Dealing with a distressed commercial real estate loan? 3 options to consider

by Phil Wuollet, CPA, M.Tax

Much has been said about the unsettled nature of U.S. commercial real estate (CRE). With the perfect storm of high interest rates (despite the Federal Reserve’s recent half-point reduction), declining property values, and increased costs, we’ve seen havoc in markets across the country. And with upwards of $1.5 trillion in CRE debt set to come due by the end of 2025, many syndicators are forced to consider their options.

In Arizona, this storm has particularly impacted the multifamily development market.

If you’re a syndicator of a multifamily project with debt coming due, it’s important to think through your next steps as soon as possible. Here are a few options to consider.

1. Refinance.

This may sound like the obvious solution, but it is not without caveats. Given today’s interest rates, refinancing your loan would likely lead to higher monthly payments, which may not meet a bank’s underwriting requirements.

To keep cash flow at its status quo, you could refinance only a portion of the loan. The shortfall, however, would need to be funded by new investments by you and your partners.

If your ownership group doesn’t want to put more money into the property, you could bring in a new group of owners. Of course, this new ownership group would want to come in as preferred investment holders—and they’d have rights to the property over your original partnership.

For example, if you were to lose the property in foreclosure, the banks get paid first and preferred equity get paid next. If there’s anything left over, it would go to your original partnership investors.

Although it isn’t ideal for you and your partners to increase your risk of not getting your investment back, you may not have a choice. If you need to refinance, the chance of getting a little back tomorrow is better than losing all of it today.

2. Sell and cover only the debt.

Unfortunately, our current tax rules may have caused some investors to have negative capital accounts due to the depreciation they took in prior years. If you’re in this situation, selling and covering only the debt may be a complicated option.

Here’s why: If you sold the property for the loan amount, your partnership would have income for depreciation recapture. Following standard operating agreements, this income would be allocated to the investors in the year of sale. (The income to the investor generally equals the amount of the negative capital account.)

As a result, you and your partners may face a tax bill, which is never enjoyable—especially after losing a property.

3. Face foreclosure.

If you decide to face foreclosure, it’s important to think through the potential ramifications. These will depend on your property’s fair market value, the amount of debt, the creation of cancellation of debt (COD) income (if applicable), and your bank’s decision to pursue or not pursue your partnership for any deficiency.

It also matters if your debt is considered recourse or nonrecourse. (Under state law, debt is typically classified as nonrecourse if no one is personally liable for it.) The tax treatment of the disposition and/or cancellation of debt income is dependent on whether the debt was recourse or nonrecourse. Further complications are present when property is foreclosed and the debt is recourse. Your operating agreement should have language to address the situation where a partner covers the shortfall on behalf of the partnership.

Weighing all of these factors can help you determine if moving ahead with foreclosure is the right option for your partnership.

Get guidance for your next steps.

Determining what to do with a distressed commercial real estate loan can be complicated, not to mention stressful. To help you fully understand your options and the tax ramifications of each, we’re here to guide you through the process—and find the right path for your partnership.

To learn more about how we can help you move forward with confidence, contact us today.