Since the onset of the subprime residential mortgage crisis, there have been dramatic increases in mortgage loan defaults, foreclosures and calls for restructuring. With enactment of the Emergency Economic Stabilization Act of 2008, pressure has intensified for mortgage servicers to modify mortgage loans to minimize foreclosures. But if such loan modifications create serious tax disadvantages to the entities that own those mortgages, it would be difficult—if not impossible—to modify mortgage loans.
Many pools of mortgages are held in tax advantaged entities that qualify for tax purposes as REMICs that avoid double taxation under the Internal Revenue Code. But for an entity to qualify as a REMIC, the pooled mortgages must be basically treated as static pools of mortgage loans. Loan modifications could force a REMIC to lose its favorable tax treatment, and once REMIC status is lost, it is lost forever.
This means that REMIC efforts to minimize foreclosures through loan modifications can threaten favorable tax status of the REMIC and its owners.
To address these risks, the Internal Revenue Service (IRS) and U.S. Department of the Treasury (Treasury) have taken actions to expand safe harbor rules that apply to REMICS. Through a number of recently issued revenue procedures, the IRS has provided assurances that REMICs can retain their favorable tax status when mortgage servicers make certain loan modifications as part of programs aimed to reduce foreclosures. The safe harbors allow REMICs to engage in certain, previously prohibited activities that in the past could have resulted in significant tax penalties.
The American Securitization Forum Framework
IRS guidance builds on recent efforts by the American Securitization Forum (ASF), an independent adjunct forum of the Securities Industry and Financial Markets Association (SIFMA), to address the subprime mortgage crisis. In June 2007, ASF published its Statement of Principles, Recommendations and Guidelines for the Modification of Securitized Subprime Residential Mortgage Loans. In the statement, ASF recommended that loan modifications should be permitted, under limited circumstances, without triggering a violation of REMIC tax status.
The statement recommended that loan modifications be made only (1) consistent with the operative securitization documents (that is, pooling and servicing agreements); (2) in a manner that is in the best interest of the securitization investors in the aggregate; (3) in the best interests of the borrower; (4) in a manner that avoids adverse tax or accounting consequences to the REMIC servicer; (5) where the loan is either in default or default is reasonably foreseeable; (6) the servicer has a reasonable basis for concluding that the borrower will be able to make the scheduled payments once modified; and (7) in a manner that provides sustainable and long-term solutions and does not reduce the required payments beyond anticipated period of borrower need.
ASF asserted that loan modifications meeting these criteria are generally preferable to foreclosure, particularly in situations in which the net present value of the loan payments is likely to be greater than the expected net recovery that would result from foreclosure. ASF subsequently refined its position in two follow-up statements: Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, issued in December 2007, and Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, issued in July 2008.
These two statements recommended that fast track modifications be allowed for subprime mortgages and borrowers that meet strict criteria. Eligible loans include specific subprime adjustable rate mortgage (ARM) loans with limited loan origination and initial interest reset dates. Within the framework, borrowers are also classified into three distinct segments based on whether the borrower is current, likely to be able to refinance or likely to have difficulty meeting the introductory rate.
IRS Issues Revenue Procedures Consistent with ASF Recommendations
In response to the ASF framework and to allow REMICs to participate in loan modifications, the IRS issued revenue procedures discussed in this section.
Revenue Procedure 2007-72 and 2008-47
In December 2007, the IRS issued Rev. Proc. 2007-72, in which the IRS stated it would not challenge the qualifications of a REMIC that followed the ASF framework’s fast track modifications. In July 2008, the IRS issued Rev. Proc. 2008-47 to replace and supersede Rev. Proc. 2007-72, extending its guidance to include residential mortgage loan modifications. In Rev. Proc. 2008-47, the IRS largely reiterated its conclusions in Rev. Proc. 2007-72:
- First, the IRS will not challenge an entity’s qualification as a REMIC on the grounds that the mortgage modifications were significant because they are deemed to fall within the exception for modifications made in anticipations of default in I.R.C. §1.860G-2(b)(3).
- Second, the IRS will not assert that the loan modifications result in a disposition of qualified mortgage subject to the 100 percent prohibited transaction tax.
