09/21/2009

REMICs: More Flexibility Provided for Modifications of Commercial Mortgage Loans

As anticipated, the United States Department of Treasury (Treasury) relaxed certain restrictions with respect to modification of commercial mortgage loans held by a Real Estate Mortgage Investment Conduit (REMIC). The Treasury also clarified when retesting for the "principally secured by real property test" is required and how retesting is conducted.

• First, on September 15, 2009, Treasury published a new revenue procedure that allows a servicer to modify certain commercial mortgage loans prior to default or imminent default if a significant risk of default is reasonably foreseeable at or before maturity. These new procedures have a retroactive effective date of January 1, 2008. IRS Revenue Procedure 2009-45 may be accessed at http://www.irs.gov/pub/irs-drop/rp-09-45.pdf.
  
  
• Second, on September 16, 2009, Treasury issued final rules reaffirming and clarifying when retesting is required to determine whether a modified loan is still principally secured by real property, expanding when retesting is required and providing an alternative test to ease the burden of this requirement. These final rules are found in 26 CFR Parts 1 and 602 and are effective with respect to modifications occurring on or after September 16, 2009.
  
  

New Foreseeable Default Modification Safe Harbor

The new revenue procedure is designed to address, among other matters, current market conditions. Many mortgage loans, which otherwise are performing, will default in the future because of the general lack of refinancing sources. Under existing law (before Rev. Proc. 2009-45), the modification of such a loan (if default has not occurred or is not imminent) would be a prohibited transaction which may result in (A) challenges to the REMIC’s status as a REMIC and (B) imposition of a 100% penalty tax on any net income on the significant modification of the loan and subsequent income from the loan.

• More Flexibility. Subject to certain prerequisites, the new procedure provides servicers more flexibility to modify loans prior to default or imminent default. These rules generally apply if (a) the original loan is not secured by a residence containing fewer than five dwelling units, (b) the servicer of the original loan reasonably believes that there is a significant risk of default of such loan on or before maturity; and (c) the servicer reasonably believes the modified loan presents a substantially reduced risk of default. A borrower’s current compliance with loan provisions will not prohibit a servicer from determining that a loan may be in significant risk of default. Moreover, there is no absolute limit as to how far in the future a servicer may foresee a potential default, although the procedure does reference the fact that a significant risk of default may exist even though the foreseen default is more than one year in the future.
  
  
• Practical Considerations. While these modifications attempt to provide more flexibility for servicers of mortgage loans in REMICs, servicers will need to refer to the contractual provisions governing the servicing of commercial mortgage loans held under each pool. If the servicing contract provisions are more restrictive than these new rules, the servicing contract provisions will govern.
  
  

New Significant Modification Safe Harbor

Final Treasury Regulations under the REMIC provisions are broader in application than the New Foreseeable Default Modification Safe Harbor as they apply to all mortgage loans held by REMICs. Generally, the final rules provide additional safe harbors from significant modification treatment and therefore, will not disqualify the modified mortgage loan as a "qualified mortgage loan" as long as it continues to be principally secured by real property. The safe harbors include:

• Waiver of a due on sale or due on encumbrance clause.
  
  
• Conversion of an interest rate under a convertible mortgage's terms.
  
  
• A release, substitution, addition or alteration of a substantial amount of the collateral for a guarantee on or other form of credit enhancement for all obligations.
  
  
• A change in the nature of an obligation from recourse to nonrecourse or vice versa.
  
  

The final rules now require retesting even when the modification is not "significant." For instance, when a servicer releases real property collateral pursuant to the borrower's unilateral option under the terms of the mortgage loan, retesting is now required.

There is a new alternative method for satisfying the principally secured test, and certain procedures are provided for determining whether the 80% test is met. The final rules clarify that a loan remains principally secured by real property if either: (i) the 80% test is satisfied based on the current values or (ii) the new alternative test is met.

• 80% Test. This test has not changed and requires that the fair market value of the real property securing the loan be equal to at least 80% of the adjusted price of the loan as of the date of the modification.
  
  
• New Alternative Test. The alternative test requires that the fair market value of the real property securing the loan immediately after the modification must equal or exceed the fair market value of real property securing the loan immediately before the modification.
  
  

The final rule also provides some guidance for determining whether either "principally secured test" is satisfied:

• Alteration to Real Property–Overall Plan. When servicers retest they must look at all the alterations to the obligation. The final rules provide an example which makes clear that when borrowers alter the real property securing a loan, the retesting must be evaluated looking at all of the alterations to the collateral, even demolition of the existing building.
  
  
• Servicer's Reasonable Belief. The final rule provides that the principally-secured test will be satisfied if the servicer reasonably believes that the modified mortgage loan satisfies either the 80% test or the alternative test based on a commercially reasonable valuation method. A new appraisal from an independent appraiser is not the only means of meeting this test. The servicer's belief will also be commercially reasonable if based on:
  
  
  • An appraisal that was obtained at origination and, if appropriate, has been updated for the passage of time and for any other changes that might affect the value of the real property;
    
    
  • The sales price of the real property in the case of a substantially contemporaneous sale in which the buyer assumes the seller's obligations under the mortgage; or
    
    
  • Some other commercially reasonable valuation method.
    
    

---

If you have questions about this e-alert, contact Ben Hobert at 816.691.2720 or Kenda Tomes at 816.691.2419.