default.
“There is well over a trillion dollars of commercial real estate debt that are coming due in the next few years, and this proposed legislation is designed to smooth the effects of this looming cliff that we’re about to jump off of,” he said.
Weil also believes the move shows a proactive move by Congress to minimize the effects of the looming maturity wave, citing the lessons learned from the global financial crisis in 2008.
Targeting loan workouts
The bill is narrowly targeted toward encouraging loan workouts. For defaulted commercial real estate loans, lenders will have the ability to either negotiate with borrowers on forbearance, or force a borrower to exercise remedies and send the property into a receivership. The lender could also foreclose and hold the property.
HR 5580 would provide tax incentives only for workouts that are involved with loan reductions, Weil said.
“If keeping the borrower was in the best interest of the lender parties, the lender might be motivated to right-size that debt to where the value is at now to incentivize the borrower to manage the property, and then pay off that loan at a reduced amount in some future date,” he added.
Polsinelli’s Duncan also noted the new bill would be helpful for some loans but likely won’t have a sweeping impact. “A write-down of principal is not going to be something the lender is going to want to do all that often. That’s not going to be a great alternative across the board,” he said.
In addition, lenders’ decision-making on which loan workout should be pursued might not be affected by the changes in tax policies either.
Duncan continued: “The first question is [still] what’s right for this loan and property. I don’t see this change as driving lenders’ behavior and influencing their direction on workouts and other resolutions.”
As the interest rate spiked over the past 12 to 18 months, floating-rate commercial real estate loans saw a large number of maturity defaults. For fixed-rate CRE loans, analysts said there will be more loan assumptions and modifications because the loans originated before 2021 are tied to much lower interest rates, so when new borrowers buy the loans, they can get loan prices that are below market value.
The House of Representatives and the Senate still need to meet to iron out differences, but Weil noted that having received bipartisan support, the bill has good prospects for passage.