Commercial Loan Workout Issues

With a hopeful end in sight to the pandemic, conventional wisdom suggests that lenders will begin the workout process with delinquent commercial property borrowers.  Indeed, in the last month or so I’ve received a number of calls from commercial property owners who may not make it through the pandemic unscathed.  Some have contemplated simply turning over the keys to their lenders or arranging for a liquidation that will bring less than what’s owed.  But that’s not the end of the story for commercial property owners who are thinking about heading down this road. 

First, let’s deal with some definitions. Foreclosure is the process by which a lender terminates an owner’s right to property through a judicial process involving a forced sale, usually at public auction, with the proceeds being used to pay off the mortgage debt. Easy enough. A short sale occurs when property is sold, but the lender agrees to take a discounted payoff with the mortgage being released even though the lender receives less money than is actually owed. Finally, with a deed in lieu transaction, the property owner voluntarily deeds the property to the lender, who accepts the deed and in return agrees to release the owner from liability for any mortgage debt.

Turning first to foreclosure, all too often borrowers assume that once their property is sold there’s no more liability. Unfortunately, however, it’s the rare foreclosure sale that brings in enough money to pay off the underlying debt. Court costs, attorneys’ fees, and other expenses get added to the debt. And, a public auction generally doesn’t bring in top dollar. The difference between the amount of debt and what the foreclosure sale brings in is called the deficiency, and the bank is generally awarded a “deficiency judgment.”

Armed with this judgment, a lender is entitled to continue to pursue you for the amount of the deficiency. However, because borrowers think that the process ended with the sale of the property they often ignore these “post judgment” proceedings – inevitably to their peril. Lenders can garnish your wages, demand financial records, and seize certain assets. And, these post judgment proceedings can come years after the deficiency judgment is granted. Certain lenders will periodically monitor your credit report to determine if, and when, its’ worthwhile to collect on a deficiency judgment.

Short sales also present a pitfall for the unwary. Many property owners assume that just because a lender releases a mortgage for less than the full amount due that they are absolved from liability. Nothing could be further from the truth. Once the mortgage is released, any remaining debt owed that lender still exists – it’s just now categorized as unsecured debt. The lender can still sue you, and ultimately get a judgment, for the amount of debt not paid off by the short sale. Once armed with a judgment, the creditor can proceed just as described above regarding a deficiency judgment. Of course, the debt might also be reported to a credit reporting agency.

What’s the property owner to do? The savvy owner addresses this issue prior to the short sale by asking the lender for a release. If the lender is unwilling, it still might be possible to negotiate a release from any remaining liability by payment of a reduced amount – perhaps even structured over a period of time. If successful, make sure everything is properly papered and consult with an attorney.

A deed in lieu of foreclosure, unlike the first two options, actually results in a forgiveness of any debt owed that is not covered by the value of the property. For a financially distressed borrower, this is quite often the best possible result. Lenders, however, will generally be averse to agreeing to a deed in lieu unless they are convinced that there’s little or no possibility of ever collecting on the “difference.”

Assume you work out a deal. If you get your lender to absolve you from the deficiency in a short sale, or through a deed in lieu, it involves your creditor forgiving some amount of debt. In the eyes of the IRS, forgiveness of debt equals income that is taxable. That’s right – you might owe tax even though you never actually received any money.

What are your options? If you were insolvent when the debt was forgiven, you may not owe any tax.  Beyond that, you’d be best off to consult with your CPA as topic is beyond the scope of this article.

The issues confronting borrowers in financial distress can be quite complex. As with most situations, there’s no excuse for not being informed or for failing to seek the help of professional advisors.