IRS Issues Guidance Permitting Certain Liens Securing Loans Held in Real Estate Mortgage Investment Conduits to Be Released SUMMARY On August 17, 2010, the Internal Revenue Service (the IRS ) issued Revenue Procedure 2010-30 (the Revenue Procedure ), which clarifies the circumstances in which liens securing commercial mortgage loans held by real estate mortgage investment conduits ( REMICs ) may be released. The Revenue Procedure is a follow-on to final regulations (the Final Regulations ) that were issued by the IRS and the Treasury Department in September 2009. The Final Regulations provide that the release of a lien on a mortgage loan held in a REMIC will not cause that loan to lose its status as a qualified mortgage so long as: (i) the lien release does not result in a significant modification to the mortgage loan under either general tax law principles or the special exemptions from the definition of a significant modification applicable to REMICs, and (ii) the loan remains principally secured by real property after the release of the lien. The latter requirement that the loan be retested for principally secured status after the lien release created concern because many existing mortgage loans already included in REMICs permit the borrower to obtain a lien release without such retesting. Under the Revenue Procedure, the IRS will not apply the retesting requirement introduced by the Final Regulations to a Grandfathered Transaction, i.e., a lien release that occurs by the operation of the terms of a debt instrument (including the exercise of a unilateral borrower option), if the terms providing for the release are contained in a contract executed on or before December 6, 2010. In addition, the Revenue Procedure provides a relief mechanism from this retesting requirement for a Qualified Pay-Down Transaction, under which a qualified amount is repaid by the borrower. The Qualified Pay-Down Transaction rules provide considerable flexibility and generally exempt a lien release from the retesting provisions of the Final Regulations in cases where the borrower repays the loan in an amount that is at least equal to the fair market value (or net proceeds available from an arm s-length sale and / or New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
condemnation) of the property to be released, plus other amounts that are (or in certain cases, are expected to be) received from a tort or insurance award. In addition, a lien release may qualify as a Qualified Pay-Down Transaction if the borrower makes a payment that, in effect, either: (i) repays at least the portion of the loan allocable to the property on which the lien was released (as measured by fair market value at the time the loan was originated), or (ii) repays enough of the loan so the overall degree to which the loan is collateralized by real property is not reduced. Under the Revenue Procedure, however, the release of an outparcel that was assigned no value at origination (and accordingly can be released without payment under the terms of the loan) will generally not constitute a Qualified Pay-Down Transaction, and would avoid retesting under the Final Regulations only if it were a Grandfathered Transaction. Accordingly, it may be advisable to assign an appropriate fair market value to an outparcel when a mortgage loan is originated so the outparcel may be released through a Qualified Pay-Down Transaction. The Revenue Procedure, like the Final Regulations, applies only to REMICs and not to fixed investment trusts. 1 The Revenue Procedure is effective for lien releases occurring on or after September 16, 2009, the effective date of the Final Regulations. BACKGROUND A. REMICS Originators of commercial mortgage loans, like originators of residential mortgage loans, often employ securitization vehicles to access capital markets and provide investors with securities that diversify the risks inherent in holding individual loans. Commercial mortgage securitization vehicles often elect to be treated as REMICs for tax purposes because the REMIC rules give issuers the flexibility to create multiple-class securitization pools while generally exempting REMICs from entity-level corporate income tax. From and after the close of the third month after a REMIC is started, substantially all of the REMIC s assets must be either qualified mortgages or other permitted investments. 2 Mortgage loans generally are not qualified mortgages unless they are principally secured by an interest in real property and are transferred to the REMIC either: (i) on the startup day in exchange for regular or residual interests in the 1 2 Fixed investment trusts have, however, asked for guidance similar to the Final Regulations. See Letter from Judith Dunn, Senior Vice President and Deputy General Counsel, Fannie Mae, to the IRS (November 19, 2009), reprinted at 2009 TNT 226-13; Letter from John A. Courson, President and Chief Executive Officer, Mortgage Bankers Association, to Pamela Law (November 13, 2009), reprinted at 2009 TNT 219-21. Code 860D(a)(4). The applicable Treasury Regulations provide a safe harbor for entities if their holdings in assets other than qualified mortgages and permitted investments are, as measured by adjusted basis, less than one percent of the entity s total assets. Treas. Reg. 1.860D-1(b)(3)(ii). -2-
