On August 17, 2010, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2010-30 (the “Rev. Proc.”), which established safe harbors under which a REMIC can release collateral from the lien of a mortgage securing a loan held by the REMIC. The Rev. Proc. is effective immediately and applies only where the REMIC cannot meet the “principally secured by an interest in real property” test (the “Principally Secured Test”) established in regulations published on September 16, 2009 (the “Final Regs”) (sometimes referred to as the “80% test”). If the Principally Secured Test is satisfied, the servicer need not comply with the provisions of the Rev. Proc. Under the Final Regs, the Principally Secured Test prohibits the release of a lien on real property collateral securing a loan held by a REMIC unless, following the release, the loan continues to be “principally secured by” an “interest in real property” (i.e., the fair market value (the “FMV”) of the real property must be at least 80% of the loan’s unpaid principal balance OR the FMV of the real property securing the loan immediately after the modification must equal or exceed the FMV of the real property securing the loan immediately before the modification).

Concerns with the Final Regs.

The Rev. Proc. is apparently intended to address the concern of numerous commentators (including this firm) who observed that the Final Regs had made it difficult or impossible for a REMIC to release property, even where the original loan documents gave the borrower the right to demand the release. Because there is no relief in the Final Regs from the “principally secured by” requirement in such a case, a servicer could potentially have been placed in a very difficult position where a borrower had a legal right to the release of a lien but doing so would cause the loan not to be “principally secured by” the remaining real estate collateral.

The other aspect of the Final Regs about which commentators expressed concern was that the Final Regs contain no exception for loans in default. As a result, a special servicer could be prevented from releasing collateral for a defaulted loan in exchange for a partial pay-down of the loan even if the loan did not meet the “principally secured by” requirement before the release, even if the transaction were in the best interests of the REMIC.

While the Rev. Proc. addresses some of the problems created by the Final Regs with respect to collateral releases for defaulted loans and releases that are provided for under the terms of the existing loan documents, immaterial or insignificant collateral releases that were never thought to cause a problem prior to the passage of the Final Regs continue to pose potential problems for both borrowers and servicers. This is particularly the case when the servicer or borrower has practical difficulties establishing that the loan satisfies the Principally Secured Test following the release, as can be the case when a loan is secured by a large portfolio of collateral properties and the collateral release relates only to a small portion of one of the properties. In these cases, it may be necessary for the borrower to obtain values of all of the collateral properties to establish that the loan meets the Principally Secured Test even though the collateral release relates only to a small portion of one of the properties.

Safe Harbors in the Rev. Proc.

The Rev. Proc. attempts to address these concerns by stating that the IRS will not challenge the status of a loan as a qualified mortgage as the result of releases of liens in two sets of circumstances:

Grandfathered transactions. The first safe harbor is for a “grandfathered transaction,” in which (1) the lien release occurs by operation of the terms of the loan documents; and (2) the terms providing for the lien release are contained in a document executed no later than December 6, 2010. This provision is designed to permit releases where the borrower has a unilateral right in the loan documents, whether or not the loan is principally secured by an interest in real property following the release.

This safe harbor may provide an opportunity until December 6, 2010, for servicers to amend existing loan documents to permit lien releases, even where the release takes place after that date. The amendment itself must be permitted by a separate exception to the prohibition against modifying mortgages held by a REMIC (e.g., the exception for modifications “occasioned by default or a reasonably foreseeable default”).

Another point of caution in connection with the safe harbor for a grandfathered transaction is that the transaction must be truly unilateral. There must be no requirement of consent or waiver by the servicer, and any conditions must be based on objective standards. If, for example, the documents require that a certain debt service ratio be met prior to the release, the servicer cannot waive even a small variance from that ratio.

Qualified Pay-Down Transactions. The second safe harbor is for a “qualified pay-down transaction,” where the lien release is accompanied by a payment by the borrower resulting in a reduction in the adjusted issue price (typically, the unpaid principal balance, the “UPB”) of the loan by an amount at least equal to one of the following:

1. Proceeds. The sum of the net proceeds from (a) an arms-length sale of the property to an unrelated person, (b) a condemnation award with respect to the property, and (c) where there is also an arms-length sale or a condemnation, an insurance or tort settlement with respect to the property; OR

2. FMV Ratio at Origination. An amount required under the loan agreement that equals or exceeds the product of (a) the UPB of the loan, multiplied by (b) the ratio of (i) the FMV at the time of the origination of the loan of the released property to (ii) the FMV at the time of the origination of the loan of all of the property that secured the loan immediately before the lien release; OR

3. FMV of Released Property. The FMV of the released property (at the time of the release), plus any tort or insurance settlement that is expected to be received with respect to the property (unless such settlement is already included in the FMV); OR

4. FMV Ratio at Release. An amount that results, immediately after the release, in the ratio of the UPB of the loan to the FMV of the property (the LTV) that continues to secure the loan being no greater than what that ratio was immediately before the release.

The FMVs in paragraphs 3 or 4 can be based on the servicer’s reasonable belief but must be based on a current appraisal of the property, an update to the origination appraisal that takes into account the passage of time and changes to the collateral property, the sales price of the real property, or a catch-all of “some other commercially reasonable valuation method.” In addition, a “reasonable belief” does not exist if the servicer has reason to know that the value provided is incorrect.

