REMICs, Mortgage Loan Modifications and COVID-19

This memorandum discusses certain tax considerations in connection with forbearances, waivers and other modifications with respect to a mortgage loan that is held by a REMIC or about to be contributed to a REMIC, in light of the fact that certain borrowers may be unable to make current or future payments on their mortgage loans due to the COVID-19 pandemic.

1.  REMIC OVERVIEW

• In general, a “real estate mortgage investment conduit” or “REMIC” is not required to pay tax on its income. Under the REMIC rules, in order for a securitization vehicle to qualify as a REMIC, among other requirements, its assets must consist of “qualified mortgages” and “permitted investments” (which include certain cash flow investments, qualified reserve assets and foreclosure property) (collectively, “qualifying assets”), and no more than a de minimis amount of other assets.

  • A REMIC may be subject to disqualification as a REMIC unless it is able to satisfy a 1% safe harbor for de minimis non-qualifying assets.If a REMIC does not satisfy such 1% safe harbor, the REMIC may lose its tax status as a REMIC and become taxable as a corporation.
  • In order to be treated as a “qualified mortgage” for a REMIC, a mortgage loan must be “principally secured” by real property and generally must be acquired within 3 months of the REMIC’s startup day (i.e. within 3 months of the securitization closing date).Very generally, a mortgage loan is principally secured by real property if the fair market value of the real property securing the mortgage loan was at least 80% of the adjusted issue price of the mortgage loan (i.e. the mortgage loan has a loan-to-value (“LTV”) ratio no greater than 125%) on its origination date or upon contribution to the REMIC (the “REMIC LTV Test”).
  • If a change is made to the terms of a mortgage loan held by a REMIC and that change is a significant modification, that mortgage loan may no longer be a qualified mortgage for a REMIC.
  • If a mortgage loan is not a qualified mortgage, the net income from that mortgage loan (e.g., interest and any gain (e.g., recoveries in excess of the REMIC’s U.S. federal income tax basis in such mortgage loan), possibly reduced by an allocable portion of the interest deductions allowed to the REMIC with respect to its regular interests) will be subject to a 100% “prohibited transactions” tax.
  • If a REMIC acquires foreclosure property (REO property) that had secured a mortgage loan that it acquired with improper knowledge, the foreclosure property may not be a qualifying asset for a REMIC.

2.   MORTGAGE LOAN ACTIONS PRIOR TO CONTRIBUTION TO A “NEW REMIC”^[1]

• DEFAULT

  • A REMIC is not per se restricted from acquiring a mortgage loan that is in default or as to which a default is reasonably foreseeable, so long as the REMIC does not ultimately acquire foreclosure property related to that mortgage loan or the REMIC sponsor did not have improper knowledge when it contributed the mortgage loan to the REMIC.
  • In general, if (i) a REMIC acquires foreclosure property in connection with a default or imminent default of a mortgage loan that it holds, and (ii) it is determined that the mortgage loan was acquired by the REMIC with an intent to foreclose, or when the relevant REMIC sponsor knew or had reason to know that a default would occur (this clause (ii) referred to as the "improper knowledge" test), the REMIC will be subject to a 100% “prohibited transactions” tax on any net income derived from the property. Further, the REMIC may be subject to disqualification as a REMIC unless it is able to satisfy the 1% safe harbor for de minimis non-qualifying assets.
  • Although there is little authority that applies the improper knowledge test in the REMIC area, it is reasonable to assume that “default” in this context means a serious default that is expected to result in the REMIC’s ownership of the underlying real property, rather than a short delinquency (e.g., 30 days or less, or possibly up to 59 days depending on the facts and circumstances) that is expected to be cured.
  • If the REMIC either sells the defaulted mortgage loan prior to foreclosing or sells the related mortgaged property at a foreclosure sale without taking ownership of the property, there should be no adverse tax consequences to the REMIC because it will not acquire a non-qualifying asset.

  Operational Considerations:  Because of the adverse tax consequences associated with failing the “improper knowledge” test, a REMIC generally should not acquire a severely delinquent mortgage loan (e.g., more than 30 days delinquent (or possibly more than 59 days delinquent depending on the facts and circumstances)). 

