Defeasance is a financing technique that removes a loan or bond from the borrower’s balance sheet by substituting a portfolio of risk-free securities that generates enough cash to cover every remaining payment on the debt. The borrower doesn’t hand money to the lender to pay the loan off. Instead, an irrevocable trust or escrow holding U.S. Treasury securities takes over, feeding scheduled principal and interest to the lender through maturity. The tool shows up most often in corporate bond indentures, commercial mortgage-backed securities loans, and municipal bond issues, where prepayment is either forbidden outright or made prohibitively expensive by call premiums and lockout periods.
Legal Defeasance and In-Substance Defeasance
The first thing to know is that defeasance comes in two flavors, and the difference drives both the accounting and the tax result.
In a legal defeasance, the loan agreement itself permits the borrower to be fully and permanently released from liability once the collateral is deposited. The borrower walks away clean. Even if the trust somehow fell short, the lender could not come back for more.
In-substance defeasance is the version borrowers actually use. The borrower deposits securities into an irrevocable trust and the debt is treated as extinguished for accounting purposes, but the borrower technically remains liable on the note. If the trust’s assets somehow failed to cover a payment, the borrower would still owe. In practice, because the collateral is U.S. government securities matched precisely to the debt’s payment schedule, the chance of shortfall is essentially zero. The accounting rules allow the debt to come off the balance sheet when the likelihood of the borrower needing to make additional payments is remote.
How a Defeasance Actually Works
The engine of every defeasance is cash-flow matching. The borrower needs a portfolio of securities that produces exactly the right amount of money on exactly the right dates to cover every remaining payment on the debt, including any final balloon at maturity. If the loan calls for $50,000 on the fifteenth of each month for six more years plus a $2 million balloon, the securities portfolio has to deliver precisely those amounts on those dates.
A defeasance consultant typically runs the analysis, mapping every future debt payment against available Treasury securities to find the cheapest combination that produces a perfect match. The collateral must be noncallable and nonprepayable so the cash flow stays predictable. Once the portfolio is identified, the borrower buys the securities through a broker and transfers them irrevocably into a trust or escrow. An independent escrow agent takes custody and disburses payments to the lender on schedule. From that point forward, the borrower’s involvement is finished. The trust operates as a self-contained payment machine, winding down as each security matures and each loan payment goes out.
Who’s Involved
A defeasance closing pulls in several professionals. The defeasance consultant structures the securities portfolio and runs the process. A certified public accountant verifies that the collateral generates sufficient cash on the correct dates to satisfy the debt. An escrow agent holds the securities and executes payments. In commercial real estate deals, a successor borrower entity is created to assume the loan obligation, and the loan servicer has to approve the arrangement. Each party brings its own legal counsel.
How Long It Takes
Defeasance is not quick. For Fannie Mae multifamily loans, the closing date 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, though some servicers take longer. Preparation before filing the formal notice can add months, especially on large or complex loans.
What Counts as Acceptable Collateral
The loan agreement dictates which securities qualify. U.S. Treasury securities are the default across nearly all transactions because they carry essentially no credit risk. Within that category, borrowers and their consultants typically work with three instruments:
- 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 makes it ideal for hitting specific payment dates.
- Standard Treasury notes and bonds, which pay semiannual interest and return principal at maturity. Useful for matching the coupon portion of debt payments.
- State and Local Government Series securities, or SLGS, special-purpose Treasury securities available only to state and local governments. Commonly used in municipal bond defeasance and customizable with specific maturity dates and interest rates.
Some loan agreements also permit agency securities from government-sponsored enterprises like Fannie Mae or Freddie Mac as alternatives to direct Treasury obligations.1Fannie Mae Multifamily Guide. Defeasance Across all agreements, the securities must be noncallable so early redemption cannot disrupt the cash flow.
What It Costs
The largest cost is the securities portfolio itself. Because Treasury yields rarely match the loan’s coupon rate exactly, the portfolio almost always costs either more or less than the outstanding loan balance. When current rates are lower than the loan’s rate, the borrower pays a premium: it takes more expensive, lower-yielding bonds to generate the same cash. When rates are higher, the portfolio costs less.
On top of the securities, third-party transaction fees typically run $50,000 to $70,000 in total. The servicer processing fee ranges from $5,000 to $40,000. Combined legal fees for servicer counsel and successor borrower counsel run $15,000 to $35,000. Accountant verification is around $3,500. Rating agency review runs anywhere from $0 to $25,000 or more, depending on whether the CMBS trust requires it. The successor borrower fee is $1,000 to $3,500, the securities intermediary fee $2,000 to $14,000, and the defeasance consultant fee roughly $7,500.
For a borrower weighing defeasance against other exit strategies, the number that matters is the all-in cost, including the portfolio premium or discount, not just the transaction fees.
