IRS Liberalizes Rules for Restructuring Mortgages Held by REMICs

INTRODUCTION

The Internal Revenue Service and the U.S. Department of Treasury recently published new guidance to provide more flexible and proactive options for restructuring securitized commercial loans held by Real Estate Mortgage Investment Conduits (REMICs). The new liberalized rules should create maneuverability for REMIC investors facing the expected wave of commercial mortgage defaults. The new rules provide safe harbor guidelines, which enable loan servicers to restructure potentially troubled mortgages before they enter default or foreclosure.

What is a REMIC?

Real Estate Mortgage Investment Conduits (REMICs) are investment vehicles that pool residential and commercial mortgage loans and issue mortgage-backed securities to investors. REMICs can be in the form of a trust, corporation, partnership, or other entity, so long as they qualify for and elect REMIC status.

REMICs enjoy favorable tax status, so that the REMIC entity does not pay federal income tax, though income earned by investors remains taxable. However, in order to maintain this beneficial tax status, the REMIC has to follow the rules regarding allowable investments and transactions—prohibited transactions are subject to a penalty tax of 100%.

What were the concerns prior to the new rules?

A projected $150 billion in commercial-mortgage-backed securities (CMBS) are coming due in the next few years. In this current economic climate, credit is tight and there is a concern that many borrowers will be unable to refinance their loans, virtually assuring their default.

Prior to the new IRS and Treasury guidance, a REMIC could have suffered a substantial tax penalty if one of the commercial mortgage loans it held was significantly modified before default occurred or became “reasonably foreseeable.” Indeed, under the previous rules, most holders and servicers did not even discuss or negotiate potential loan modifications until the loan was in default in order to avoid adverse tax consequences.

What do the new rules do?

The new guidance is specifically designed to enable more flexibility in allowing the modification and restructuring of troubled loans before they go into default. The new guidance is stated in two separate documents:

1) First, the IRS issued Revenue Procedure 2009-45, dated September 15, 2009, which allows the modification of loans that are held in a REMIC that are not actually in default, but which the loan servicer or holder “reasonably believes” are a significant default risk. Previously, it was interpreted that such loan modifications were limited only to imminent defaults, but now the modification is allowed based on “a diligent contemporaneous determination of that risk,” taking into account the representations of the borrower and other relevant information. Moreover, under the new guidance, there is no limit to how far in the future the default may be foreseeable – the reasonably foreseeable default could be a year or more away, but still be allowed under the new rules.

Revenue Procedure 2009-45 provides limited safe harbor for modifications of commercial mortgage loans without the threat of an IRS challenge to the REMIC’s tax qualification as a result of those modifications. Its principal contributions are to clarify that established commercial REMICs have the possibility to make loan modifications without losing preferred tax status if: a) the servicer or holder reasonably believes that there is a significant risk of default under the current, unmodified loan; and b) the servicer or holder reasonably believes that the loan modification substantially reduces the risk of default.

Moreover, the Revenue Procedure expressly contemplates that permitted modifications include interest rate changes, principal forgiveness, and extensions of loan maturity, as long as the servicer or holder satisfies the safe-harbor conditions.

2) Second, new Treasury regulations (TD 9463, effective September 15, 2009) expand the list of permitted loan modifications that will not be considered “prohibited transactions” and therefore will not jeopardize a REMIC’s tax qualification status. These changes are much more limited than those permitted under the Revenue Procedure. Specifically, the new regulations add two new allowable modifications:

a)  a modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral, so long as, after the modification, the loan is still principally secured by an interest in real property; and

b)  a modification of the recourse nature of the loan (from recourse to non-recourse and vice versa) so long as, after the modification, the loan is still principally secured by an interest in real property.

The new Treasury regulations also set forth two methods for determining how the “principally secured by an interest in real property” standard applies in the case of modification: i) The fair market value of the interest in real property securing the loan is at least 80% of the loan’s issue price on the date of modification; OR ii) the fair market value of the interest in real property securing the loan equals or exceeds the fair market value of the interest in real property that secured the loan prior to modification. By virtue of the second method, this requirement should not be an issue if the applicable modification does not affect the secured property, such as an extension of the maturity date or an interest rate reduction

Impact of the New Rules

The new guidance should allow for the modification of REMIC-held commercial loans that are currently performing, but that are at risk of default on their maturity date for any number of reasons, without adversely impacting a REMIC’s tax status. This was the government’s intent in promulgating the new rules – to provide increased flexibility that will help minimize the expected future wave of defaults and the negative economic impact that would result.

The new guidance speaks only to the REMIC tax classification consequences of loan modifications; it does not alter the REMIC’s obligations to abide by the terms of Pooling and Servicing Agreements or similar contracts. Moreover, by allowing modifications in advance of imminent or actual default, senior interest holders may have to wait longer before recovering on their investments; on the other hand, junior interest holders have a better chance of recovering on their investments than they would if a default occurs.

Any portfolio that includes REMIC holdings requires careful study by a team comprised of an experienced tax lawyer who is grounded in the REMIC rules and real estate taxation issues, a real estate lawyer seasoned in title and workout matters, and a transactional lawyer well-versed in parsing complex securitization documents.

The troubled waters of real estate finance challenge the ability of investors to protect and maximize their positions, but well-advised and strategic investors may be able to make good use of the tools described above.

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H. Jacob Lager

Michael J. Zerman

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