The Internal Revenue Service and U.S. Department of Treasury recently published new Treasury Regulations (Regulations), promulgated under Section 860G of the Internal Revenue Code and Revenue Procedure 2009-45, which ease the Code's restrictions on modifications of commercial mortgage loans held by real estate mortgage investment conduits (REMICs). Although the new guidance does not address contractual restrictions on servicers' authority to modify commercial mortgage loans, the IRS and Treasury seek to make clear that the federal income tax tail will not wag the loan-servicing dog.


Commercial mortgage loans are often held in REMICs, which are pass-through entities for federal income tax purposes. Under prior rules, a REMIC risked disqualification (and, thus, taxation as a corporation) if a loan it held was significantly modified before a default was "reasonably foreseeable," unless the modification was occasioned by specifically enumerated events.

Because "significant modification" can cause a debt to be treated as if it were reissued in exchange for the unmodified debt under general federal income tax principles (including the Section 1001 Regulations), economically sensible changes to the terms of a loan held by a REMIC could have severe adverse tax consequences. In practice, the "reasonably foreseeable" standard often was read narrowly and, as a consequence, holders and servicers of commercial mortgage loans held by a REMIC frequently were willing to negotiate modifications only when they determined that a default was imminent or had already occurred.

In the current environment of frozen credit markets, a dwindling tenant pool, and refinance opportunities that are few and far between, billions of dollars of commercial mortgage loans are still performing thanks to an interest-only, non-amortizing structure, often propped up by lender-funded interest reserves and principals "coming out of pocket" to make payments. Recognizing the danger this financial sword of Damocles presents to the U.S. economy, Treasury and the IRS sought to provide holders and servicers with additional flexibility to restructure commercial mortgage loans.

Recent Guidance

The new Regulations under Section 860G expand on prior proposed Treasury Regulations that provide exceptions to the general rule prohibiting significant modifications to loans held by REMICs. Under the Proposed Regulations, a modification was allowed, even if it was a significant modification under the Section 1001 Regulations, when the loan was in default or default was reasonably foreseeable or if the modification was occasioned by one of the following:

  • Assumption of the loan
  • Waiver of a due-on-sale or due-on-encumbrance clause
  • Conversion of an interest rate consistent with the terms of the loan documents

The new Regulations provide two additional exceptions:

  • Substitution or release of collateral
  • Modification to the recourse nature of the loan

Importantly, the two new exceptions apply only if the loan remains "principally secured" by an "interest in real property" following the modification, even if the modification is otherwise permitted by the underlying loan documents. This may have the unintended consequence of making certain modifications more difficult than before the new guidance was issued. The new Regulations provide two tests for determining whether that standard has been met: (i) The fair market value of the interest in real property securing the loan must be at least 80 percent of the loan’s issue price as of the date of the modification, or (ii) the fair market value of the interest in real property securing the loan must equal or exceed the fair market value of the interest in real property that secured the loan before the modification.

For purposes of the first test, a servicer may rely on an independent appraisal, an update of an existing appraisal, another commercially reasonable valuation method, or the sale price set forth in a purchase contract for a sale of the real property in connection with an assumption of the loan. For purposes of the second test, a servicer may rely on the valuation methods set forth above but may not rely on the sale price.

In addition to the Regulations promulgated by Treasury, the IRS issued Revenue Procedure 2009-45, which is designed to offer some clarity and comfort to those determining whether default is "reasonably foreseeable" for purposes of the REMIC rules. The Revenue Procedure provides a limited safe harbor for servicers to modify commercial mortgage loans without fear that the IRS will challenge the REMIC's tax qualification.

The Revenue Procedure allows loan modifications on or after January 1, 2008, if:

  • For the three-month period beginning with the formation date of the REMIC, no more than 10 percent of the stated principal of the REMIC's  assets was overdue by 30 days or more
  • Either the holder or servicer of the loan believes, based on all facts and circumstances, that there is a significant risk of default
  • Either the holder or servicer of the loan reasonably believes that the modification substantially reduces the risk of default

The belief of the holder or servicer must be based on a "diligent contemporaneous determination" of the risk of default, taking into account representations of the borrower and other relevant factual information. The IRS expressly stated that there is no maximum time for making such a determination, and therefore a holder or servicer may determine that a default is reasonably foreseeable even if the potential default will not occur within the year.