  • However, it may be possible to contribute a severely delinquent mortgage loan to a REMIC if foreclosure is not anticipated by the REMIC sponsor because, for example:

    • the REMIC sponsor believes the default will be cured without a foreclosure (e.g., the REMIC sponsor believes that the borrower eventually will have the ability to pay in full) or a subsequent loan modification is anticipated that will cure the default, or
    • the transaction documents provide that the mortgage loan is “foreclosure-restricted” (permitting only a sale of the mortgage loan) or that the related mortgage loan seller is required to repurchase the mortgage loan under its mortgage loan purchase agreement in lieu of foreclosure by the REMIC.
  • Please refer to Section 5 for a discussion of a recent IRS Revenue Procedure that may provide certain relief for New REMICs under the "improper knowledge" test for forbearances and related modifications granted on COVID-19 affected mortgage loans.

• MODIFICATION

  • If a mortgage loan is subject to a “significant modification” (very generally, a modification where the legal rights or obligations under the mortgage loan are altered to a degree that is economically significant), then the “origination date” for purposes of the REMIC LTV Test generally will be the modification date, rather than the initial origination date.
  • However, if the mortgage loan is modified (even if significantly modified) in connection with a default or reasonably foreseeable default (or another specific REMIC exception or general safe harbor for modifications of debt instruments is available) (see Section 4), then the “origination date” for purposes of the REMIC LTV Test remains the initial origination date . (Example: A mortgage loan is in default, and prior to contribution to a REMIC, such mortgage loan is modified to reallocate reserves, render it interest-only and extend the maturity date, bringing the mortgage loan into performing status. There is no change to the relevant REMIC LTV Test date, and such modification does not prohibit contribution to a REMIC.)
  • Also, if the LTV ratio of a performing mortgage loan satisfies the REMIC LTV Test on the date of modification then there should be no issue from a REMIC perspective in contributing such mortgage loan to a REMIC (although there may be commercial issues with respect to any revised LTV ratio).(Example: A mortgage loan is not in default and default is not reasonably foreseeable, and prior to contribution to a REMIC, such mortgage loan is modified to reallocate reserves, render it interest-only and extend the maturity date. The “origination date” for purposes of the REMIC LTV Test is the date of modification. If the REMIC LTV Test is satisfied based on a new appraisal as of the date of modification, such mortgage loan can be contributed to a REMIC.)

  Operational Considerations:  If a mortgage loan is significantly modified after origination, a new appraisal may be required prior to inclusion of the modified mortgage loan in a REMIC to confirm that the REMIC LTV Test is met as of the modification date, unless the modification (i) is permitted under a specific REMIC exception (e.g. is occasioned by a default or reasonably foreseeable default), or (ii) satisfies a general safe harbor for modifications of debt instruments. (See Section 4)

• FORBEARANCE AND RELATED MODIFICATIONS

  • Please refer to Section 5 for a discussion of a recent IRS Revenue Procedure that may provide certain relief for New REMICs under the REMIC LTV Test for forbearances and related modifications granted on COVID-19 affected mortgage loans.

3.   MORTGAGE LOAN ACTIONS FOR “EXISTING REMICS”^[2]

• DEFAULT

  • A REMIC is not restricted from continuing to hold a mortgage loan that is in default or as to which a default is reasonably foreseeable.