Accounting Treatment
Under U.S. GAAP, an in-substance defeasance qualifies as a debt extinguishment when the borrower irrevocably places assets in a trust dedicated solely to servicing the debt and the probability of the borrower needing to make additional payments is remote. When those conditions are met, the debt comes off the balance sheet.
The income statement then picks up a gain or loss on extinguishment, equal to the difference between the debt’s net carrying amount and the cost of the securities deposited in the trust. Net carrying amount is the face value of the debt adjusted for any unamortized premium, discount, or issuance costs.2Deloitte Accounting Research Tool. 9.3 Extinguishment Accounting
If the portfolio costs less than the net carrying amount, the company records a gain. This happens when market rates have risen above the loan’s original coupon, making the replacement securities cheaper. If the portfolio costs more, the company records a loss. Either way, the gain or loss is recognized in income during the period of extinguishment and classified as a separate item, typically within nonoperating income.2Deloitte Accounting Research Tool. 9.3 Extinguishment Accounting The company must also disclose the nature of the arrangement and the amount of debt that remains legally outstanding even though it has been removed from 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, constitutes a significant modification of the debt instrument under Treasury regulations. A significant modification is treated as an exchange of the old debt for a new instrument, 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 realize 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 treated as a significant modification because the borrower remains obligated on all payments. The IRS views this as a change only in the collateral securing the debt, not a change in the debt itself.3eCFR. 26 CFR 1.1001-3 – Modifications of Debt Instruments No exchange occurs, so no gain or loss is recognized. That produces a strange result: the same transaction that removes debt from the balance sheet under GAAP has zero immediate tax impact when structured as an in-substance defeasance. This disconnect between book and tax treatment is one reason in-substance defeasance is more popular than the legal version.
Where Defeasance Actually Gets Used
Corporate Bonds
Corporations turn to defeasance mostly to escape restrictive covenants embedded in bond indentures. Those covenants can limit taking on additional debt, pursuing acquisitions, or paying dividends. When a company wants strategic flexibility but the bonds are noncallable, or the call premium would be enormous, defeasance offers an alternative. By depositing Treasury securities 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 company regains freedom to restructure, borrow, or pursue transactions that were previously blocked.
The economics depend heavily on rates. When market rates are high relative to the bond’s coupon, the Treasury portfolio needed to replicate the payment stream is cheaper, because higher-yielding securities produce more cash per dollar invested. That rate differential can make defeasance materially less expensive than paying a call premium. When rates are low, the math often works against it and companies tend to wait.
Commercial Real Estate and CMBS Loans
Defeasance is a fixture of the commercial real estate market, especially for loans that have been securitized into CMBS. CMBS loans typically include lockout periods of five to ten years during which the borrower cannot prepay at all, 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 that lockout, defeasance is often the only available path. A special purpose entity is created to serve as a successor borrower. The original borrower buys Treasury securities matching the remaining CMBS 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 keeps receiving its scheduled payments as if nothing changed, because from its perspective, nothing did.
Most of the complexity and cost live here. The servicer, rating agencies, and multiple attorneys all have to sign off, the CPA has to verify the cash-flow match, and the successor borrower entity has to be structured properly. A single missed date in the securities portfolio can derail the whole transaction.
Municipal Bonds
Municipalities use defeasance to retire outstanding bonds, most commonly through advance refunding. In a typical advance refunding, a city or county issues new bonds at a lower rate and uses the proceeds to buy government securities that go into an escrow account. That escrow services the old, higher-rate bonds until they can be called or mature, effectively replacing expensive debt with cheaper debt.
The Tax Cuts and Jobs Act of 2017 changed this landscape by eliminating the tax-exempt status of advance refunding bonds. Before that change, 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 borrowing costs and cuts the savings that made advance refunding attractive.
Municipalities can still defease bonds through current refunding, where the new bonds are issued within 90 days of the call date. Those refunding bonds retain their tax-exempt status. Some issuers have explored taxable advance refunding bonds when the interest rate savings are large enough to justify the higher cost. The tool remains active in public finance; the calculation is just harder than it used to be.
Defeasance vs. Yield Maintenance
Commercial mortgage borrowers often face a choice between defeasance and yield maintenance as their prepayment exit. 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 rate and the current Treasury yield for a comparable term. It is a one-time payment compensating the lender for lost interest, and once accepted the process is done.
Defeasance requires a full securities portfolio and a multi-party closing that can take months and cost $50,000 to $70,000 in fees alone. So why choose it? The answer is rates and loan terms. When rates are rising, defeasance can be cheaper because the replacement bonds are less expensive. Yield maintenance penalties tend to shrink in that environment, since the gap between the loan rate and current rates narrows. In a falling-rate environment, yield maintenance penalties can balloon, sometimes past the cost of defeasance.
Many CMBS loans don’t offer a choice. The loan documents specify which method is available, and some loans permit only defeasance during the lockout period, with yield maintenance available only in the final years before maturity. Check the loan documents early, because the available exit strategy shapes the economics of any sale or refinancing.