On September 15, 2009, the Internal Revenue Service (“IRS”) issued final regulations (“Final Regulations”) clarifying the federal income tax consequences of modifications to the terms of securitized commercial mortgage loans held in a “real estate mortgage investment conduit” (“REMIC”). The Final Regulations generally permit more flexible modifications with respect to loans held by a REMIC.
The IRS also issued Revenue Procedure 2009-45 (the “Revenue Procedure”) which permits REMICs and fixed investment trusts to modify commercial mortgage loans prior to a default without jeopardizing the securitization vehicle’s tax status.
I. Final Regulations
The Final Regulations provide that modifications to a commercial mortgage loan that (i) release, substitute, add or otherwise alter “a substantial amount of the collateral” or a guarantee or other credit enhancement for the loan or (ii) change the nature of the obligation from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), or vice-versa, are not “significant modifications” for REMIC purposes so long as the loan remains principally secured by an interest in real property.
The Final Regulations also provide that a release of a lien on real property will not cause the mortgage to lose its status as a “qualified mortgage” for REMIC purposes if (i) the lien release is not a significant modification under the REMIC rules and (ii) the mortgage continues to be principally secured by real property after the lien release.
II. Principally Secured Tests
The Final Regulations specify alternative tests for determining whether an obligation remains “principally secured by an interest in real property.”
An obligation will continue to be principally secured by an interest in real property following a modification if the fair market value of the real property interest securing the obligation (determined as of the date of the modification) is at least 80 percent of the adjusted issue price of the modified loan. If a servicer reasonably believes that the obligation satisfies this test, then the obligation is deemed to meet this test.
B. Alternative Test
An obligation will also continue to be principally secured by an interest in real property following a modification if the fair market value of the real property interest securing the obligation (immediately after the modification) equals or exceeds the fair market value of the interest in real property that secured the obligation immediately before the modification. This test can be satisfied by a current appraisal, an original and updated appraisal, or some other commercially reasonable method, and the servicer must not actually know or have reason to know that this test is not satisfied. A servicer can also rely on a sales price stated in a sales contract for the real property in connection with an assumption of the debt secured by the real property.
III. Challenges and Opportunities of Final Regulations
As the Final Regulations add the principally secured requirement to real property lien releases, borrowers will now have to meet this requirement as well as the release requirements in the loan documents. However, the second principally secured test outlined above could facilitate modification of distressed, “underwater” loans where collateral is not released in connection with the modification. The Final Regulations are effective as of September 16, 2009.
IV. Revenue Procedure
The Revenue Procedure permits servicers to modify commercial mortgage loans if the servicer reasonably believes there is a significant risk of default on the loan and, by agreeing the modification, the risk of default is substantially reduced. Such reasonable belief can be formed via credible factual representations of the borrower, and the length of time in which the default may occur. There is no maximum period after which default is no longer considered foreseeable.
V. Challenges and Opportunities of Revenue Procedure
Servicers could find that a loan posed a significant risk of default even though such default may not occur until a year or more in the future. Also, in appropriate circumstances, a performing loan could pose a significant risk of default in the future. It is likely that servicers will need to consider a borrower’s request for a modification under the Revenue Procedure with its duties to comply with the contractual provisions of a REMIC’s governing documents. The Revenue Procedure is effective for modifications effected after January 1, 2008.
The Final Regulations and the Revenue Procedure are intended to grant flexibility to pre-default loan modifications. However, as more modifications are considered, servicers and borrowers will need to balance this increased flexibility with their existing contractual obligations under the loan documents.