• MODIFICATION

  • As mentioned above, under the REMIC rules, in order for a securitization vehicle to qualify as a REMIC, among other requirements, its assets must consist of “qualified mortgages” and “permitted investments” (which include certain cash flow investments, qualified reserve assets and foreclosure property), and no more than a de minimis amount of other assets. In general, qualified mortgages are mortgage loans that are principally secured by real property and that are acquired within 3 months (or in certain limited cases 2 years if the REMIC qualified replacement mortgage rules are satisfied) of the REMIC’s startup day.
  • If a mortgage loan that is owned by a REMIC has been subject to a “significant modification” (very generally, a modification where the legal rights or obligations under the mortgage loan are altered to a degree that is economically significant), that mortgage loan is deemed to be reissued and acquired by the REMIC on the modification date rather than on the REMIC’s startup day, unless such modification (i) is permitted under a specific REMIC exception (e.g. is occasioned by a default or reasonably foreseeable default), or (ii) satisfies a general safe harbor for modifications of debt instruments. (See Section 4).Consequently, unless this modification occurs within 3 months (or in certain limited circumstances, 2 years) of the REMIC’s startup day, or satisfies a specific REMIC exception or general safe harbor for modifications of debt instruments, a significantly modified mortgage loan will lose its status as a qualified mortgage.(Example: A performing mortgage loan in an Existing REMIC is significantly modified (and deemed to be reissued) 3 years after the startup day for the REMIC. Such mortgage loan is no longer a qualified mortgage.)
  • If a mortgage loan is not a qualified mortgage, (i) it may jeopardize the REMIC’s special tax status if the REMIC does not satisfy the 1% safe harbor for de minimis non-qualifying assets, in which case the REMIC may become taxable as a corporation, and (ii) the net income from such mortgage loan (e.g., interest and any gain (e.g. recoveries in excess of the REMIC’s U.S. federal income tax basis in the mortgage loan), possibly reduced by an allocable portion of the interest deductions allowed to the REMIC with respect to its regular interests) will be subject to a 100% “prohibited transactions” tax.

  Operational Considerations:  In order to avoid the adverse tax consequences described above, a REMIC should not modify a mortgage loan it owns unless the modification (i) is permitted under a specific REMIC exception (e.g. is occasioned by a default or reasonably foreseeable default), (ii) satisfies a general safe harbor for modifications of debt instruments, or (iii) occurs within 3 months (or possibly 2 years if the REMIC qualified replacement mortgage rules are satisfied) of the REMIC’s startup day and the REMIC LTV Test is satisfied. (See Section 4)

• FORBEARANCE AND RELATED MODIFICATIONS

  • Please refer to Section 5 for a discussion of a recent IRS Revenue Procedure that may provide certain relief under the foregoing REMIC rules related to significant modifications and deemed reissuances in connection with forbearances and related modifications granted on COVID-19 affected mortgage loans.

4.   SPECIFIC REMIC EXCEPTIONS AND GENERAL SAFE HARBORS

• Examples of modifications that are permitted under special REMIC rules, i.e. constitute a “specific REMIC exception,” include:

  • A modification that is occasioned by a default or a reasonably foreseeable default. No regulation defines when a mortgage loan is in default or when a default is reasonably foreseeable. For the sake of prudence (and subject to special considerations for commercial mortgage loans described under “IRS Safe Harbor for Commercial Mortgage Loans (Rev. Proc. 2009-45)” below), it should be assumed that:
    • a mortgage loan is in default only if: (1) there is a required payment that has not been made by its due date, taking account of any grace periods (or there is a default in a significant non-payment term) and (2) the servicer of the mortgage loan has begun to take steps to collect on the mortgage loan (or otherwise cause the obligor to cure such non-payment default), such as sending out a delinquency notice; and
    • absent notification from the borrower of an anticipatory breach, a default is reasonably foreseeable only if: (1) personnel at the servicer responsible for servicing the mortgage loan actually believe that a default is foreseeable, (2) the servicer has begun to take actions (which may be internal) to reduce the risk of such default and (3)(a) there currently exists a set of circumstances where a material non-payment default will occur with the passage of time or (b) the value of the collateral securing the mortgage loan is significantly below the outstanding principal amount of the mortgage loan.
  • An assumption of the mortgage loan (including where a buyer of the mortgaged property (x) acquires the property subject to the mortgage, without assuming any personal liability; (y) becomes liable for the debt but the seller also remains liable; or (z) becomes liable for the debt and the seller is released by the lender).
  • A waiver of a due-on-sale clause or a due-on-encumbrance clause.
  • Conversion of an interest rate by a mortgagor pursuant to the terms of a convertible mortgage loan.
  • A modification that releases, substitutes, adds, or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for, a recourse or nonrecourse mortgage loan, so long as the mortgage loan continues to be principally secured^[4] by an interest in real property following the release, substitution, addition, or other alteration.
  • A modification that changes the nature of the mortgage loan either from: (a) recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), or (b) nonrecourse (or substantially all nonrecourse) to recourse (or substantially all recourse), so long as the mortgage loan continues to be principally secured^[4] by an interest in real property following such a change.

