On November 9, 2007, the Internal Revenue Service (the “IRS”) issued proposed regulations (the “Proposed REMIC Regulations”) that would permit certain types of modifications to commercial real estate mortgage loans held by a real estate mortgage investment conduit (“REMIC”) without jeopardizing the qualification of the REMIC or causing a prohibited transaction with respect to the mortgage loan.1 The Proposed REMIC Regulations would permit:

(i) modifications that release, substitute, add or otherwise alter a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a recourse or nonrecourse obligation; and

(ii) a change in the nature of the obligation from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse);

provided that the mortgage loan continues to be “principally secured” by an interest in real property after the relevant modification (i.e., the loan-to-value (LTV) ratio is not greater than 125%). In addition, the Proposed REMIC Regulations require an independent third-party appraisal to be prepared at the time of the modification to establish the fair market value of the mortgaged property. Further, the preamble to the Proposed REMIC Regulations notes that even if a modification does not jeopardize the qualification of the REMIC or cause a prohibited transaction, the REMIC residual interest holder may recognize taxable gain or loss as a result of the modification.

The Proposed REMIC Regulations are the first guidance issued pursuant to the IRS’s pilot program for soliciting industry input on technical tax issues.2 Although the stated purpose of the Proposed REMIC Regulations is to address the concerns raised by the commercial real estate industry that the existing REMIC regulations do not adequately accommodate legitimate business needs in the commercial mortgage securitization market, they do not incorporate all the issues raised by industry participants and, in fact, raise some new concerns. In addition, the Proposed REMIC Regulations contain what appear to be technical errors that will need to be addressed before final regulations are issued.

The Proposed REMIC Regulations are not effective until they are published in final form and will apply prospectively to mortgage loan modifications made after that date.

Loan Modifications and the REMIC Rules

The REMIC provisions of the Internal Revenue Code were enacted by Congress in 1986 to be the exclusive means of issuing multiple classes of securities backed by a fixed pool of real estate mortgages without the imposition of an entity level tax. To ensure that REMICs remain static investment vehicles, REMICs are subject to several requirements regarding their asset composition, and are generally prohibited from actively managing their assets. In general, a REMIC has three months to acquire its initial assets and two years to substitute a new mortgage loan for a defective one. Substitutions after that date are not permitted, and the disposition of a performing mortgage loan generally constitutes a “prohibited transaction,” subjecting the REMIC to a 100% penalty tax on any gain.

Because the collateral securing commercial mortgage loans are income-producing properties, borrowers under commercial mortgage loans held by a REMIC may request the servicer to change the terms of their mortgage loans in the ordinary course of managing their properties, reserves, transfers, etc. Treasury regulations governing the modification of all debt instruments (including mortgage loans) provide that if the change to the terms of a debt instrument constitutes a “significant modification,” then the original obligation is deemed to be exchanged for the modified obligation at the time the modification occurs. Thus, if a REMIC were to significantly modify a mortgage loan more than three months after the startup day (two years for a loan subject to a breach of representation) and the mortgage loan was not in default (or default was not reasonably foreseeable), then the deemed exchange would be a prohibited transaction and would disqualify the mortgage loan and possibly the REMIC itself. These limitations have made it difficult for servicers to distinguish between permissible and impermissible modifications and stymied borrowers making legitimate business requests.

The existing REMIC regulations provide that certain alterations in the terms of a mortgage loan held by a REMIC are not treated as modifications even if those changes would otherwise constitute a significant modification of the mortgage loan under the general debt modification regulations. These are changes occasioned by (1) default or reasonably foreseeable default, (2) assumption of the mortgage loan, (3) waiver of a due-on-sale or due-on-encumbrance clause, or (4) adjustment of the interest rate on a convertible mortgage.3 These exceptions were adopted in 1992 and accommodated the most frequent issues that arose at that time in the context of residential mortgages, but predated the growth in the market for commercial mortgage loans and therefore are inadequate to deal with the complex issues that arise in the day-to-day administration of commercial mortgage loans.

