The deterioration of the real estate and credit markets has resulted in a sharp increase in the number of defaulted CMBS mortgage loans and with that a knee-jerk reaction from some quarters calling for changes to and “modernizations” of the real estate mortgage investment conduit (“REMIC”) provisions of the Internal Revenue Code that govern the formation and operation of the trusts that hold mortgage loans in CMBS.

One such initiative resulted in the IRS issuing Rev. Proc. 2009-45 on September 15, 2009 to provide guidance on the REMIC provisions and to allow for earlier and more proactive modifications of loans that might later default. As discussed below, this Revenue Procedure, while well intended, leaves many questions unaddressed and otherwise misses the mark.



A REMIC can only hold “qualified mortgages” and “permitted investments” for purposes of the asset test for qualification. A “qualified mortgage” is acquired by the REMIC by the end of the third month following the REMIC’s startup day.

Under the REMIC rules, if a qualified mortgage is modified in a manner that is “significant,” the original qualified mortgage is treated, for tax purposes, as having been exchanged for the loan as modified. This “new” loan is treated as not having been held by the REMIC at the time the REMIC was formed and may therefore not be considered a “qualified mortgage.” There are, however, helpful exceptions to this rule. One exception is that a significantly modified qualified mortgage continues as a qualified mortgage if the modification was occasioned by “default or reasonably foreseeable default.” See Jennifer O’Connor, “Defaulted Loan Modifications: Making Sense of the Code and Regulations” for a detailed discussion of the scope of the default modification rule.

Rev. Proc. 2009-45—An Overview

Some CMBS industry participants suggested that the current default modification rules needed clarification to allow special servicers greater flexibility to deal proactively with potential defaults of qualified mortgages. In particular, it was suggested that the default modification rules should expressly allow for a determination of a default that is “reasonably foreseeable” based on a borrower’s representation that, at some time in the future, the borrower may not be able to obtain financing for the collateral property in order to pay off its loan or that the loan may otherwise default. This position was adopted by the IRS in Rev. Proc. 2009-45, provided the special servicer makes a “diligent contemporaneous determination” of the risk of default and has no reason to know that any borrower representation of a potential default may be false.

Not all loans held by REMICs fit under Rev. Proc. 2009-45. Coverage under Rev. Proc. 2009-45 is not afforded to modifications prior to January 1, 2008. In addition, Rev. Proc. 2009-45 is not available if, as of the three month period beginning on the REMIC’s startup day, more than 10% of the stated principal of the total assets of the REMIC were, at the time they were contributed to the REMIC, overdue by at least 30 days or loans on which a default was reasonably foreseeable.

A loan fitting within the scope of Rev. Proc. 2009-45 can be modified without concern that the modification may subject the REMIC to tax, if based on the all the facts and circumstances, the servicer “reasonably believes” that there is a “significant risk” of default of the loan at maturity or some early date. This belief must be based on a “diligent contemporaneous determination” of the default risk and can take into account a factual representation made by the borrower, provided the servicer does not have reason to know that the representation is false. In clarifying this standard, the IRS noted that there is no maximum time period for the determination and that, under the appropriate circumstances, the servicer may reasonably believe that there is a significant risk of default even if the potential default is more than one year in the future. Finally, the servicer must reasonably believe that the modified loan presents a “substantially reduced risk of default” as compared to the loan prior to the modification.

Like any revenue procedure, Rev. Proc. 2009-45 is issued by the IRS and only reflects the IRS’s position on a legal issue, in this case the “reasonably foreseeable default” rule. Rev. Proc. 2009-45 does not change the law on this issue and loan modifications not fitting under the criteria of Rev. Proc. 2009-45 may not cause REMIC tax problems if these modifications otherwise fall under the REMIC exception for modifications of loans that are occasioned by the borrower’s “default” or “reasonably foreseeable default.”

Rev. Proc. 2009-45 is retroactive to January 1, 2008. The IRS apparently believes that the standards in Rev. Proc 2009-45 represent an expansion of the types of loans where default is “reasonably foreseeable” and that retroactive application of the revised rule is necessary to relax the existing, more restrictive rule in order to avoid putting at risk many REMIC trusts that modified loans during 2008.

Finally, the servicer must “reasonably believe” that there is a “substantially reduced risk of default” for the loan following the modification. This may limit the modifications the servicer can make.

Potential Problems

Clarifying the universe of “reasonably foreseeable defaults” to include potential defaults that fit under Rev. Proc. 2009-45’s criteria and that may be based, in part, on borrower representations of possible future defaults misses the mark.

In the current environment, there are very few loan modifications that a special servicer is permitted and willing to undertake under an existing Pooling and Servicing Agreement (or “PSA”) that would not be permitted under the prior “reasonably foreseeable” default standard. What’s more, a number of the modifications described in Rev. Proc. 2009-45 may not cause REMIC tax problems even if the borrower’s default is not considered “reasonably foreseeable.” For example, whether or not a borrower’s default is “reasonably foreseeable” no REMIC tax problem results from an extension of a loan’s maturity by the lesser of 50% of the loan’s original terms or 5 years. Similarly, a change in a loan’s interest rate that impacts the loan’s yield by less than the greater of 25 basis points or 5% of the loan’s original yield will not cause a REMIC problem under any circumstances.

What the position adopted in Rev. Proc. 2009-45 fails to account for is that the issues in the current marketplace with respect to proactive modifications of potentially troubled loans are caused, not by any perceived limitations of the current REMIC rules, but rather from the express limitations in PSAs governing the special servicer’s duties to the REMIC’s certificateholders. Absent amendment, these limitations in existing PSAs will continue whether or not the class of permissible default modifications is expanded to include as “reasonably foreseeable defaults” those covered by Rev. Proc. 2009-45 or even if the REMIC rules were changed altogether to allow significant modifications of loans whether or not there is a potential borrower default.

Special servicers cannot, under the existing terms of a typical PSA, elect to modify loan terms without economic justification. This is an investor/PSA issue, not a REMIC tax qualification issue that can be remedied by clarifying the REMIC rules governing defaulted loan modifications. Under existing PSAs, the special servicer is required to take action that results in the highest return to the REMIC. It is difficult to suggest that a special servicer’s agreeing to modify a qualified mortgage years in advance of a perhaps tenuous potential default is more likely to be in the best interest of, and otherwise results in a better return to, the REMIC’s investors than would the other possible strategies available to the special servicer. Such strategies include: a wait-and-see approach, a foreclosure, or a future modification at the time when borrower’s potential default is more concrete, all of which allow the special servicer to consider options in greater detail.


The IRS’s clarification in Rev. Proc. 2009-45 of the class of “reasonably foreseeable defaults” to include as potential defaults those that may be based, in part, on borrower representations of future defaults fails to address the cause of the perceived problem of an unwillingness of the special servicer to undertake proactive loan modifications of a potentially defaulting loan. Special servicers typically elect not to modify the terms of a borrower’s potentially troubled loan not because of REMIC tax concerns but rather because the special servicer does not think that any requested modification at that time complies with the provisions of the PSA that require the special servicer to modify qualified mortgages in a manner that is in the best interest of the REMIC’s certficateholders.