Distressed Real Estate and Tax Alert
October 5, 2009
Authors:
Thomas J. Lyden
tom.lyden@klgates.com
+1.202.778.9449
David H. Jones
david.jones@klgates.com
+1.704.331.7481
Anthony J. Barwick
tony.barwick@klgates.com
+1.919.743.7340
K&L Gates is a global law firm with
lawyers in 33 offices located in North
America, Europe, Asia and the Middle
East, and represents numerous GLOBAL
500, FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies,
entrepreneurs, capital market
participants and public sector entities.
For more information, visit
www.klgates.com.
New REMIC Rules May Provide More Room to
Modify Commercial Real Estate Loans
Background
The Internal Revenue Service (the “IRS”) recently released two pieces of guidance
concerning the types of modifications that can be undertaken with respect to
commercial mortgage loans held by a REMIC without jeopardizing its status as a
REMIC or otherwise subjecting the REMIC to adverse tax consequences. The
guidance provides a measure of clarity on issues confronted by mortgagors, REMICs
that issue commercial mortgage-backed securities (“CMBS”), and investors that hold
CMBS.
First, the IRS released final regulations that now permit a REMIC to change the
collateral for, the guarantees on, and the credit enhancement for mortgage loan held
by a REMIC or to change the recourse or non-recourse nature of a mortgage loan
without jeopardizing REMIC status. The regulations also outline the circumstances
in which a REMIC is allowed to release a lien on real property securing a mortgage
obligation held by the REMIC without causing the mortgage obligation to cease to
be a permitted asset in the hands of the REMIC.
Second, in Revenue Procedure 2009-45, the IRS describes certain situations in which
it will not challenge the tax status of a REMIC due to the REMIC’s modification of a
commercial mortgage loan that is currently a performing mortgage loan but where, in
the view of the mortgage loan servicer, a significant risk of default exists, even if the
default is expected to occur only at some distant future date. Under existing rules, a
reasonably foreseeable risk of default must exist before a REMIC can modify a loan
without incurring adverse tax consequences.
Industry sources report that more than $150 billion of loans held by REMICs and
other CMBS issuers will come due between now and 2012. Year to date, reports
indicate that 528 such loans valued at $4.7 billion were not refinanced at their
maturities even though about 75% of these loans were secured by commercial real
estate generating sufficient cash to service the debt. Because financing remains
scarce and commercial property values continue to decline, evidence indicates that
“maturity defaults” for commercial properties with little or no amortization during
the loan term will continue to be a widespread problem, further constraining the
capital markets and depressing property values. The recently released guidance
provides servicers more flexibility to negotiate loan workouts that are in line with
workouts available to traditional bank borrowers and should to some extent remove
at least one tax impediment to a successful recovery in the commercial real estate
markets.
A. The Regulations
Under general tax principles applicable to all debt instruments, including mortgage
loans held by a REMIC, a significant modification of a mortgage loan is treated as a
Distressed Real Estate and Tax Alert
debt-for-debt exchange in which the debtor is
considered to have issued a new debt instrument to
the holder in exchange for the existing unmodified
debt instrument. Generally, if a mortgage loan is
acquired by a REMIC other than during a limited
three month start-up period or in certain other
limited circumstances, it will not be considered a
“qualified mortgage” in the REMIC’s hands and will
be considered to be a non-permitted asset. Put
another way, a significant modification of a
mortgage loan held by a REMIC is treated as an
exchange of the unmodified loan for the modified
loan (a debt-for-debt exchange), and if this
modification happens after the start-up period, this
debt-for-debt exchange would be treated as an
acquisition of a new mortgage loan, and therefore, a
non-permitted asset. A REMIC is subject to a tax at
a rate of 100% on any income from a non-permitted
asset and if more than a de minimis amount of a
REMIC’s assets are non-permitted assets, it will lose
its status as a REMIC. If such a result were to
occur, the REMIC could become taxable as a
corporation. Existing regulations provide that
certain loan modifications, although treated as
significant modifications under general tax
principles, will not cause the modified mortgage
loan to be treated as other than a qualified mortgage.
In particular, the existing regulations provide that
any modification of a qualified mortgage occasioned
by default or a reasonably foreseeable default will
not cause the modified mortgage loan to cease to be
a qualified mortgage. The recently released
regulations expand the list of permissible
modifications.