Issues Raised by the Proposed Regulations

(1) Principally secured test. Under the existing REMIC regulations, a mortgage loan’s satisfaction of the “principally secured” requirement is tested either at origination or at the REMIC’s closing date. A decline in the value of real property after the testing date does not disqualify a mortgage loan. However, under the Proposed REMIC Regulations, a substantial change in the collateral, a guarantee or other credit enhancement, or a change from recourse nature to nonrecourse is only allowed if a new “principally secured” test is met. While it would be sensible for the regulations to prohibit a release or substitution of collateral that would cause a mortgage loan to fail the principally secured test, there should be no policy concern if, for example, (a) a release is accompanied by a principal pay down that maintains or improves the LTV ratio of the mortgaged property, (b) a property of equal or greater value is substituted for a removed property or (c) property is added that improves the LTV ratio. Furthermore, there is no reason to re-test the “principally secured” nature of the mortgage loan if the change is to a guarantee or other form of credit enhancement, because these do not affect the value of the mortgaged property.

(2) The appraisal requirement. The qualified mortgage test that applies at the inception of a REMIC does not require that the LTV ratio be established by any particular method. To require an appraisal by an independent appraiser in order to permit a modification is a potentially onerous new requirement. An appraisal can be time-consuming and expensive, particularly if the mortgage loan is secured by multiple properties. Less cumbersome alternatives exist, such as brokers’ price opinions and “desktop” appraisals by the servicer that use usual appraisal methodologies. The cost of such an appraisal will lie either with the borrower, who may be unwilling to bear it, or with the REMIC itself, causing unexpected losses to subordinate certificateholders.

(3) What is a “substantial” amount? Under existing REMIC regulations, servicers typically require an opinion of counsel to determine whether a “substantial” change in collateral, a guarantee, or credit enhancement will cause a disqualifying “significant modification” of a mortgage loan. The Proposed REMIC Regulations will still require this legal judgment or order to determine whether the “principally secured” test applies and whether an appraisal must be obtained. This requirement eliminates the greater efficiency sought by servicers.

(4) Unintended effect on non-substantial and unilateral changes. By providing that a mortgage loan ceases to be a qualified mortgage unless its lien is released in compliance with the above rules for altering a “substantial amount” of the collateral, the Proposed REMIC Regulations could be read to disallow (a) a non-substantial release of collateral and (b) a unilateral change by the borrower that the lender cannot prevent, which would not have been “significant modification” under the general debt modification regulations in the first place. These implications are likely unintentional and can be changed through technical corrections.

(5) Changes from nonrecourse to recourse. As drafted, the Proposed REMIC Regulations cover a change from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), but not vice versa. However, the preamble to the Proposed REMIC Regulations appears to contemplate that a change from nonrecourse (or substantially all nonrecourse) to recourse (or substantially all recourse) would also be allowed. This glitch should be corrected in final regulations.

(6) Industry proposals not included. In response to IRS Notice 2007-17, commentators suggested that any new regulations expressly apply to the following modifications: (a) changes in a permitted prepayment date or defeasance provision, (b) the substitution of a new obligor or the addition or deletion of a co-obligor, (c) the imposition or waiver of a prepayment penalty or other fee, and (d) a change in a principal payment schedule following a prepayment. The Proposed REMIC Regulations do not include these changes. The preamble to the Proposed REMIC Regulations explains that these suggestions were not adopted because either the modification is adequately dealt with under the general debt modification regulations or, in the case of defeasance, no expansion of the current provisions is warranted. The Proposed REMIC Regulations also fail to adopt the industry proposal that the REMIC exceptions for modifications be extended to grantor trusts that hold mortgage loans, leading to potentially different treatment depending on whether a REMIC or grantor trust is used.


The Proposed REMIC Regulations broaden the permissible mortgage loan modifications in a way that should help property and loan administration. However, as drafted, the Proposed REMIC Regulations do not significantly reduce compliance issues for servicers and trustees in responding to requests for changes in loan terms or reduce the expense and time needed to process such requests. Further, the new appraisal requirement would add time and expense without any practical necessity. Finally, the Proposed REMIC Regulations will not avoid the need to determine if a modification results in the recognition of gain or loss to the REMIC, and therefore to the REMIC residual holder.

The IRS has requested comments and requests for a public hearing, due by February 7, 2008.

A copy of the Proposed REMIC Regulations is attached to this memorandum.