The Internal Revenue Service (“IRS”) has issued new guidance that should help borrowers with distressed commercial real estate – previously hampered by tax rules – to restructure loans which have been packaged into commercial-mortgage-backed securities, generally held by a type of tax-efficient vehicle called Real Estate Mortgage Investment Conduits (“REMICs”). REMICs are state-law entities (corporation, partnership, trust etc.) whose assets consist of a pool of “qualified mortgages” which are loans principally secured by an interest in real property. Among the rules applicable to REMICs is that significant modifications of loans are prohibited except in limited circumstances. This constraint on the ability to modify the terms of mortgage loans held by REMICs has caused significant difficulties in the current recession.
The new guidance from the IRS should help alleviate these problems. First, the IRS issued Revenue Procedure 2009-45. Previously it has been the belief by most in the industry that loan modifications “occasioned by defaults or reasonably foreseeable defaults” (which are permitted by the REMIC rules) are limited only to “imminent defaults”. Under the Revenue Procedure, the IRS will not challenge the modification of a securitized loan (including actual exchanges) if, based on the facts and circumstances, there is a significant risk of default of the mortgage loan upon maturity OR at an earlier date (emphasis added)1. The Revenue Procedure specifically states that there is no limit for how far in the future a default would be per se not foreseeable. This thus also affects the ability to have a securitized loan transferred to special servicing. The Revenue Procedure is effective for loan modifications effected on or after January 1, 2008.
In addition, the IRS issued final regulations (the “New Regulations”) that expand the list of permitted loan modifications that will not constitute “prohibited transactions” for REMICs. Prior to the issuance of the New Regulations, existing law permitted modifications very limited situations (changes occasioned by defaults or reasonably foreseeable defaults, assumption of the mortgage loan, waiver of a due-on-sale or due-on-encumbrance clause, or adjustment of the rate on a convertible mortgage.)
The New Regulations expand currently permissible modifications by adding two new allowable modifications:
- A modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral for, a guarantee of, or other form of credit enhancement for the obligation so long as after the change, the loan is still principally secured by an interest in real property; and
- A change of an obligation from recourse (or substantially all recourse) to nonrecourse (or substantially nonrecourse), or vice versa, so long as after the change, the loan is still principally secured by an interest in real property.
The New Regulations also provide new flexibility in determining how the “principally secured by an interest in real property” test would be applied in the case of a loan modification, including requiring replacement or substitute collateral to only have equal or greater value than the current value (i.e., the value at the time of the modification) of any collateral it replaces, as well as for allowing for additional methods of making valuations.
The above changes apply for loan modifications made on or after September 16, 2009.
This new IRS guidance does not affect whether a modification of a loan is a taxable exchange. These rules remain unchanged.
The new IRS guidance allowing additions to and/or changes in collateral and guarantees and the IRS’s position on what are “foreseeable defaults” should allow commercial loans which are currently performing but are at risk of default on maturity due to lack of a refinancing market to be extended or otherwise modified since such modifications would not affect a REMIC’s tax status, a requirement that must be satisfied under all REMIC servicing agreements for any modification or other changes to a loan. The inability to perform these kinds of loan modifications or even to be able to talk to the special servicers who are authorized under the REMIC documents to make loan modifications led, in part, to General Growth Properties Inc.’s bankruptcy.
1This rule does not apply to a loan securing a residence that contains fewer than five dwelling units and that is the principal residence of the issuer of the loan and also does not apply to REMICs which hold, as of the three-month period after the startup date, more than 10% of its assets in the form of loans on which, at the time of acquisition by the REMIC, payments were overdue by at least 30 days or for which, at the time of acquisition by the REMIC, a default was reasonably foreseeable.
This G&S Advisory was authored by Kenneth Liu and Robert Towsner.
For questions regarding the information contained in this G&S Advisory, please contact your usual Goulston & Storrs attorney or:
Steven R. Schneider
Robert S. Towsner
Pursuant to IRS Circular 230, please be advised that, this communication is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of (i) avoiding penalties under U.S. federal tax law or (ii) promoting, marketing or recommending to another taxpayer any transaction or matter addressed herein.
This advisory should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and any specific legal questions you may have.
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