- Third, the IRS will not challenge an entity’s qualification as a REMIC on the grounds that the modification caused a reissuance of the REMIC’s regular interests.
- Fourth, if the securitization entity is a grantor trust, the IRS will not assert that the mortgage modifications result in the prohibited power to vary investments.
To make it clear that Rev. Proc. 2008-47 is intended as a safe harbor, the IRS cautioned that “[n]o inference should be drawn about whether similar consequences would obtain if a transaction falls outside the limited scope” of Rev. Proc. 2008-47.Revenue Procedure 2008-28
In May 2008, to expand the safe harbor protections, the IRS issued Rev. Proc. 2008-28 to address additional questions of whether loan modifications undertaken as part of foreclosure prevention programs would have adverse tax consequences to REMICs and REMIC owners. The IRS clarified that, if the conditions specified in Rev. Proc. 2008-28 are met, it will not challenge the securitization entity’s qualifications as a REMIC.
Rev. Proc. 2008-28 applies to a mortgage loan held by a REMIC if the mortgage meets six requirements:
- the mortgage must be secured by one to four unit single family residences;
- the residence is owner occupied;
- only 10 percent or less of the stated principal of total assets of the REMIC consists of loans with payments 30 days or more past due at the time of securitization;
- the servicer reasonably believes that there is a significant risk of foreclosure;
- the terms of the modification are less favorable to the lender; and
- the servicer believes the modification has substantially reduced the risk of a foreclosure.
Proposed Treasury Regulations
Although current REMIC Treasury regulations provide some flexibility to allow for loan modifications, a large number of other modifications continue to pose problems under the REMIC regulations. This is particularly true because commercial mortgage loans have become increasingly common in REMIC pools, presenting ongoing servicing concerns beyond those of residential mortgage loans.
To address these concerns and to acknowledge legitimate business practices currently used in the commercial mortgage securitization market, the Treasury issued Prop. Treas. Reg. §§1.860G-2(a)(8) and 2(b)(3) to expand the safe harbor rules to allow servicers to modify commercial mortgages held by a REMIC. The proposed regulations seek to strike a balance between accommodating the legitimate business concerns of the commercial real estate industry with the requirement that a REMIC remain a substantially fixed pool of mortgages that is not engaged in an active lending business.
While the proposed regulations go some distance toward easing the concerns of REMICs holding significant commercial mortgage loans, of particular concern is the Treasury’s proposal that collateral be retested by an independent appraiser for every modification that meets certain criteria. This formal appraisal requirement is unnecessarily burdensome. Hopefully, the proposed regulations, when finalized, will not require formal appraisals in situations where the value of the collateral will not decline or where the collateral will decline on a pro-rata basis in relation to the loan.
Obviously if loan modifications create serious tax disadvantages to those entities holding the pools of mortgages, modifications will be difficult--if not impossible-- to negotiate.
Rules Applicable to Foreclosure Property
When modifications cannot prevent or cure a default on a commercial loan held by a REMIC, the foreclosure rules (keyed to the foreclosure property REIT rules) apply. Unless otherwise extended, the grace period for the treatment of property as foreclosure property is at the end of the third taxable year beginning after the year that the REMIC Owned Real Estate (REO) property was acquired. A grace period can, however, under certain circumstances, terminate early. In a situation where REO property is not a permitted asset, all income and gain from that property is subject to the 100 percent prohibited transaction tax. Further, REO property can affect the tax status of a REMIC because a REMIC can only hold a de minimis amount of non-permitted assets.
Over the past year, or so, the actions of the IRS and Treasury to expand loan modification safe harbor rules and to update the REMIC regulations have set a clear standard within which REMICs and REMIC owners can be assured of continued favorable tax status. As a result, REMICs are now able to more effectively address the consequences of the current subprime mortgage crisis.
As the subprime crisis and its bailout unfolds, additional safe harbor areas are likely to be identified. Given the quick responses of the IRS and Treasury to the ASF efforts, hopefully the government will continue to assist REMICs and REMIC owners to enter into additional types of loan modifications to avoid foreclosures while maintaining favorable REMIC tax status.