The US Treasury and Internal Revenue Service released two pieces of guidance yesterday, a Revenue Procedure effective as of January 1, 2008, and Regulations effective on or after September 16, 2009, that expand a real estate mortgage investment conduit's (REMIC) ability to modify a mortgage loan without triggering certain negative tax consequences to the REMIC. In theory, this guidance provides borrowers with greater flexibility than they currently have to negotiate a loan modification when a REMIC holds the loan.

In Revenue Procedure 2009-45, the IRS provides a safe harbor allowing REMICs to modify certain mortgage loans without concern that the IRS will challenge its tax status as a REMIC or assert that the modification was a prohibited transaction under the REMIC rules. Generally, a “significant” loan modification can cause a termination of a REMIC’s favorable tax status or give rise to a prohibited transaction tax. The regulations currently mitigate the potential harshness of the rule with respect to troubled loans, however, by providing that loan modifications are not “significant” under the REMIC rules if the modifications are “occasioned by default or a reasonably foreseeable default.”

Under the current climate, the Treasury and IRS believe that REMICs should be able to work with borrowers in danger of default prior to the time that a default occurs or the loan is non-performing. Therefore, if all of the following conditions are met, the IRS will not assert that a REMIC’s modification of a mortgage loan calls into question the REMIC’s tax status and the IRS will not contend that the modifications are prohibited transactions under the REMIC rules. The conditions are as follows:

1. The existing mortgage is not secured by a residence that contains fewer than five dwelling units and that is the principal residence of the issuer of the loan.

2. As of three (3) months after the REMIC’s startup day, no more than 10 percent of the stated principal of all the REMIC’s assets consisted of mortgage loans in which the payments were then overdue by 30 days or more or for which default was reasonably foreseeable.

3. Based on all the facts and circumstances, the mortgage holder or servicer reasonably believes that there is a significant risk of default of the loan upon maturity of the loan or at an earlier date.

4. Based on all the facts and circumstances, the mortgage holder or servicer reasonably believes that the modified loan presents a substantially reduced risk of default, as compared with the pre-modification loan.

It appears that the Revenue Procedure is intended to deal with some of the issues regarding the “stickiness” of loans in a REMIC because it is generally the case that REMICs will often not begin even to entertain consideration of modification of a loan until it has been in default for several months.  The Revenue Procedure clearly indicates that it is not necessary to wait until there is a default before the loan can be modified.  However, while the Revenue Procedure allows a REMIC greater flexibility in negotiating a loan modification with a borrower, it remains to be seen whether the REMIC would be willing to exercise that flexibility due to the “facts and circumstances” test required to fall under the Revenue Procedure’s safe harbor.

In TD 9463, the Treasury and IRS finalized regulations that expand the list of permitted loan modifications that do not trigger the “significant modification” rules discussed above. Thus, while these regulations provide a different set of rules than the Revenue Procedure, both increase a REMIC’s ability to modify loans without affecting its tax status or triggering a prohibited transaction tax. These regulations provide that the following modifications do not result in a significant modification under the REMIC rules:

1. a release of a lien on real property that does not result in a significant modification under Treasury Regulation Section 1.1001-3; and,

2. changing a loan from recourse to nonrecourse and vice versa.

Additionally, the Regulations provide a REMIC with more flexibility in retesting the value of real estate securing a modified loan, including the ability to retest without a formal appraisal.

Please contact any member of the Arent Fox Tax Practice Team with further questions about REMICs or this recent guidance.

Robert Honigman
honigman.robert@arentfox.com
202.857.6041