On November 8, 2007, the Department of the Treasury issued proposed regulations (the “Proposed Regulations”) regarding modifications of commercial mortgage loans held by real estate mortgage investment conduits (“REMICs”) that would expand the list of permitted loan modifications. The government had previously solicited input from tax practitioners and industry sources regarding whether to permit additional types of modifications that frequently arise in the commercial mortgage loan context. The Proposed Regulations would permit two additional types of modifications: (i) changes in the collateral for, guarantees on, or other forms of credit enhancement for a loan; and (ii) changes in the nature of a loan from recourse to nonrecourse. In each case, the loan must remain principally secured by an interest in real property after the modification.

In general, if a loan held by a REMIC is modified and the modification is a “significant modification,” then the modified obligation is treated as a newly originated obligation contributed to the REMIC and the unmodified obligation is deemed to have been disposed of by the REMIC. This can have a number of adverse tax consequences for the related REMIC, including a 100 percent prohibited transactions tax on any gain realized from the deemed disposition and, in some circumstances, imposition of a 100 percent prohibited transactions tax on the post-modification income from the loan or failure of the REMIC to continue to qualify as a REMIC. The current REMIC regulations regarding modifications provide for certain exceptions to this rule in the form of permitted modifications, most notably modifications when a loan is in default or default is reasonably foreseeable.

The Proposed Regulations would permit two additional types of modifications: 

  • 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 obligation, so long as the obligation continues to be principally secured by an interest in real property following such release, substitution, addition or other alteration; and 
  • a change in the nature of the obligation from recourse (or substantially all recourse) to nonrecourse (or substantially all nonrecourse), so long as the obligation continues to be principally secured by an interest in real property following such a change.

The Proposed Regulations provide that, for purposes of determining whether a loan continues to be principally secured by an interest in real property after a modification, the fair market value of the real property must be determined by an independent appraiser as of the modification date and measured against the adjusted issue price of the modified loan as of that same date. The preamble to the Proposed Regulations indicates the exception for permitted modifications applies only for purposes of determining whether the modified loan continues to be a qualified mortgage or the modification causes a prohibited transaction, but not for purposes of determining whether there was a deemed exchange of the unmodified loan for the modified loan, which would require that the REMIC report any gain or loss associated with such exchange.

Commentators had suggested including several additional permitted modifications that were not incorporated in the Proposed Regulations, such as provisions expanding acceptable methods and times for defeasance and permitting the addition or waiver of prepayment penalties, changes to the obligor or coobligor, and changes to the amortization schedule of a loan.

The Proposed Regulations would apply to modifications made to the terms of a loan on or after the date on which the Proposed Regulations are published in final form. The IRS has requested that any comments on the Proposed Regulations be submitted by February 7, 2008.