Investment Trusts

Some commercial mortgage loans are held in investment trusts that are grantor trusts for federal income tax purposes (Investment Trust). Unlike REMICs, Investment Trusts are not subject to the rigorous statutory requirements of Section 860A of the Code. However, an Investment Trust risks disqualification as a trust and treatment as a business entity (and, as a result, as a partnership for federal income tax purposes) if the Investment Trust can modify the investments held in the trust. As in the case of a REMIC, the effect of the Section 1001 Regulations is that an economically sensible modification to a commercial mortgage loan held by an Investment Trust could jeopardize the trust’s federal income tax status.

In the Revenue Procedure, the IRS announced that it would not challenge the tax status of an Investment Trust based on a modification to a loan where a default is reasonably foreseeable. This announcement affects only an Investment Trust's qualification as a grantor trust and not the underlying consequences to beneficiaries arising from such a modification.

Potential Hazards of Treasury and IRS Guidance

Both sets of guidance apply only to the tax classification consequences of modifying commercial mortgage loans held by REMICs and Investment Trusts. Neither the Regulations nor the Revenue Procedure affects the Section 1001 Regulations or changes any other tax consequences arising from modifications.

Importantly, notwithstanding the new IRS guidance, holders and servicers of commercial mortgage loans held in a REMIC remain bound by the terms of the applicable Pooling and Servicing Agreements (PSAs) to which they are parties. Accordingly, any contemplated modification must be reviewed and analyzed in the context of the applicable provisions of each related PSA. Although PSAs generally provide that any modification must (i) not constitute a "significant modification" under Section 860G and (ii) be reasonably likely to produce a greater recovery on a net present value basis than would a liquidation of the related asset, any modification must also be made consistent with "Accepted Servicing Practices" or the "Servicing Standard," the detailed definitions of which are specifically set forth in the related PSA.

Also set forth in PSAs are provisions governing who may make modifications and when. Generally, "Master Servicers" will document modifications made to performing loans, but the scope of a Master Servicer's authority to make modifications is strictly limited. In the distressed context, the Master Servicer’s primary role is to determine whether and when to "transfer" the loan to the "Special Servicer." The PSA usually provides guidance here via defined terms, such as "Specially Serviced Mortgage Loan" or "Servicing Transfer Events," which include thresholds such as: (i) a Scheduled Monthly Payment is more than 60 days delinquent; (ii) the borrower has entered into or consented to bankruptcy; or (iii) a material default has occurred or is imminent and is not likely to be cured by the borrower within 60 days. Once the loan has been transferred, PSAs generally provide the Special Servicer with much more latitude to make modifications, subject to the "net present value" test and the "Servicing Standard" described above. Both Master Servicers and Special Servicers, however, will often also be required to obtain the consent of certain classes of certificateholders, and in some cases the rating agencies, before making a modification.

Additionally, several PSAs expressly prohibit modifications that would be considered significant under the Section 1001 Regulations. Similarly, in the case of Investment Trusts, the trust documents may prohibit significant modifications as defined by the Section 1001 Regulations. Because the new guidance impacts only classification consequences, and not the Section 1001 Regulations, the holders and servicers of commercial mortgage loans may still have their hands tied by the PSAs.


Although the Regulations and the Revenue Procedure may not greatly expand the universe of potential modifications to commercial mortgage loans in light of contractual restrictions, both Treasury and the IRS have made it clear that they will not stand in the way of such modifications. As a result, where a default is "reasonably foreseeable," as that term has been expanded by the Revenue Procedure, the determination of whether and how to modify a commercial mortgage loan held in a REMIC or an Investment Trust will be driven by economics, underwriting, market conditions, the limitations of the PSAs, and the relationships among the parties, not the tax consequences.

If you have any questions regarding the Regulations and Revenue Procedure, please feel free to contact a member of Ballard Spahr's Tax or Commercial Real Estate Recovery Groups, including:

Wendi L. Kotzen | 215.864.8305 |
Wayne R. Strasbaugh | 215.864.8328 |
Dominic J. De Simone | 215.864.8704 |
Thomas A. Hauser | 410.528.5691 |
Kelly M. Wrenn | 202.661.2204 |



Copyright © 2009 by Ballard Spahr LLP.
(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.