Some Questions and Answers

As with the safe harbor for grandfathered transactions, the safe harbor for qualified pay-down transactions solves some problems but raises new questions.

Calculating Net Proceeds. First, the Rev. Proc. states almost as an afterthought that “net proceeds” for purposes of qualified pay-down transactions is the “amount realized” from the transaction under Code Section 1001, as if everyone were well versed in the nuances of the “amount realized” calculation under that Section. Code Section 1001 itself does not specifically address the issue of whether expenses incurred in the release and disposition of the real property reduce the amount realized from the transaction. Issues will necessarily arise related to the impact on the amount realized/net proceeds calculation of such expenses as attorneys’ fees, sales brokerage commissions, and advertising expenses. Except where the seller is a dealer in real property (which could conceivably be the case for some borrowers), those expenses should reduce the net proceeds, but the determination of what constitutes “net proceeds” will require coordination with the seller/borrower to make certain that its tax treatment of these expenses is consistent with the REMIC’s characterization.

Application of Pay-down Amount. Note too that all of the net proceeds must be used to pay down the loan. In some cases, the servicer could prefer to put all or a portion of the net proceeds in a reserve rather than applying them to principal, but doing so is not permitted by the Rev. Proc.

The pay-down provisions apply with respect to the borrower’s obligations under the loan documents. Depending upon the provisions of the relevant pooling and servicing agreement (the “PSA”), however, the servicer may elect – or be required – to apply the cash received to satisfaction of other liabilities (e.g., property protection or other advances whether or not these amounts have been added to the borrower's obligation under the terms of its loan). The important concept under the Rev. Proc. is that the net proceeds reduce the principal owed by the borrower, not how the cash received is booked by the REMIC.

How the principal prepayment is applied under the loan documents may also raise issues for the servicer in applying the qualified pay-down transaction exception. If the prepayment is not permitted in the loan documents, as is generally the case in fixed rate CMBS transactions, a question arises as to whether payments of debt service must be reamortized or principal must be applied to reduce the final principal payments. Given the purpose of the qualified pay-down transaction exception (to ensure that the collateral is used to pay down the loan), we believe the pay-down amount must be used to reduce the current balance of the loan (either by shortening the amortization period or by reducing payments over the existing term of the loan), rather than being held in suspense, but the issue is not free from doubt. If the pay-down amount was simply held in suspense for application to the final balloon payment it would seem, at a minimum, that the servicer hoping to qualify the transaction under the Rev. Proc. would have to commit to use the pay-down amount only to reduce the principal amount of the loan. Any use of funds held in suspense for any other purpose (expenses, interest, etc.) would not be in line with the requirement of the Rev. Proc that the pay-down amount be used to reduce the adjusted issue price of the related loan.

The Rev. Proc. does not recognize that prepayments of performing loans are usually not permitted in loans held by REMICs, because purchasers of interests in REMICs typically demand that their cash flows be predictable. It is rare, for example, that 100% of condemnation proceeds received in a transaction are directed by the loan documents to be applied to principal on the loan. Rather, these proceeds are applied differently depending on the size of the condemnation, requirements to restore, and other factors specific to the transaction.

In cases where the release relates to a performing loan and the applicable PSA governing the securitization does not permit the borrower to partially prepay its loan, the servicer will need to be comfortable that the loan will satisfy the Principally Secured Test following the release or is part of a grandfathered transaction, as a pay-down of the loan under the qualified pay-down transaction rules will not be permissible under the PSA in these circumstances.

Cross-Collateralized and Defaulted Loan Assumptions. Finally, there will be questions under the Rev. Proc. raised in connection with releases of property from cross-collateralization provisions and by releases of multiple parcels where the servicer needs to use separate forms of qualified pay-down transactions in order to take advantage of the Rev. Proc. Similarly, assumptions in which only a portion of such collateral is being acquired will inevitably raise difficult issues. For example, if a loan collateralized by multiple parcels is in default and the servicer wishes to have only the portion of the loan that is collateralized by a single parcel assumed by a third party (e.g., because that parcel is more easily marketable or because of differences in enforcement laws among the jurisdictions in which the parcels are located), we believe that, as to the existing loan, the amount assumed with respect to the released parcel can be treated as “net proceeds” for purposes of the exception for qualified pay-down transactions. As to the new loan (i.e., the portion of the loan that has been assumed by the third party), a portion of the collateral has been released (i.e., the other parcels that formerly secured the entire loan), but we believe that the new loan should also satisfy the exception for qualified pay-down transactions if the assumption was to a bona fide third party and should also satisfy the Principally Secured Test after the “release.” The technical application of the provisions of the Rev. Proc. in this fact pattern are not clear, however, so further analysis may be necessary depending on the specific facts of a given transaction.

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It is clear that the Rev. Proc. will present difficult issues of interpretation and will add yet another layer of complexity to the servicer’s review of proposed transactions. If nothing else, many attorneys’ math skills will be severely challenged by the new rules. Once again, the IRS has attempted to correct problems created by a previous set of rules but has inadvertently created new problems that servicers and their counsel must now address