Many commercial mortgage loans are held in “securitization” vehicles, such as real estate mortgage investment conduits (REMICs) and investment trusts. In each case, the entity is not subject to tax with respect to its income; instead, its income is taxed to its beneficial owners. As a result, ensuring that an entity’s status as a REMIC or investment trust is preserved is of paramount concern.
For an entity to qualify as a REMIC, all the interests in the entity must consist of one or more classes of “regular interests,” and a single class of “residual interests.” In addition, these interests must be issued on the “start-up day.” An entity qualifies as a REMIC only if — as of the close of the third month beginning after the start-up day and at all times thereafter — substantially all of the entity’s assets consist of “qualified mortgages” and “permitted investments.” A mortgage is not a qualified mortgage unless it is transferred to the REMIC on the start-up day.
Under the tax code, specifically Regulation Section 1.1001-3(b), a “significant modification” of a debt instrument produces a deemed exchange of the original debt instrument for a new debt instrument. Accordingly, one or more significant modifications of loans held by a REMIC may terminate the qualification if the modifications cause less than substantially all of the assets of the REMIC to be qualified mortgages.
Certain modifications, however, are not deemed significant. In particular, if a change in terms is “occasioned by default or a reasonably foreseeable default,” the change is not a significant modification.
Further, Section 860F(a)(1) imposes a tax on REMICs equal to 100% of the net income derived from “prohibited transactions.” The disposition of a qualified mortgage is a prohibited transaction, unless the disposition is in accordance with the foreclosure, default, or imminent default of the mortgage.
In effect, the Internal Revenue Service has now taken steps to expand the notions of default, imminent default, and reasonably foreseeable default. The government’s purpose is to ensure that the impending modifications to commercial mortgage loans — that most analysts are predicting — do not cause REMICs and investment trusts linked to these transactions to forfeit their favorable tax status.
“If the modifications meet these requirements, the IRS will not challenge a vehicle’s qualification as a REMIC and will not contend that the modifications are prohibited transactions.” — Robert Willens
Therefore, Rev. Proc. 2009-45 applies to a modification of a mortgage loan held by a REMIC or an investment trust if:
· The premodification loan is not secured by a residence that contains fewer than five dwelling units and is the primary residence of the issuer of the loan;
· As of the end of the three-month period beginning on the start-up day, no more than 10% of the stated principal amount of the total assets of the REMIC were represented by loans meeting this description: at the time of the contribution to the REMIC, the payments on the loans were then overdue by at least 30 days or a default was reasonably foreseeable;
· The holder or servicer “reasonably believes” there is a “significant risk” of default;1
· The holder or servicer reasonably believes that the modified loan presents a significantly reduced risk of default.
If the modifications meet these requirements, the IRS will not challenge a vehicle’s qualification as a REMIC and will not contend that the modifications are prohibited transactions. Moreover, in these cases the IRS will not challenge a vehicle’s classification as a trust (on the grounds that the modifications manifest a “power to vary investments”).
The Revenue Procedure applies to loan modifications effected on or after January 1, 2008. Thus, the IRS is taking preemptive steps to head off any collateral damage, such as loss of favorable tax status, that might accompany what might well be a significant incidence of loan modifications in the commercial mortgage space.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1There is no maximum period after which default is per se not foreseeable. In appropriate circumstances, a holder or servicer may reasonably believe that there is a significant risk of default even though the foreseen default is more than one year in the future.