• Examples of modifications that meet a safe harbor for modifications of debt instruments available under general tax law include:

  • A modification resulting in a deferral of a payment if the deferred payment is unconditionally payable no later than the end of the period that begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years and 50% of the original term of the mortgage loan.
  • A modification in future interest or principal payments that changes the yield of a mortgage loan (determined as of the date of the modification) by no more than the greater of 25 basis points and 5% of the annual yield of the unmodified mortgage loan (e.g., 50 basis points if the original yield is 10%).
  • A modification that adds, deletes, or alters customary accounting or financial covenants.
  • Forbearance: The failure of a borrower to perform its obligations under a mortgage loan is not itself an alteration of a legal right or obligation and is not a modification. Notwithstanding the foregoing, absent a written or oral agreement to alter other terms of the mortgage loan, an agreement by the holder to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds -- (A) two years following the borrower’s initial failure to perform; and (B) any additional period during which the parties conduct good faith negotiations or during which the borrower is in a Title 11 bankruptcy proceeding or similar case.

• IRS Safe Harbor for Commercial Mortgage Loans (Rev. Proc. 2009-45): Rev. Proc. 2009-45 provides that, in the case of a modification of a commercial mortgage loan, if the safe harbor requirements described below are satisfied, the IRS generally will not challenge a REMIC’s qualification as such on the grounds that a modification of a mortgage loan is not one of the types of modifications permitted under the REMIC rules or otherwise gives rise to a reissuance of the mortgage loan. The safe harbor applies to modifications of a commercial mortgage loan (a “pre-modification loan”) that is held by a REMIC, if all the following conditions are satisfied:

  • as of the end of the 3-month period beginning on the REMIC’s startup day, no more than 10% of the stated principal of the total assets of the REMIC are represented by mortgage loans for which, at the time of contribution to the REMIC, (i) the payments were overdue by at least 30 days or (ii) a default on the mortgage loan was reasonably foreseeable;
  • based on all of the facts and circumstances, the servicer reasonably believes that there is a significant risk of default of the pre-modification mortgage loan upon maturity of the mortgage loan or at an earlier date. This reasonable belief must be based on a diligent contemporaneous determination of that risk, which may take into account credible written factual representations made by the borrower if the holder or servicer neither knows nor has reason to know that such representations are false; and
  • based on all the facts and circumstances, the servicer reasonably believes that the modified mortgage loan presents a substantially reduced risk of default, as compared with the pre-modification mortgage loan^[3].
  • (Example: A borrower has made timely payments on a mortgage loan that matures in 12 months. Market conditions indicate that refinancing options may be unavailable to the borrower at maturity. The borrower provides a written factual representation to the servicer that it will likely be unable to pay or refinance its mortgage loan at maturity, and the servicer neither knows nor has reason to know that such representation is false. The servicer modifies the mortgage loan to extend the maturity date, reduce the principal balance and increase the interest rate. Based on the facts and circumstances and a diligent contemporaneous determination, the servicer reasonably believed that there was a significant risk of default under the pre-modification loan, and the modification reduced the risk of default. Such modification meets the reasonable belief test set forth in Rev. Proc. 2009-45.)