REMIC or (ii) within three months of the startup day under a contract in effect on the startup day. 3 The scope of other permitted investments for REMICs is limited to cash-flow investments 4 (amounts received under qualified mortgages that are temporarily reinvested in other assets prior to distribution), certain qualified reserve assets 5 and foreclosure property. 6 A REMIC can face adverse tax consequences if a significant modification occurs vis-à-vis any mortgage loan that it owns. Specifically, current Treasury Regulations provide that a significant modification to a debt instrument held by a REMIC causes the original instrument to be treated as if it were retired and reissued. 7 Thus, a significant modification to a mortgage loan can cause that investment to cease to be a qualified mortgage. A modification is typically significant for REMIC purposes if it would be significant under the general tax principles of Treasury Regulations Section 1.1001-3(e). However, certain modifications that might otherwise be significant under these general rules, including those occasioned by default or a reasonably foreseeable default, are not significant modifications for REMIC purposes. 8 If an entity no longer holds substantially all of its assets in qualified mortgages and other permitted investments, that entity can also lose its REMIC status and become subject to entity-level taxation as a taxable mortgage pool. B. RECENT DEVELOPMENTS On September 15, 2009, the IRS issued the Final Regulations, which provide that a lien release whether in connection with default, reasonably foreseeable default or otherwise will not cause a mortgage loan to lose its status as a qualified mortgage so long as: (i) the lien release would not result in a significant modification, either under general tax principles or because of the special exemptions from the definition of a significant modification applicable to REMICs, and (ii) the loan remains principally secured by real property after the release of the lien. 9 The preamble to the Final Regulations observed that a release... pursuant to the borrower s unilateral option... is not a release that 3 4 5 6 7 8 9 Code 860G(a)(3)(A)(i) & (ii). Code 860G(a)(5)(A). Code 860G(a)(5)(B). Code 860G(a)(5)(C). Treas. Reg. 1.860G-2(b)(1). Treas. Reg. 1.860G-2(b)(3). The Final Regulations are discussed further in the Sullivan & Cromwell LLP Publication entitled : IRS Guidance on Modifications of Commercial Mortgages Held by Real Estate Mortgage Investment Conduits and Fixed Investment Trusts (September 16, 2009), which may be obtained by following the instructions at the end of this publication. -3-
disqualifies a mortgage loan, so long as the mortgage continues to be principally secured by real property after giving effect to any releases. 10 Prior to the issuance of the Final Regulations, many lenders and borrowers interpreted the then-existing guidance as not requiring that mortgage loans be reexamined under the principally secured test after a release, pursuant to a unilateral option in favor of the borrower included in the terms of the original debt instrument, of one of several properties in exchange for a prepayment of 100% or more of the portion of the loan allocated to such property. Accordingly, a significant number of outstanding mortgage loans grant borrowers a unilateral lien release option without conditioning that right on the satisfaction of the principally secured test after the release. 11 THE REVENUE PROCEDURE The Revenue Procedure limits the requirement to retest whether a mortgage loan is principally secured by real property in a lien release transaction that qualifies as either a Grandfathered Transaction or a Qualified Pay-Down Transaction. If a lien release meets the requirements of the Revenue Procedure, the IRS will not challenge whether the loan is a qualified mortgage on the grounds that the loan is not principally secured by an interest in real property after the release of the lien. A. GRANDFATHERED TRANSACTIONS The Grandfathered Transaction provision of the Revenue Procedure provides administrative forbearance from the requirement to retest an existing (or soon-to-be-executed) mortgage loan under the principally secured rules after the release of a lien that occurs under the terms of the loan s governing documents, and generally reflects what, as discussed above, many commercial lenders and borrowers understood 10 11 T.D. 9463. The Final Regulations specify alternative tests for determining whether an obligation remains principally secured by an interest in real property. Under the Final Regulations, the fair market value of the underlying security is deemed to be at least 80% of the adjusted issue price of the modified obligation (which is the standard that otherwise must be satisfied for an obligation to be principally secured by an interest in real property) if the servicer reasonably believes that the fair market value of the real property securing the loan is at least 80% of the adjusted issue price of the modified loan. To arrive at a reasonable belief that this criterion is satisfied, a servicer is not required to (but may) obtain a new or updated independent appraisal. Alternatively, the servicer may use: (i) the sales price of the interest, if a substantially contemporary sale has occurred under which the buyer assumed the mortgage, or (ii) some other commercially reasonable valuation method. Additionally, the Final Regulations provide an alternative test under which, if the fair market value of the real property securing the loan is not at least 80% of the adjusted issue price of the modified loan, the mortgage will nonetheless be principally secured by an interest in real property if the fair market value of the real estate that secures the loan immediately after the modification equals or exceeds the fair market value of the property that secured the loan immediately before the modification, as determined by a current appraisal, an original (and updated) appraisal or some other commercially reasonable method, and the servicer does not actually know, or have reason to know, that the criterion is not satisfied. See Treas. Reg. 1.860G-2(b)(7)(iii). See, e.g., Letter from the Commercial Mortgage Securities Association to Joshua D. Odintz (Nov. 4, 2009), reprinted at 2009 TNT 216-21. -4-
