New IRS Revenue Procedure Should Provide Greater Flexibility in REMIC Loan Workouts
On September 15, 2009, the IRS issued Rev. Proc. 2009-45, which should provide borrowers and loan servicers with greater flexibility to modify the terms of mortgage loans held by a “REMIC.” By way of background, any modification of a loan held by a REMIC, if such modification is considered a “significant modification” under applicable federal income tax rules, could trigger substantial, adverse tax consequences to the REMIC, including a 100% penalty tax on a prohibited transaction (the impermissible disposition by the REMIC of a qualified mortgage) and the potential loss of pass-through REMIC status (which, among other things, would mean the imposition of a corporate level tax on the income of the REMIC). However, the modification of a mortgage loan will not be treated as a “significant modification” for REMIC purposes if the loan modification is “occasioned by default or a reasonably foreseeable default.”
Under present market conditions, many commercial property loans are currently performing, but the borrowers may be unable to repay the outstanding principal balance of the loans at maturity without obtaining new financing, which may be unavailable in the necessary amounts. Although the borrowers might view a potential default on maturity of the loan (which might be many months away) as reasonably foreseeable, the potentially draconian tax consequences to the REMIC resulting from a loan modification that was later determined not to be occasioned by “a reasonably foreseeable default” has caused most servicers of REMIC loans to refuse to even discuss a loan modification in the absence of an actual default. Recently, some high profile property owners have deliberately stopped making loan payments to cause a default and thereby bring servicers to the table for modification negotiations.
In Rev. Proc. 2009-45, the IRS has attempted to provide guidance on when default on the maturity of a loan is “reasonably foreseeable.” In particular, Rev. Proc. 2009-45 provides that modifications to certain commercial loans held by a REMIC will be treated as occasioned by “a reasonably foreseeable default” (and thereby not treated as a “significant modification” for REMIC purposes), if the servicer or lender reasonably believes there is a “significant risk of default” upon maturity of the loan or at an earlier date even though (a) the anticipated default is more than one year in the future, and (b) the subject loan is currently performing. This new guidance on the meaning of “reasonably foreseeable default” should remove a major tax impediment to loan modifications for a significant class of REMIC loans, although it remains to be seen whether servicers will, in practice, actually take advantage of this new rule or whether they will be reluctant to risk making determinations as to “reasonableness” that may be second-guessed by the IRS.
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