IRS Relaxes REMIC Loan Modification Rules
On Tuesday, September 15, 2009, the Internal Revenue Service (IRS) and Department of Treasury issued two directives relaxing certain restrictions on Real Estate Mortgage Investment Conduits (REMIC) with respect to negotiating pre-default modifications to loans they hold. Revenue Procedure 2009-45 and amendment to § 860G under 26 C.F.R. part 1 went into effect the following day.
Generally, REMICs are vehicles used to securitize mortgages. A REMIC itself is not taxed, although the profits made by its investors are. In exchange for REMIC’s efficient structure and tax-free status, it is highly-regulated under the tax code. In particular, substantially all of a REMIC’s assets must consist of “qualifying mortgages” and “permitted investments.” Under the tax code, conducting a prohibited modification involving a loan held by a REMIC may result in a 100 percent tax liability to the REMIC. Until now, negotiating commercial loan modifications prior to a default was prohibited and would adversely impact a REMIC.
The new IRS directives were prompted by increasing defaults and past due payments in the commercial real estate sector. Moreover, commercial mortgage-backed securities currently embrace an estimated $150 billion in loans that will mature sometime between 2009 and 2012. Accordingly, the recent announcements were largely prompted by concerns of a pending rise in commercial loan defaults, at a time when credit and liquidity are scarce.
IRS Revenue Procedure 2009-45
The IRS now allows servicers to discuss the modification of a loan before the borrower faces imminent default. Under the previous interpretation of the regulation, a loan modification could only be discussed when the loan was “occasioned by default or a reasonably foreseeable default.” The intent of Revenue Procedure 2009-45 is to allow a modification of the loan to occur, allow the parties more time to restructure loans and avoid possible default without losing the advantaged treatment of the tax status. Specifically, Revenue Procedure 2009-45.07 recognizes that “the complexity of the mortgage loans themselves and the consequent complexity of modifications to them necessitate a substantial period prior to any expected payment or maturity default for the negotiation of any such modifications.”
How does a SERVICER Modify a COMMERCIAL loan and keep its tax status AS A REMIC?
Revenue Procedure 2009-45, in pertinent part, allows a REMIC to modify a mortgage loan if the following requirements are met:
- The holder or servicer “reasonably believes” that there is a “significant risk” of default, based on existing, investigated facts and circumstances. A relevant factor is “how far in the future the possible default may be.” There is “no maximum period, however, after which default is per se not foreseeable.” § 5.03
- The holder or servicer “reasonably believes” that the modification presents “a substantially reduced risk of default.” § 5.04
- The loan modification must have been “effected on or after January 1, 2008.” § 8
Thus, if the above and certain other requirements are met, the IRS should not challenge the REMIC’s tax classification, or assert that a loan modification was a “prohibited modification.”
26 CFR PART 1 UNDER § 860 OF THE INTERNAL REVENUE CODE
Additionally, as part of the recent changes, an amendment was made to 26 CFR part 1 under § 860 of the Internal Revenue Code, redefining the term “significant” and “principally secured.”
A significantly modified obligation “generally fails to be a qualified mortgage” for a REMIC. The new regulation excepts from the definition of “significant” the following: changes in collateral; guarantees; and credit enhancement of an obligation; changes to the recourse nature of an obligation; and certain lien releases. These changes are permitted so long as the obligation continues to be principally secured by an interest in real property.
Previously, a significantly modified obligation had to be principally secured by an interest in real property by satisfying the “80 percent” test. The test refers to the fair market value (FMV) of real property that secures the obligation, which must equal at least 80 percent of the obligation’s adjusted price. A decline in the collateral’s value, however, could cause a mortgage loan to fail to meet the “80 percent” test. The IRS added an alternative method for modified mortgage loans to be principally secured if the FMV of the interest in real property after the modification equals or exceeds the FMV of the interest in real property that secured the loan immediately before the modification.
It remains to be seen how extensively the new, more relaxed REMIC rules are relied upon by servicers to modify loans in the months and years to come.