Defeasance is a technique that removes a loan from the borrower’s balance sheet by replacing it with a portfolio of risk-free securities, usually U.S. Treasuries, that generates exactly enough cash to make every remaining payment on the debt. The borrower doesn’t pay the lender off directly. Instead, an irrevocable trust takes over, feeding scheduled principal and interest to the lender through maturity. The tool shows up most often in corporate bonds, commercial real estate loans, and municipal finance, where prepayment is either forbidden outright or carries a penalty large enough to make a direct payoff impractical.
The Two Forms: Legal and In-Substance
Defeasance comes in two varieties, and the difference drives everything that follows, from the accounting entries to the tax bill.
In a legal defeasance, the original loan agreement allows the borrower to be fully and permanently released from liability once the collateral is deposited. The borrower walks away with no remaining obligation, even if the trust later came up short.
In-substance defeasance is far more common. The borrower deposits securities into an irrevocable trust, and the debt is treated as extinguished on the financial statements, but the borrower technically remains liable on the note. If the trust’s assets somehow failed to cover payments, the borrower would still be on the hook. In practice the collateral is U.S. government securities precisely matched to the debt’s payment schedule, so the chance of shortfall is essentially zero. The accounting rules allow the debt to come off the balance sheet when the likelihood of any future payment by the borrower is remote.
How the Transaction Works
The heart of every defeasance is cash-flow matching. The borrower needs a portfolio of securities that throws off exactly the right amount of money on exactly the right dates to cover every remaining payment on the loan, including any balloon at maturity. If the loan requires $50,000 on the fifteenth of each month for six more years plus a $2 million balloon at the end, the portfolio has to deliver precisely those amounts on those dates.
A defeasance consultant usually runs the analysis, mapping each future debt payment against available Treasury securities to find the cheapest combination that produces a perfect match. The collateral has to be noncallable and nonprepayable so the cash flow can’t be disrupted. Once the portfolio is identified, the borrower buys the securities through a broker and transfers them irrevocably into a trust or escrow account. An independent escrow agent takes custody and handles payments to the lender from then on. The borrower’s involvement ends.
The process is not quick. For Fannie Mae multifamily loans, the closing must fall between 30 and 45 calendar days after the servicer receives the defeasance notice.1Fannie Mae Multifamily Guide. Defeasance CMBS loans follow a similar window. Months of preparation typically come before the formal notice.
What Qualifies as Collateral
The loan agreement dictates which securities can be used. U.S. Treasuries are the default in nearly every transaction because they carry essentially no credit risk. Three instruments do most of the work:
- Treasury STRIPS, zero-coupon securities created by separating a Treasury bond’s principal and interest components. Each STRIP matures on a single date and pays a single lump sum, which is ideal for matching specific payment dates.
- Standard Treasury notes and bonds, which pay semiannual interest and return principal at maturity.
- State and Local Government Series (SLGS), special-purpose Treasury securities available only to state and local governments, commonly used in municipal bond defeasance because they can be customized with specific maturity dates and interest rates.
Some loan agreements also permit agency securities from government-sponsored enterprises like Fannie Mae or Freddie Mac.1Fannie Mae Multifamily Guide. Defeasance The constant across every agreement is that the securities must be noncallable, so the cash flow can’t be interrupted by early redemption.
What Defeasance Costs
The largest expense is the securities portfolio itself. Treasury yields rarely match the loan’s coupon rate perfectly, so the portfolio usually costs either more or less than the outstanding loan balance. When current interest rates are lower than the loan rate, the borrower pays a premium, because it takes more lower-yielding bonds to produce the same cash flow. When rates are higher, the portfolio costs less.
On top of the securities, third-party transaction fees typically run between $50,000 and $70,000 in total. That covers the servicer processing fee, legal fees for servicer and successor borrower counsel, accountant verification of the cash-flow match, any required rating agency review, the successor borrower fee, the securities intermediary fee, and the defeasance consultant’s fee. For a borrower weighing defeasance against another exit route, the all-in cost including any portfolio premium is the number that matters, not the fees alone.
Accounting Treatment
Under U.S. Generally Accepted Accounting Principles, an in-substance defeasance qualifies as a debt extinguishment when the borrower irrevocably places assets into a trust dedicated solely to servicing the debt and the probability of the borrower needing to make further payments is remote. Once those conditions are met, the debt comes off the balance sheet.
The event that hits the income statement is the gain or loss on extinguishment. It equals the difference between the debt’s net carrying amount, which is the face value adjusted for any unamortized premium, discount, or issuance costs, and the cost of the securities deposited in the trust.2Deloitte Accounting Research Tool. 9.3 Extinguishment Accounting
If the portfolio costs less than the net carrying amount, the company records a gain. If it costs more, the company records a loss. The gain or loss is recognized in income during the period of extinguishment and typically classified within nonoperating income.2Deloitte Accounting Research Tool. 9.3 Extinguishment Accounting The company also has to disclose the nature of the arrangement and the amount of debt that remains legally outstanding even though it no longer appears on the balance sheet.
