New IRS Rule Allows Commercial Loan Modifications Before Default

Earlier this week, the IRS issued several highly anticipated guidelines that will allow certain borrowers who are current on their commercial mortgage loan obligations to negotiate and modify their loans without triggering an adverse tax consequence to the holder of the loan. The guidance allows loan servicers to modify these loans regardless of when they mature and whether they are performing if the servicer believes there is a significant risk of future default under the loans.

Loans that mature within the next few years face underwriting standards substantially more stringent than when the loans were originated. Consequently, many loans that are now performing face a significant risk of default at maturity.

The new IRS guidelines specifically relate to commercial mortgage loans held by real estate mortgage investment conduits (REMICs). Tax law precludes REMICs from reinvesting mortgage loan proceeds and acquiring "new" loans.

The problem is that a mortgage loan that is substantially modified is generally treated as a "new" loan for these purposes. There are exceptions to this prohibition against acquiring new loans—as long as the loan modification creating the new loan occurs in a workout setting. But these exceptions apply only if the old loan is currently in default or there is a reasonably foreseeable default.

Potentially Defaulting Borrowers Can Now Negotiate

The new guideline (Revenue Procedure 2009-45) allows loan modifications if the loan servicer reasonably believes there is a significant risk of default on the loan, and the modified loan will present a substantially reduced risk of default. This relaxation of the requirements allows potentially defaulting borrowers to approach their loan servicers prior to default to negotiate and modify their existing loan obligations.

List of Loan Modification Exceptions Expanded

In addition, the IRS also issued final regulations (TD 9463) expanding the list of exceptions that are not considered "significant modifications" of an obligation held by a REMIC. These final regulations, which take effect September 16, expand the list of exceptions to include loan modifications that release, substitute, add, or otherwise alter a substantial amount of the collateral or change the recourse nature of the loan.

Eighty Percent Test Remains in Place

The news on the tax front is not all good, however. Many stakeholders had hoped the new guidance would relax requirements for determining whether a modified loan continues to qualify as "principally secured by an interest in real property"—a critical requirement for an REMIC.

The current test for meeting this standard is the so-called 80 percent test. That is, the fair market value of the underlying real estate must cover at least 80 percent of the debt.

There were hopes that loan modifications under the new guidelines would not require redetermination of whether the 80 percent test continued to be satisfied as long as the loan originally met the test. While the new guidance permits certain internal valuation estimates rather than requiring external appraisals, the IRS was unwilling to eliminate the requirement to reapply the 80 percent test at the time of a significant modification.