5.   IRS GUIDANCE ADDRESSING COVID-19 

• Background: The IRS recently issued Rev. Proc. 2020-26, which provides certain:

  • safe harbors for New REMICs which seek to acquire certain mortgage loans for which the borrower has participated in or is currently participating in a COVID-19 forbearance “program”, such that the REMIC will not be deemed to have improper knowledge of an anticipated default for purposes of the rules governing REMIC foreclosure property, and
  • safe harbors for Existing REMICs (as well as grantor trusts) that hold certain mortgage loans as to which the borrower has participated in or is currently participating in a COVID-19 forbearance “program”, such that such forbearance (and related modifications) will not jeopardize the tax status of the REMIC.
• What is a Forbearance “Program”? For purposes of Rev. Proc. 2020-26, a forbearance “program” exists when a holder or servicer of mortgage loans intends, either voluntarily or through a state mandated loan forbearance program, to provide forbearances for the next 3 to 6 months to borrowers that are experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency. These programs often contemplate related modifications in addition to the forbearance itself. For example, loan payments deferred as result of the forbearance may be added to the principal amount of the loan to be paid by the borrower after what would otherwise be the final payment on the loan. Other programs contemplate that, at the end of the forbearance period, an amortizing loan will be re-amortized to preserve the original maturity date.

• SCOPE and APPLICATION of Rev. Proc. 2020-26.Rev. Proc. 2020-26 applies to the following transactions:

  • New REMICs - The direct or indirect acquisition by a New REMIC on or after March 27, 2020, of any mortgage loans for which (i) between March 27, 2020, and December 31, 2020, inclusive, the borrower requested or agreed to a forbearance, and (ii) the forbearance was granted under a forbearance program that is for borrowers experiencing a financial hardship due to the COVID-19 emergency and that are “identical” or “similar” to those described in the preceding paragraph.For such mortgage loans acquired by New REMICs, such forbearances (and all related modifications) are not, for purposes of the REMIC rules, (i) treated as evidence that the REMIC had improper knowledge of an anticipated default, or (ii) taken into account in the determination of the origination date of the mortgage loan for purposes of the REMIC LTV Test.
  • Existing REMICs – Forbearances of mortgage loans held by Existing REMICs that are made under forbearance programs for borrowers experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency and that are “identical” or “similar” to those described in the second preceding paragraph, and pursuant to which, between March 27, 2020, and December 31, 2020, inclusive, the borrower requests or agrees to the forbearance (and all related modifications). For such mortgage loans held by Existing REMICs, forbearances (and all related modifications) described in Rev. Proc. 2020-26 will not jeopardize the tax treatment of the REMIC (i.e. for purposes of the REMIC rules, such forbearances (and all related modifications) (i) are not treated as resulting in newly issued mortgage loans, and (ii) are not prohibited transactions).
  • Applicability to CMBS - Although Rev. Proc. 2020-26 specifically addresses federally backed mortgage loans participating in a forbearance program under the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. No. 116-136, 134 Stat. 281 (2020) (the CARES Act), and also addresses certain mortgage loans that are not federally backed mortgage loans, there is no specific mention of commercial mortgage loans. The IRS has confirmed informally, however, that commercial mortgage loans, in addition to residential and multifamily mortgage loans, are intended to be within the scope of the relief.

• Operational Considerations:

  • New REMICs: Prior to the release of Rev. Proc. 2020-26 it was unclear whether inclusion of a mortgage loan subject to a COVID-19 forbearance agreement in a New REMIC might cause the New REMIC to fail the improper knowledge test. Rev. Proc. 2020-26 resolves this issue by providing that if a New REMIC acquires one or more mortgage loans on or after March 27, 2020, with respect to which the borrower has requested and agreed to a COVID-19-related forbearance agreement and modification that is within the scope of Rev. Proc. 2020-26, then such prior forbearance (and all related modifications) will not result in the New REMIC having had improper knowledge of an anticipated default. Accordingly, any resulting foreclosure property acquired by the REMIC should be treated as a qualifying asset should the REMIC foreclose with respect to such mortgage loan.
  • Existing REMICs: Prior to the release of Rev. Proc. 2020-26, it was unclear as to whether a COVID-19 forbearance agreement (and related modifications) would constitute a modification for which default is reasonably foreseeable, in particular where it is not feasible (or even permitted) to obtain detailed information from borrowers as to their financial hardship. Under Rev. Proc. 2020-26, it is not necessary to determine if default on a mortgage loan is reasonably foreseeable so long as the COVID-19 forbearance agreement (and related modifications) meet the applicable requirements.