Handing Back the Keys

Why you should read this. The 10-year Treasury closed the third quarter at 5.29%, its highest since May 2002, after its biggest quarterly rise since 1994. Buyers are retrading signed deals, the CRE Finance Council’s sentiment index fell 17.5% to a three-year low, and Wells Fargo’s finance chief told analysts that when “rates go up, valuations got to go down.” Some $875 billion of commercial and multifamily mortgages mature this year, and lenders want fresh equity before they extend.

So owners face three exits: modify the loan, hand back the keys, or bring in rescue capital. We price each one, partner by partner, on a single hypothetical office building, from the owner’s seat. The question is simple: who in your cap table carries negative capital, and which exit settles it at the lowest rate? (The building may go. The negative capital stays.)

Our thesis. Scholes and his co-authors put it best: “the taxing authority is an uninvited party to all contracts.” In a loan workout it never signs, yet it collects on every version of the deal. The tax bill on a failed building is mostly a bill for deductions already taken. The exit decides only when it is paid, at what rate, and by whom.

One building, three exits

Harbor Office Partners LLC bought an office building in 2012 for $120 million, took $38 million of depreciation, and did a cash-out refinancing in 2021. Today it owes $98 million on a nonrecourse loan against a building appraised at $70 million. Oakridge Family Holdings, the 90% investor, carries $14.4 million of negative tax capital. Here is what each exit costs Oakridge.

The figures are hypothetical and rounded; the full alert walks every number, Harbor’s seat included.

Executive summary

• A pure extension rarely triggers tax. A significant modification is a deemed exchange, but a privately held loan of $100 million or less, paying at least the applicable federal rate, keeps an issue price of par. No cancellation-of-debt income.
• Big, quoted loans are different. Above $100 million, a dealer quote can make the loan “publicly traded.” A $130 million loan quoted at 70 throws off $39 million of COD on an extension that counts as a significant modification.
• A new guarantee can tax the LPs. A sponsor guarantee on a nonrecourse loan shifts liability shares away from the investors; on our facts it puts $7.2 million of ordinary income on Oakridge.
• Handing back the keys is a sale. Under Tufts, a deed in lieu of nonrecourse debt realizes the full loan balance. Oakridge recognizes $14.4 million of gain and owes about $4.15 million, with no cash.
• Recourse debt changes the character. The same handback on a recourse note produces COD income and a loss; the COD can sometimes be excluded at the partner level, the gain on a nonrecourse handback cannot.
• Rescue capital can trigger a chargeback. When a new investor’s money pays down nonrecourse debt, the regulation’s exception protects only the partner who contributed. Legacy investors can be charged ordinary income on money they never put in.
• In distress, the revaluation is a book-up. A revaluation cannot book the property below the nonrecourse debt. Revaluing to $98 million before the paydown should eliminate the chargeback and keep the $16 million deferred. The amended operating agreement decides it.

What we would require

• A partner-level schedule of tax capital, outside basis, liability shares, and minimum gain, run on all three exits before anyone signs a term sheet.
• A recourse map for every loan, built from the documents and state law rather than the partnership’s liability-sharing rules.
• An issue-price memo on every modification, and a cumulative log of every amendment since origination.
• A revaluation resolution, and a rescue-capital term that says who funds the paydown and who bears the tax if legacy partners do not.
• An investor notice that flags any COD and the election deadlines before the K-1 goes out.

Our take

The market is asking whether lenders will keep extending. For the owners of a decade-old leveraged building, that is the second question. The first is who holds the negative capital. That number does not change with the exit; the year, the rate, and the partner who pays do.

The deed in lieu is the most honest exit: the gain is real, it is taxed at a capital rate, and the partners see it coming. The modification is the cheapest in tax and the most expensive in cash. The rescue recap is the one we would slow down. It is sold as painless, and it can be, but only if someone remembers to revalue. A chargeback nobody priced is still a chargeback.

So the useful question for an owner this quarter is “which of our partners can afford which exit, after tax, and have we written that into the deal before the lender writes it for us?”

Important notes

Statutory references in the alert are to the Internal Revenue Code of 1986, as amended, and to Treasury regulations, each as in effect on October 15, 2026. The alert addresses U.S. federal income tax only. Harbor Office Partners LLC, Oakridge Family Holdings, Harbor Partners, and Westbrook Capital Solutions Fund III are hypothetical, and figures are rounded. Market figures are as reported by the sources named in the alert, which do not always agree.

This client alert is for general information only. It is not tax, legal, investment, or accounting advice. Consult your own advisers about your particular circumstances before acting on any matter discussed here. Questions: Carlos Schmidt, CPA, carlos@lapresallc.com, (917) 558-6393.

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Download the alert (PDF, 12 pages, 333 KB)

This alert is for general information only and is not tax, legal, investment, or accounting advice. Consult your own advisers before acting. Carlos A. Schmidt, MBT, MBA, CPA · carlos@lapresallc.com · (917) 558-6393.