You or your business own a commercial building? Notice how the banks have changed, lately? According to a 2023 Wall Street Journal article, in the next three years nearly $1.5 trillion in commercial mortgages is coming due and many borrowers may not be able to refinance, as lenders are getting increasingly skittish about lending. Delinquencies are rising as a result, as loans mature and banks dry up. The first step, for an owner in that situation, is obvious: ask the bank for a loan modification. If that doesn’t work, what then?
The Modification Process
So why does the modification process often break down? Perhaps the most obvious reason is that the lender is out of the loan business, at least for the moment. In the first quarter of 2023 the CBRE Lending Momentum Index - which measures commercial real estate lending in the United States - dropped 54 percent from a year earlier, the Journal reported. As deposits fell, banks said they were stepping back until a new real estate price level was established. Banks out of the loan business have little interest in rewriting existing ones, because a modification basically means they are keeping their money invested in your property for longer.
Second, why did the default happen? It’s common practice when a borrower defaults to try to renegotiate an extension or settlement, and banks are sometimes willing to extend grace. They might in particular if the default was due to external market conditions and not the borrower’s own choices. If, on the other hand, the lender feels that the default was a result of the way the business or the property was operated, it will have less of an incentive to give the borrower time. Be honest about the cause of the problem when you go back to the bank, and convince the lender that the default was outside your control.
A modification isn’t the only option for a borrower who’s defaulted. When the lender won’t agree to an amendment, the borrower can still try other deals. For example, the lender might be willing to settle for a discounted payoff of the loan. Or the borrower (or a company affiliated with the borrower) can buy the loan itself from the lender, at a discount. And the borrower can give the property back to the lender, by deed in lieu of foreclosure. All of these have their own costs, but all of them are better than just letting things slide until the lender decides to foreclose and the property ends up being sold at a public auction to the lender or to someone else.
The worst thing that can happen to the borrower is foreclosure, and preventing that is the entire purpose of a workout. It can also come quicker than borrowers anticipate. In many states, California and Texas among them, the lender can foreclose through a trustee’s sale, which might be scheduled a short time after the borrower receives a notice of default. In California the period is three months and 21 days. In Texas, 41 days. In New Jersey and other states, a trustee’s sale isn’t an option. Instead the lender has to sue, obtain a foreclosure judgment and a writ of execution from the court, and then get the sheriff’s office to hold a sale. It’s slower, but it ends up in the same place.
So, either way, the property gets sold at a public auction to the highest bidder. For cash. With one important exception: the lender gets to do a credit bid - you know, where instead of paying cash, they just write off all or part of the mortgage balance. If the credit bid is the highest bid, the lender takes the property, and its loan gets paid off to the extent of the bid. The buyer at the sale usually takes the property clear of any liens junior to the lender that foreclosed on it, but subject to any liens senior to it. And the proceeds - if there’s any - get used first to pay the costs of the sale, second to the lender that foreclosed, third to junior lienholders in order of priority, and only then to the borrower.
So why do we care about the “credit bid”? Good question! If someone guaranteed the loan, the amount of the credit bid could matter a lot. If the lender has a full credit bid, then it has received complete satisfaction of the debt, and therefore it has no claim against the borrower for any deficiency judgment (in states where the right to a deficiency judgment has not been cut back). That’s why, when a solvent guarantor stands behind a mortgage loan, it will bid only the amount it needs to win the auction. The rest it will pursue against the guarantor. You, perhaps.
Tax Side Effect
There’s also a tax side effect. A foreclosure (and a deed in lieu of foreclosure, too) is considered a sale of the building for income tax purposes. If the amount realized in the sale exceeds your adjusted basis, you will have a taxable gain, even though you got no cash and lost the building. If the amount realized is less than your adjusted basis, you have a loss. Ask an accountant before you agree to hand over the keys and see whether you’re on the plus side or the minus side of that equation.
It helps too to keep in mind the lender’s perspective. When the property is sold at foreclosure for less than the loan balance and part of the debt remains unpaid, the lender can deduct the uncollectible part as a bad debt. If the lender gets the property by deed in lieu of foreclosure, the lender can deduct the difference between its basis in the loan, usually the loan balance, and the fair market value of the property. In other words, the lender has other ways to write off its loss, and a sensible offer of a discounted payoff or a deed in lieu of foreclosure may look more attractive than a fight.
But what’s the next step in 2026 if the modification fails? Don’t let the notice of default put you on the back foot. Know why you went into default and be prepared to explain why. Understand your options for compromise: not just a modification, but also a discounted payoff, a loan buy-out by you or an affiliate, or a deed in lieu. Find out if a personal guarantee puts your home and savings in danger, and whether tax consequences would be part of losing your property. And get help negotiating as soon as possible, because once the foreclosure sale date is on the calendar, the lender has all the leverage.
