Alert: IRS & Treasury Department Relax CMBS Tax RulesAaron Nocjar and Lisa Zarlenga
September 30, 2009
Alert: IRS & Treasury Department Relax CMBS Tax Rules
More than $150 billion of commercial real estate loans bundled into commercial mortgage-backed securities (CMBS) will mature between 2009 and 2012. In today’s economy, the commercial real estate industry is facing limited refinancing options, which decreases the likelihood of successful debt refinancings and increases the likelihood of commercial property foreclosures.
Since much of the pre-existing CMBS debt is securitized through either real estate mortgage investment conduits (REMICs) or non-REMIC investment trusts, commercial property owners and servicers of these securitization vehicles have faced several perceived tax obstacles in attempting to rework commercial real estate loans.
Existing Tax Law. Under existing tax law, REMICs and non-REMIC investment trusts are subject to myriad requirements to ensure that they hold a substantially fixed pool of real estate mortgages and have no power to vary the composition of their mortgage assets. For example, substantially all of a REMIC’s assets must consist of qualified mortgages, which were transferred to it on its “startup day” in exchange for interests in the REMIC.
Under existing tax rules, a significant modification of a mortgage produces a deemed exchange of the original mortgage for a new one. As a result, even if a REMIC initially qualified, one or more significant modifications of mortgages could cause its qualified mortgages to fall below the substantially all threshold and terminate the REMIC’s qualification.
The existing tax rules carve out certain loan modifications, so that, even if they are significant, they do not negatively impact a REMIC’s qualified mortgages. In particular, if a change in terms is “occasioned by default or a reasonably foreseeable default,” the change is not a significant modification.
Similarly, the existing tax rules impose a tax on REMICs equal to 100 percent of the net income derived from “prohibited transactions,” which are defined as the disposition (including a deemed exchange resulting from a significant modification) of a qualified mortgage, unless the disposition falls within certain exceptions, including a disposition incident to the foreclosure, default, or imminent default of the mortgage.
Some may have perceived that these existing tax rules (and the servicers’ fiduciary obligations to CMBS investors) prevented servicers from reworking CMBS loans unless the loans actually were in default or payment default was imminent. Many commercial property owners do not currently face “imminent” payment default. However, because they face limited or no refinancing options, this may create today a reasonably foreseeable risk of payment default, although well before any actual (or imminent) payment default.
New IRS/Treasury Guidance. The IRS and Treasury Department issued guidance earlier this month that removes some of these perceived tax obstacles for commercial property owners and the servicers that administer their loans in securitization vehicles. The guidance (Treas. Reg. § 1.860G-2, Rev. Proc. 2009-45, and Notice 2009-79) is aimed at preventing the deleterious tax effects CMBS investors may have feared would arise if servicers reworked securitized debt, primarily the loss of tax-favored classifications and increased tax costs for the securitization vehicles.
Specifically, Revenue Procedure 2009-45 provides that the IRS will not challenge a securitization vehicle’s qualification as a REMIC or investment trust nor treat the modifications as prohibited transactions, as long as the modifications generally meet the following requirements:
First, at the time of their initial contribution to the securitization vehicle, no more than a small portion (10 percent) of the loans must have been in default or reasonably foreseeable of being in default; and
Second, servicers need to “reasonably believe that there is a significant risk of default” on or before maturity of the loan. They do not have to wait until actual payment (or imminent) default.
However, in an effort to tailor this benefit, the revenue procedure requires that the reasonable belief of a significant risk of default must be based on a “diligent contemporaneous determination” of that risk, which may take into account “credible written factual representations” made by the borrower but only if the servicer “neither knows nor has reason to know” that such representations are false.
In weighing the significance of the risk of default, a relevant factor may be how far in advance the possible default is. The revenue procedure, though, indicates that there is no maximum period after which the risk of default is per se not significant. Also, past debt service performance is a factor in assessing such risk, but the guidance makes clear that a significant risk of default still may exist even if the relevant loan is fully performing.
In addition, Treas. Reg. § 1.860G-2 expands the types of permitted modifications to commercial mortgage loans held in REMICs to include certain changes in collateral, guarantees, and credit enhancement of an obligation as well as changes to the recourse nature of an obligation. However, the modifications are permitted only if the obligation continues to be “principally secured by an interest in real property.”
Prior to this change in the regulation, this requirement was met only if the fair market value of the real property securing the obligation equaled 80 percent of the adjusted issue price of the obligation (the “80 percent test”). That test was retained in the modified regulation, but the IRS expanded it to include an alternative test.
Under the alternative test, a modified debt obligation continues to be principally secured by real property if the fair market value of the interest in real property that secures the obligation immediately after the modification equals or exceeds the fair market value of the interest in real property that secured the obligation immediately before the modification. In an environment of plummeting property values, this alternative test should be a welcomed feature of the modified rules.
Recognizing the impracticalities of obtaining appraisals and the sophistication of servicers today, the IRS and Treasury did not require independent appraisals to meet these “principally secured” tests. These tests may be satisfied if the servicer “reasonably believes” (based on, among other methods, a “commercially reasonable valuation method”) that the modified obligation satisfies the 80 percent test or the alternative test, unless the servicer actually knows, or has reason to know, that the test is not satisfied. Although not free from ambiguity, the “reasonable belief” approach should provide servicers with a bit more tax comfort when considering debt workouts with commercial property owners.
Finally, recognizing that much of the relief provided focuses on REMICs, Notice 2009-79 asks for comments with respect to how investment trusts that are not REMICs may face some of the same tax issues that REMICs face when considering debt workouts with commercial property owners. This aspect of the guidance indicates a willingness on the part of the IRS and Treasury to consider the issuance of additional guidance not only for REMICs but also for non-REMIC investment trusts holding commercial real estate mortgages.
Interpretational Issues. As commercial property owners, servicers, and CMBS investors begin to consider how this guidance alters the current state of play in the securitization market, interpretational issues will arise. How will (and should) the IRS and Treasury interpret the phrase “reasonably believe that there is a significant risk of default” before maturity? What will (and should) be the outer bounds of a “diligent contemporaneous determination” of that risk? What will (and should) be “credible written factual representations” made by the borrower with respect to such risk? In weighing the significance of the risk of default, how far in advance must (and should) the possible default be to trigger a heightened evidentiary requirement to establish a significant risk of default? With respect to the 80 percent test and the alternative test, what are the outer bounds of the phrase “a commercially reasonable valuation method”?
These are just a few of the potential issues in the new guidance, and the IRS and Treasury have indicated that they are not finished considering these and other related issues.
If you wish to discuss the potential impact this guidance may have on your organization, please contact the following Steptoe tax partners: Aaron Nocjar, firstname.lastname@example.org, who advises clients in structuring transactions involving partnerships, limited liability companies, S-corporations, and other pass through entities or Lisa Zarlenga, email@example.com, who practices in the area of federal income taxation, with a focus on corporate transactional and planning matters.
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