Specifically, a servicer on behalf of a REMIC may
undertake the following modifications without
causing the modified mortgage loan to lose its status
as a qualified mortgage:
•
•
A modification that releases, substitutes, adds,
or otherwise alters a substantial amount of the
collateral for, a guarantee on, or other form of
credit enhancement for a recourse or nonrecourse obligation; and
A change in the recourse nature of a mortgage
loan from recourse (or substantially all recourse)
to non-recourse (or substantially non-recourse)
or vice versa.
Contrary to recommendations made by several
commentators on earlier proposed regulations, the
final regulations contain a retesting requirement
under which a modification described in either of
the two bullet points listed above will be a permitted
modification only if, following the modification, the
modified loan continues to meet a “principally
secured” test.
The regulations also clarify that a release of a lien
on real property collateral securing a mortgage that
would not be a significant modification under
general tax principles (such as a substitution of
collateral under a unilateral right given to the
mortgagor under the terms of the mortgage loan)
will be permitted as long as the mortgage loan
continues to be principally secured by an interest in
real property after giving effect to any releases,
substitutions, additions or other alterations to the
collateral. Thus, any change to a mortgage loan that
involves a lien release, even if it is in connection
with a modification permitted under the “default or
reasonably foreseeable default” standard of the
existing regulations, will require a retesting
following the release.
Generally, a mortgage loan will be a qualified
mortgage only if it is principally secured by an
interest in real property at the time it is contributed
to the REMIC. Existing regulations provide that a
mortgage loan will be considered to be “principally
secured” if the REMIC sponsor (generally, the
person who forms the REMIC) reasonably believes
that the fair market value of the interest in real
property securing the mortgage equals at least 80percent of the mortgage’s adjusted issue price (the
“80% test”) either at the time the obligation is
originated or at the time it is contributed to the
REMIC (in other words, the mortgage loan can have
no greater than a 125% LTV). No post contribution
testing was required under existing regulations.
The recently released regulations, however, provide
that in the case of a modification of the type
described in the two bullet points above, or in
connection with any lien release (other than in a
defeasance transaction where treasury securities are
posted as collateral and other requirements are met),
the collateral value of the obligation will need to be
re-tested in order to satisfy the “principally secured”
requirement. Consequently, the fair market value of
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Distressed Real Estate and Tax Alert
the modified mortgage real property collateral must
at least equal 80% of the adjusted issue price of the
modified mortgage loan immediately after the
modification. This standard will be difficult to
satisfy if the value of the property has decreased
significantly from the date of origination to the date
of modification, which is precisely what one would
expect when dealing with a distressed mortgage
loan.
In response to comments received with respect to
earlier proposed regulations, and in view of how
difficult it would likely be to satisfy the 80% test,
the recently released regulations provide for an
alternative method for determining compliance with
the “principally secured” retesting requirement.
Under the alternative test, a modified loan will be
principally secured if the fair market value of the
interest in real property that secures the mortgage
loan immediately after the modification equals or
exceeds the fair market value of the interest in real
property that secured the mortgage loan immediately
before the modification.
The principally secured tests may be difficult to
satisfy even if the lien release is accompanied by a
contemporaneous partial prepayment if the overall
value of the real property securing the mortgage loan
has declined.
For example, assume a REMIC owns a mortgage
loan that it acquired at a time when its unpaid
principal balance and its adjusted issue price was
$80 and that this loan was secured by two parcels of
commercial real property, one having a value of $90
and one having a value of $5. Now assume that in
connection with a reasonably foreseeable default, the
REMIC agrees to modify the loan. Assume that
immediately before the modification, the adjusted
issue price of the loan was still $80 but that the fair
market value of the first parcel of property had
declined to $60 and the fair market value of the
second parcel had declined to $2. If the
modification consisted solely of a deferral of
payments or a reduction in interest rate, no retesting
would be required.
Assume, however, that in connection with the
modification, the REMIC releases its lien on the
second property for a prepayment of $2. In this
case, retesting is now required and the modified loan
would not satisfy either of the tests. The ratio of the
fair market value of the real property, now $60, to
the adjusted issue price of the loan, now $78 ($80
reduced by the $2 prepayment), would be less than
80%. Moreover, the alternative test would not be
satisfied because the fair market value of the real
property securing the loan immediately before the
modification would be $62 and immediately after
the modification it would only be $60. The IRS has
been made aware of the difficulty presented in
satisfying the tests in these circumstances but it
remains to be seen whether the IRS will take further
steps to make the rules more workable.
