This edition of the REO Advisor examines the parameters of the REO holding or “grace period" and explores the limits of reconstruction projects at REO properties.

Example 2. On behalf of a REMIC, the special servicer recently foreclosed on a warehouse in Florida. Shortly after the foreclosure, the REO property suffered significant damage caused by a hurricane. The roof of the warehouse was blown off which then caused the collapse of the entire West side wall of the building. The special servicer is assessing the scope of the rehabilitation work and, also, a possible increase in the usable square footage of the warehouse (given a recent increase in demand for warehouse space) by changing the footprint of the building as part of the effort to rebuild the collapsed West side wall. Can the special servicer engage in this construction project?

Answer: It will be possible for the REMIC to repair the warehouse to its original configuration but any proposed expansion of the building will not be permitted. A REMIC will be subject to a 100% prohibited transaction tax on any income which it generates from construction activities at the REO property. This potential tax requires the special servicer to carefully consider any REO construction plans. The good news is that not all construction activities are treated the same. In the above example, the special servicer’s reconstruction of the warehouse to replace the roof, and any other construction which is undertaken solely to repair the damage caused by the hurricane, will not be considered as construction activity that would be subject to the prohibited transaction tax. This is a concession granted to REMICs in the Regulations that recognizes that REMICs need to repair, maintain, and restore REO properties in order to be able to operate these properties in the manner in which they acquired them. This concession is, however, limited and the REMIC is not allowed to look to the repair and maintenance exception to reposition an REO asset in a manner that is different following the construction. Accordingly, the special servicer’s plan to rebuild the collapsed West side wall of the warehouse in a configuration other than the original, pre-hurricane, configuration would cause concern because that construction activity would increase the original square footage of the warehouse thus likely increasing its value, useful life, and effectively changing the REO property from that which was originally acquired through foreclosure. In this case, and in order to avoid the REMIC being taxed in connection with this construction activity, the special servicer should rebuild the collapsed wall to its original specifications and configuration. See Kilpatrick Townsend, Servicer Survival Guide 2017-2018 Edition, Tom Biafore and Steve Edwards "The Dos and Don'ts of REO: Prohibitions on Trade or Business and New Construction" for a detailed discussion of the limitations of a REMIC in connection with construction at REO properties.