The IRS has issued final regulations (T.D. 9463) expanding the list of permitted loan modifications to include certain modifications of commercial mortgages held by real estate mortgage investment conduits (REMICs). The final regulations are effective September 16, 2009, and adopt the 2007 proposed regulations (REG- 127770-07) with modifications. The IRS is requesting comments on further amendments needed to the regulations in Notice 2009-79. The Service also released Rev. Proc. 2009-45, announcing that it would not challenge the tax status of REMICs or investment trusts that modified mortgage loans under certain conditions.
The REMIC provisions under Secs. 860A–860G create a passthrough vehicle that issues multiple classes of interests in pools of residential or commercial mortgage loans. All income from the mortgage loans in the REMIC is taxed to the holders of regular and residual interests in the REMIC. Among the requirements for qualification is that mortgage loans held by the REMIC must consist of qualified mortgages that are principally secured by an interest in real property. All loans must be acquired on the REMIC’s startup day or within three months thereafter, except that a REMIC may exchange a defective loan for a qualified replacement mortgage for up to two years.
If an obligation is significantly modified, the modified obligation is treated as one that was newly issued in exchange for the unmodified obligation that it replaced (Regs. Sec. 1.860G-2(b)(1)). If a significant modification occurs after the obligation has been contributed to the REMIC and the modified obligation is not a qualified replacement mortgage, the modified obligation will not be a qualified mortgage, and the deemed disposition of the unmodified obligation will be a prohibited transaction under Sec. 860F(2). A prohibited transaction is subject to a 100% tax on the net income from the transaction under Sec. 860(a)(1).
A significant modification is any change in the obligation’s terms that would be treated as an exchange of obligations under the rules for determining gain or loss in Sec. 1001 and the regulations (Regs. Sec. 1.860G-2(b)(2)). Regs. Sec. 1.1001-3 defines what modification is and provides that a modification that is significant will be treated as a deemed exchange of the original loan for a new loan. Regs. Sec. 1.860G-2(b)(3) sets forth four types of loan modifications expressly permitted without regard to Regs. Sec. 1.1001-3:
- Changes in the obligation’s terms occasioned by default or a reasonably foreseeable default;
- Assumption of the obligation;
- Waiver of a due-on-sale clause or a due-on-encumbrance clause; and
- Conversion of an interest rate by a mortgagor under the terms of a convertible mortgage.
In Notice 2007-17, the IRS solicited input on whether it should amend the REMIC regulations to expand the list of permitted commercial loan modifications to reflect the evolution of market practices in the mortgage-backed securities industry.
Regs. Sec. 301.7701-4 allows a trust to be classified as an investment trust if it does not have power under the trust agreement to vary the certificate holders’ investment.
Commercial Mortgage Loans
It is common practice with commercial mortgage payments for all or a large portion of the principal to be due at maturity. It is typically expected that the borrower will satisfy the payment by obtaining a new loan on the same real property. The current credit markets have made obtaining financing or refinancing more difficult. As a result, many borrowers face an increased risk of defaulting on their loans at maturity.
Loan servicers have developed procedures to monitor the status of commercial properties that secure loans and the likelihood that borrowers will be able to refinance. These procedures increase the ability to foresee potential difficulties or defaults well in advance of actual occurrence. Many industry participants believe these procedures and experience using them make it possible to predict when and how a loan may be modified to avoid default. Possible modifications include interest rate changes, principal forgiveness, extensions of maturity, and other timing changes. The complexity of modifications often necessitates a substantial period of time to complete them.
The Final Regs.
The final regulations expand the list of exceptions permitted in Regs. Sec. 1.860G-2(b)(3) to include changes in collateral, guarantees, credit enhancement of an obligation, and changes to the recourse nature of an obligation. The obligation must continue to be principally secured by an interest in real property for the changes to be permitted. In response to comments on the proposed regulations, the IRS made several clarifications in the final regulations.
Lien Release Rule
The proposed regulations declared that a lien release resulting from collateral changes would not disqualify a mortgage. Commentators suggested that the proposed regulations could be interpreted to prohibit other types of lien releases, including those caused by default, excepted under Regs. Sec. 1.860G-2(b)(3)(i) from being significant modifications.
The final regulations clarify that a lien release on real property does not result in a significant modification under Regs. Sec. 1.1001-3 that disqualifies a mortgage as long as the mortgage continues to be principally secured by an interest in real property after the modification.
Requirement to Retest the Collateral Value
To be principally secured by real property, the property’s fair market value (FMV) at the origination of the obligation or at the time it is contributed to a REMIC must be at least 80% of the obligation’s adjusted issue price order for the obligation (Regs. Sec. 1.860G-2(a)(1)). The proposed regulations would require the 80% test to be satisfied when a mortgage is modified by changes in collateral, guarantees, credit enhancements, or recourse changes.
Commentators suggested requiring retesting only when a modification could decrease the value of the real property relative to the mortgage amount. The IRS rejected that request but altered the test to be more flexible (see below) and created an alternative test as a concession. The alternative test allows a mortgage loan to remain principally secured by real property if the real property’s FMV immediately after the modification equals or exceeds the FMV of the real property immediately before the modification. The final regulations also require retesting for any lien release, even if it is not a significant modification.