the law to be before the Final Regulations were issued. Under the Revenue Procedure, a Grandfathered Transaction is the release of a lien on an interest in real property that: (i) is not a significant modification of the debt instrument because it occurs by the operation of the terms of the debt instrument (including a lien release pursuant to the exercise of a unilateral option of the borrower) and (ii) occurs pursuant to terms contained in a contract that is executed no later than December 6, 2010. The mortgagor in a Grandfathered Transaction generally will be able to exercise its right to have an outparcel (or other designated property) that was assigned no value at origination released without payment. B. QUALIFIED PAY-DOWN TRANSACTIONS Under the Revenue Procedure, a Qualified Pay-Down Transaction is a transaction in which: (i) a lien is released on a real property interest, and (ii) the borrower makes a payment resulting in a reduction in the adjusted issue price of the loan by a qualified amount. A qualified amount is an amount that equals or exceeds any one of the following: The sum of: (i) the net proceeds available to the borrower from an arm s-length sale of the property to an unrelated party, (ii) the net proceeds from the receipt of a condemnation award with respect to the property, and (iii) in any case where (i) or (ii) applies, the net proceeds from the receipt of an insurance or tort settlement with respect to the property; 12 An amount determined under the loan agreement which equals or exceeds the product of: (i) the adjusted issue price of the obligation at the time when the lien is released multiplied by (ii) the fraction of the fair market value of the released interest in real property at the time of origination over the aggregate fair market value at origination of all of the real property interests that secured the loan immediately prior to the lien release; The fair market value at the time of the transaction of the interest in real property in respect of which the lien was released, plus the amount of any tort or insurance settlement that has been (or is expected to be) received with respect to the property that is not reflected either directly or indirectly in the fair market value of the property at the time of the transaction; or A repayment amount which ensures that, immediately after the transaction, the ratio of the adjusted issue price of the loan to the fair market value of the interests in real property securing the loan is no greater than that same ratio immediately before the transaction. A Qualified Pay-Down Transaction, moreover, is deemed to exist if the servicer reasonably believes that a qualified amount has been paid in connection with the release of the lien. Under the Revenue Procedure, whether a servicer is entitled to reasonably believe that a qualified amount has been paid is determined by reference to the Final Regulations, under which, to arrive at a reasonable belief, a servicer may obtain a new or updated independent appraisal, use the sale price of the interest in a 12 An example in the Revenue Procedure illustrates that these amounts need not be paid contemporaneously with the release of the lien. In the example, the lender releases a lien in connection with the sale of two parcels of property, both of which had been damaged in a casualty. When the sale proceeds are received, the borrower sells the properties and remits the sale proceeds to the lender. On a later date, the borrower receives an insurance settlement and makes an additional payment on the loan with the settlement proceeds. Despite these timing differences, this transaction is treated as a Qualified Pay-Down Transaction. -5-
transaction where the property is sold and the obligation is assumed, or use some other commercially reasonable valuation method. 13 However, the Qualified Pay-Down Transaction rules will not permit the release of an outparcel for no consideration, even if that outparcel is assigned no value at origination and can be released under the terms of the loan contract. Accordingly, parties negotiating mortgage loan transactions that may be included in a REMIC and for which the loan documents will be executed after December 6, 2010 should consider these rules before including outparcels or other surplus land within the loan collateral. Alternatively, these lenders and borrowers may wish to assign an appropriate fair market value to an outparcel so it may be released through a Qualified Pay-Down Transaction. C. EFFECTIVE DATE The Revenue Procedure is effective for releases of liens on real property interests securing mortgage loans held by REMICs that occur on or after September 16, 2009, the effective date of the Final Regulations. * * * Copyright Sullivan & Cromwell LLP 2010 13 See Treas. Reg. 1.860G-2(b)(7)(ii). -6-
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