Tax Consequences
The tax treatment turns on whether the borrower is legally released, and it runs in the opposite direction from the accounting treatment.
A legal defeasance, where the borrower is released from all liability, is treated as a significant modification of the debt instrument under Treasury regulations. A significant modification is deemed an exchange of the old debt for a new one, which triggers gain or loss recognition under Section 1001 of the Internal Revenue Code.3eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments The borrower may have cancellation-of-indebtedness income or a deductible loss depending on the difference between the debt’s adjusted issue price and the amount paid to defease it.
An in-substance defeasance is not a significant modification, because the borrower remains obligated on all payments. The IRS views the transaction as a change only in the collateral securing the debt, not in the debt itself.3eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments No exchange occurs, so no gain or loss is recognized. The same transaction that removes debt from the balance sheet under GAAP therefore has zero immediate tax impact when structured as an in-substance defeasance. That disconnect is one reason in-substance defeasance dominates in practice.
Where Defeasance Gets Used
Corporate Bonds
Corporations turn to defeasance mainly to escape restrictive covenants in their bond indentures. Covenants can limit additional borrowing, acquisitions, or dividends. When a company wants strategic flexibility but the bonds are noncallable, or the call premium would be enormous, defeasance offers a way out. By depositing Treasuries into a trust that covers the remaining bond payments, the company satisfies the indenture and is released from the covenants. The bonds remain outstanding in a technical sense, but the restrictions fall away.
The economics depend on the rate environment. When market rates are high relative to the bond’s coupon, the portfolio needed to replicate the payment stream is cheaper, because higher-yielding securities produce more cash per dollar invested. That differential can make defeasance significantly less expensive than paying a call premium. When rates are low, the math often works against it.
Commercial Real Estate (CMBS Loans)
Defeasance is a fixture of the commercial real estate market, especially for loans securitized into Commercial Mortgage-Backed Securities. CMBS loans typically include lockout periods of five to ten years during which prepayment is simply not allowed. The restriction exists because CMBS bondholders bought a specific stream of future payments, and prepayment would disrupt it.
When a property owner needs to sell or refinance during the lockout, defeasance is often the only path. The borrower creates a Special Purpose Entity to serve as a successor borrower, purchases Treasury securities that match the remaining loan payments, deposits them into the SPE, and the SPE is substituted onto the loan. The original property is released from the mortgage lien and freed for sale or new financing. The CMBS trust continues receiving its scheduled payments as if nothing changed, because from its perspective, nothing did.
Defeasance vs. Yield Maintenance
Commercial mortgage borrowers typically face a choice between defeasance and yield maintenance as their exit route. Yield maintenance is simpler: the borrower pays a penalty calculated as the present value of the remaining loan payments, discounted by the difference between the loan’s interest rate and the current Treasury yield for a comparable term. It’s a one-time payment that compensates the lender for lost interest income.
Defeasance requires buying an entire securities portfolio and running a multi-party closing. So why would anyone choose it? Interest rates and loan terms. When rates are rising, defeasance can be cheaper because the replacement bonds are less expensive, while yield maintenance penalties tend to shrink as the gap between the loan rate and current rates narrows. In a falling-rate environment, yield maintenance penalties can balloon and sometimes exceed the cost of defeasance.
Many CMBS loans don’t offer a choice. The loan documents specify which method is available, and some permit only defeasance during the lockout, with yield maintenance available only in the final years before maturity. Check the loan documents early, because the available exit shapes the economics of any sale or refinancing.
Municipal Bonds
Municipalities use defeasance to retire outstanding bonds, most commonly through advance refunding. The city or county issues new bonds at a lower rate and uses the proceeds to buy government securities that are deposited in an escrow account. That escrow services the old, higher-rate bonds until they can be called or mature, effectively swapping expensive debt for cheaper debt.
The Tax Cuts and Jobs Act of 2017 changed this picture by eliminating the tax-exempt status of advance refunding bonds. Before that, municipalities could issue tax-exempt bonds to refund outstanding debt more than 90 days before the call date. Any advance refunding bonds issued after December 31, 2017, are taxable, which raises the borrowing cost and shrinks the savings that made advance refunding attractive.
Municipalities can still defease bonds using current refunding, where new bonds are issued within 90 days of the call date, and those refunding bonds keep their tax-exempt status. Some issuers have also used taxable advance refunding bonds when the interest rate savings are large enough to justify the higher cost. The elimination of tax-exempt advance refunding complicated the decision, but defeasance remains an active tool in public finance.