Modified Appraisal Test
The proposed regulations would have required an appraisal by an independent appraiser to satisfy the 80% test. Commentators requested more flexibility in meeting the standard. The final regulations permit a mortgage to satisfy the 80% test at the time of modification if the servicer reasonably believes it does. The servicer must base this belief on any commercially reasonable valuation method. A nonexclusive list of acceptable methods is included in the final regulations.
Change from Nonrecourse to Recourse
The final regulations clarify that an obligation may change from nonrecourse to recourse as long as the mortgage continues to be principally secured by an interest in real property.
Rev. Proc. 2009-45
The IRS announced in Rev. Proc. 2009-45 that it would not challenge the tax status of REMICs or investment trusts that hold mortgage loans that are modified under certain conditions. The IRS cautions that taxpayers should not draw conclusions about the consequences of situations or transactions that are not covered in this guidance. Specifically, the IRS has stated that if the conditions listed below are met, it will:
- Not challenge the status of a REMIC for loan modifications that are not among the exceptions listed in Regs. Sec. 1.860G-2(b)(3);
- Not contend that the modifications are prohibited transactions under Sec. 860F(a)(2) that result in the disposition of qualified mortgages because they are not listed as exceptions in Secs. 860F(a) (2)(A)(i)–(iv);
- Not challenge the classification as a trust under Regs. Sec. 301.7701-4(c) because the modifications give the power to vary the certificate holders’ investment; and
- Not challenge the status of a REMIC because the modifications result in a deemed reissuance of REMIC regular interests.
The following conditions must be satisfied for a loan modification to receive the treatment above:
- The loan must not be secured by the principal residence of the loan issuer or by a residence with fewer than five dwelling units.
- If a premodification loan is held by a REMIC, as of the end of the threemonth period beginning on the startup day, no more than 10% of the REMIC’s total assets may be loans that were overdue by 30 days or have default reasonably foreseeable at the time of contribution.
- If a premodification loan is held by an investment trust, no more than 10% of the stated principal of all debt instruments held by the trust may be overdue by 30 days or have default reasonably foreseeable at the time of contribution.
- The holder or servicer must have a reasonable belief based on diligent contemporaneous determinations that there is a significant risk that the premodification loan will default at or before maturity. This belief may be based on factual representations by the issuer that the holder or servicer has no reason to belief are false. One relevant factor is how far in the future default may be. However, there is no limit on how far in the future default may be foreseeable.
- The holder or servicer must reasonably believe that the modified loan has a substantially reduced risk of default compared with the premodification loan based on all facts and circumstances.
In Notice 2009-79, the IRS reflected on comments received about Notice 2007-17 and the then-proposed regulations to amend the REMIC regulations. The IRS remarked that several commentators recommended expanding the scope of the regulations to permit investment trusts to modify commercial mortgage loans to the same extent that REMICs may under amended Regs. Sec. 1.860G- 2(b)(3). However, those commentators did not give detailed reasons why this expansion was necessary.
The final regulations were not expanded to include mortgage modifications held by investment trusts. The IRS requested comments on whether such an expansion is necessary and why (comments were due by November 14, 2009). The IRS specifically asked:
- Is it common practice to hold mortgage loans in investment trusts? If so, how are the trusts structured? What is the business purpose and utility of a REMIC holding commercial mortgages through an investment trust?
- Are there any fact patterns with modifications permitted under Regs. Sec. 1.860G-2(b)(3)(i) carried out through investment trusts that are consistent with case law and prior administrative pronouncements that are not covered by the amendment to Regs. Sec. 1.860G-2(b)(3)?
- Are there alternative structures consistent with case law and prior administrative pronouncements that would allow investment trusts to hold modified mortgage loans? Do the REMIC rules need to be changed to facilitate these alternative structures?
Servicers of commercial mortgages have been under pressure to grant relief to debtors that are in danger of defaulting. But REMIC trustees and servicers of mortgages in REMICs have been reluctant to modify loans at all, at least not without the advice of counsel, because of concern that any such modifications will cause a deemed exchange that will be a prohibited transaction under Sec. 860F(a)(2).
Specifically, the concern is that modifications could be significant modifications that result in the deemed issuance of a modified mortgage that is not a qualified replacement mortgage. The final regulations expand the list of exceptions for modifications that will never be treated as significant modifications for these purposes, which should make trustees and servicers more inclined to restructuring overtures by strapped borrowers.
In addition, Rev. Proc. 2009-45 seeks to address the concern that REMICs and investment trusts could lose their status and possibly face penalties if they hold a large number of qualified mortgages that are significantly modified. By effectively creating a safe harbor for modifications to some commercial mortgages—specifically those with a high risk of default— the revenue procedure should also facilitate restructuring of these mortgages. However, some types of restructuring and other modifications of commercial loans remain outside the safe harbors created in the regulations and the revenue procedure.
David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
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