New Tax Rules for Modifying Commercial Loans
September 24, 2009
Lisa C. Henderson, Partner – Tax Services
The Treasury Department and the Internal Revenue Service (IRS) recently announced that certain modifications to commercial loans undertaken after 2007 to prevent default will not be prohibited transactions or threaten the tax status of a Real Estate Mortgage Investment Conduit (“REMIC”), or of a fixed investment trust, which holds such loans. Revenue Procedure 2009-45 (9/15/09)
The recent upheaval in financial markets has created challenges not contemplated when the IRS promulgated rules for REMICs and fixed investment trusts.
Under current rules, most of the assets held by a REMIC must be considered to be qualified mortgages. A “qualified mortgage” is a loan for which the principal is secured by interests in real property and which is acquired within the first 3 months of the start up, or closing date, of the REMIC. If a loan loses its status as a qualified mortgage, all income, including interest and gain on disposition, recognized from the loan is subject to a 100% tax on prohibited transactions.
Under the rules applicable to REMICs, if a loan held by a REMIC is modified after the 3-month start up period, the REMIC is treated as if it exchanged the old loan for a new loan outside the start-up period. Such an exchange is a prohibited transaction with regard to the sale of the old loan. Additionally, the new loan will no longer be a qualified mortgage, thereby threatening the favorable tax status of the REMIC.
In general, the determination as to whether such a modification would produce these harsh results is predicated on the occurrence of a significant modification. A significant modification generally exists if it triggers a taxable gain or loss under other provisions of the Internal Revenue Code. However, under regulations specifically applicable to REMICs, certain modifications are deemed not to be significant and do not affect the status of the REMIC or subject it to the prohibited transactions tax. For example, if the modification is “occasioned by default or a reasonably foreseeable default,” that change is not deemed to be a significant modification.
Similar rules apply to protect the grantor trust status of fixed investment trusts which agree to modify loans they hold.
Rev Proc 2009-45 has been issued with a keen understanding of the commercial loan market. For instance, the principal on a commercial loan is often paid only at maturity and such payment is often effectuated by the borrower securing a new loan secured by the same property. Given current market conditions, such refinancing may not be possible and there may be more defaults even in the situation where the underlying property is generating sufficient cash flow to satisfy the debt service on the loan. Additionally, it is well understood that pool administrators have set up procedures for monitoring the status of the property securing a loan and may predict the likelihood of a borrower being unsuccessful in its attempt to refinance a loan or sell the underlying property. Based on this, it may be possible to foresee the risk of forfeiture well before the date of maturity.
It is also well understood that industry participants can reasonably predict whether particular modifications, such as rate changes, forgiveness of principal, or extensions of maturity, will have an impact on whether a loan can continue to perform and reduce the risk of foreclosure. Given the complexity of the market, negotiations of a modification may need to begin well before the maturity date of the loan.
Rev Proc 2009-45 permits a REMIC to modify a commercial loan without being exposed to the prohibited transactions tax or jeopardizing its tax status, and likewise permits a fixed investment trust to do so without jeopardizing its grantor trust status, under the following circumstances:
- The loan, before modification, is a commercial loan, i.e., not secured by a residence that contains fewer than five dwelling units and that is the principal residence of the issuer (borrower) of the loan.
- For a REMIC, as of the end of its 3-month start-up period, no more than 10% of the stated principal of its total assets were loans on which, at the time contributed to the REMIC, payments were already overdue by at least 30 days or a default was reasonably foreseeable. For a fixed investment trust, as of all dates when assets were contributed, the same 10% limitation applies.
Comment: This limitation aims to deny the benefits of the new revenue procedure to a REMIC or fixed investment trust formed specifically to modify delinquent loans. (A similar limitation applies to the permitted modification of residential loans in Revenue Procedure 2008-28).
- Based on all the facts and circumstances, the holder or servicer reasonably believes that there is a significant risk of default on the pre-modification loan upon its maturity or earlier.
- Based on all the facts and circumstances, the holder or servicer reasonably believes that the modified loan presents substantially reduced risk of default as compared to the pre-modification loan.
Such reasonable beliefs must be based on a contemporaneous determination of the risks of default and may be based on credible written factual representations made by the issuer of the loan, so long as the holder or servicer has no reason to believe such representations are false.
Comment: One relevant factor in the reasonableness of such a determination is how far in the future such a default on the pre-modification loan is expected to occur. However, there is no maximum period beyond which such a default is per se not foreseeable. In certain circumstances, risk of default may be more than one year in the future. Additionally, a servicer may feel that a loan has significant risk of default even though the loan is currently performing.
For more information, please contact your Frank, Rimerman + Co. LLP tax professional.
Any tax advice in this communication is not intended or written by Frank, Rimerman + Co. LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing, or recommending to another party any matters addressed herein. With this communication, Frank, Rimerman + Co. LLP is not rendering any specific advice to the reader.
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