The final regulations improve upon the previously
issued proposed regulations in that they do not
require an appraisal for purposes of demonstrating
compliance with the principally secured
requirement under either of the above-described
tests. Under the final regulations, if a servicer
reasonably believes that a modified mortgage loan
satisfies the principally secured requirement under
either of the above-described tests, the modified
loan will be considered to satisfy the principally
secured requirement. A servicer can base such a
reasonable belief on: (i) a current appraisal by an
independent appraiser; (ii) an original appraisal
undertaken in connection with the origination of the
mortgage loan, updated as appropriate for any
changes that might affect the value of the real
property; or (iii) some other commercially
reasonable valuation method. In spite of this
increased flexibility, many servicers may be
reluctant to proceed without a new appraisal.
The recently released regulations are effective for
modifications and lien releases occurring after
September 15, 2009.
B. Rev. Proc. 2009-45
Revenue Procedure 2009-45 provides that the IRS
will not challenge the tax status of any REMIC or
any non-REMIC investment trust and will not treat
the modification of a commercial mortgage by a
REMIC as a prohibited transaction if:
•
The servicer reasonably believes that there is a
significant risk of default on the un-modified
mortgage loan upon the maturity of that
mortgage loan or at an earlier date; and
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Distressed Real Estate and Tax Alert
•
The servicer reasonably believes that the
modified loan presents a substantially reduced
risk of default, as compared to the un-modified
mortgage loan.
For purposes of the revenue procedure, a
commercial mortgage loan is any loan other than a
one-to-four family residential mortgage loan.
A servicer’s “reasonable belief” that a significant
risk of default exists must be based on a diligent
contemporaneous determination of that risk, which
may take into account credible written factual
representations made by the mortgagor if the
servicer has no reason to know that such
representation is false. The revenue procedure
specifies that a mortgage loan may be currently
performing in accordance with its terms and still
present a significant risk of default, and the fact that
such default may not occur until some time in the
distant future does not, in and of itself, negate a
reasonable belief that such default will be likely.
The revenue procedure provides that risk of default a
year of more in the future may support a reasonable
belief.
In short, in the case of commercial mortgage loans,
the revenue procedure puts a gloss on the standard
set out in the existing regulations that permit a
REMIC to modify a mortgage loan without adverse
tax consequences so long as default is reasonably
foreseeable with respect to the mortgage loan. In
effect, the revenue procedure provides that default
can be reasonably foreseeable even if a loan is
performing and even if the foreseeable default event
lies in the distant future.
By its terms, the revenue procedure applies only to
REMICs (and non-REMIC investment trusts) that
were formed to hold pools of performing
commercial mortgage loans. Specifically, for the
revenue procedure safe harbor to apply, no more
than 10% of the pool of loans (by unpaid principal
balance) could have been more than 30 days or more
delinquent at the inception of the REMIC or nonREMIC investment trust. It should be noted,
however, that the revenue procedure provides a safe
harbor, not a bright line test. Thus, for example, a
REMIC that did not satisfy the startup-day
delinquency test would not qualify for the safe
harbor, but it could undertake loan modifications of
the type described in the revenue procedure without
automatically violating standards set out in the
regulations for loan modifications.
Conclusion
The two pieces of guidance discussed above are of
some help in dealing with the refinancing crisis
facing the commercial real estate sector and should
provide servicers with useful tools to assist the
workout process in advance of an imminent default
scenario. These changes remove a significant
disincentive for the revision of commercial
mortgages otherwise performing but at significant
risk of default upon maturity. Making the servicer a
more active participant in the pre-default process
and accelerating discussions among all stakeholders
will undoubtedly result in tensions among these
parties. Servicers will be further required to quickly
decide ahead of a default what will be in the best
interest of the CMBS holders and which borrowers
are basically sound and which loans it makes more
sense to foreclose quickly.
While some of the adverse tax consequences for
doing so have been removed by the recent guidance,
it remains to be seen to what extent servicers will
otherwise be empowered to navigate the myriad
interests of the bondholders and other participants in
the REMIC structure in a pre-default scenario. In
many instances the pooling and servicing
agreements will limit the servicer’s options for
permissible loan modifications. Typically, absent a
default or foreclosed property scenario, any powers
of amendment vested in the servicer are limited to
those that are ministerial in nature and the servicer
does not have the ability to otherwise deal with the
loan obligations constituting the trust property of
the REMIC. As such, the servicer will not likely act
on its ability to enter into one of the expanded
permitted list of loan modifications without added
comfort from the holders of the interests in the
REMIC insuring the servicer that such modification
is permissible or will not otherwise violate the terms
of its pooling and servicing agreement with the
holders.
If you have questions with respect to any of the
foregoing, please contact the authors of this Alert.
October 5, 2009
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Distressed Real Estate and Tax Alert
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