The Internal Revenue Service on Monday, April 13 issued welcome relief to the securitization industry, providing that certain forbearances and related modifications to mortgages will generally not cause real estate mortgage investment conduits (REMICs) and other securitization vehicles to lose their special tax status if such modifications arise from new programs/procedures created by the CARES Act or by similar programs/procedures to address the coronavirus (COVID-19) emergency.
A substantial number of Federally and non-Federally backed mortgage loans are either already held by or are destined for various securitization vehicles, each type of which have rigid rules regarding the mortgage loans themselves and what modifications may be made once the mortgage loan has been securitized. The Revenue Procedure addresses the uncertainty regarding whether a forbearance granted due to a COVID-19 emergency could run afoul of the permissible modifications in two such securitization vehicles: REMICs and certain “investment trusts,” often referred to as “grantor trusts,” in the securitization context. The Revenue Procedure applies to (i) forbearances of any federally backed mortgage loan or Federally backed multifamily mortgage loan, and any related modification provided under Sections 4022 or 4023 of the CARES Act and (ii) forbearances of any mortgage loan not covered by (i) above that are (a) provided by a holder or a servicer, (b) agreed to by the borrower of any Federally or non-Federally backed mortgage loan, and (c) made under forbearance programs for borrowers experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency. The forbearance program must be identical or similar to the forbearance programs contemplated by servicers of Federally backed mortgage loans, as described in the CARES Act, and must be requested or agreed to by the borrower between March 27, 2020, and December 31, 2020.
Questions: Will a forbearance and any related modification of a mortgage loan held by a REMIC affect the qualification of such REMIC or result in a prohibited transaction? Will a forbearance and any related modification create a deemed reissuance of a REMIC regular interest?
Background: REMICs, governed by Sections 860A–860G of the Internal Revenue Code of 1986, as amended (Code) and the related Treasury Regulations, are the securitization vehicle most frequently used for mortgage loans. For an entity to qualify as a REMIC, certain of the requirements include that: (i) all of the interests issued by the REMIC must consist of one or more classes of regular interests and a single class of residual interests, (ii) the terms of any regular interest must be fixed on the “startup day” of the REMIC, and (iii) payments of principal on the regular interests may not be contingent, subject to certain exceptions such as due to defaults on mortgage loans or unanticipated expenses incurred by the REMIC. The assets of a REMIC must consist of substantially all “qualified mortgages” (but for a permissible de minimis amount equal to less than 1%, measured by the adjusted basis of such assets against the adjusted basis of the qualified mortgages). Subject to a few limited exceptions, a qualified mortgage must be transferred to a REMIC on the “startup day” thereof in exchange for REMIC regular or residual interests.
As a general matter, under the Treasury Regulations promulgated pursuant to Section 1001, a modification of a debt instrument (such as a mortgage loan) that rises to the level of a “significant modification” is treated as the exchange of the old debt instrument for a new debt instrument. Under the rules described above, if a forbearance and any related modification were “significant modifications,” the REMIC could be treated as disposing of an old mortgage loan (not permissible except in a limited number of circumstances) and acquiring a new mortgage loan (not permissible as per the rule described above). If one or more “significant modifications” were to result in more than a de minimis amount of the assets of the REMIC to consist of other than “qualified mortgages,” the REMIC could lose its qualification as a REMIC, which could subject the issuing entity to entity level taxation and/or potentially result in the REMIC regular interests not qualifying as debt instruments.
Further, REMICs may only dispose of qualified mortgages: (i) pursuant to the substitution of a qualified replacement mortgage for a qualified mortgage (or the repurchase in lieu of substitution of a defective obligation), (ii) pursuant to a disposition incident to the foreclosure, default, or imminent default of the qualified mortgage, (iii) pursuant to the bankruptcy or insolvency of the REMIC, (iv) pursuant to a qualified liquidation, (v) required to prevent default on a regular interest where the threatened default resulted from a default on one or more qualified mortgages, or (vi) to facilitate a clean-up call. Any other disposition is a “prohibited transaction” and is subject to a 100% prohibited transaction tax on the net income.
Revenue Procedure Conclusion: The forbearance and any related modification (i) will not be treated as resulting in a newly issued mortgage loan for purposes of the REMIC rules, (ii) will not be treated as a “prohibited transaction”, and (ii) will not result in a deemed reissuance of REMIC regular interests. Thus, there would be no related loss of status as a REMIC, entity level taxation or failure of REMIC regular interests to qualify as debt instruments.
Questions: Prior to acquisition by a REMIC, if a borrower is given a forbearance on a mortgage loan, will such forbearance create evidence that the REMIC has “improper knowledge” of anticipated default? Will the prior forbearance be taken into account in determining the origination date of the mortgage loan for REMIC purposes?
Background: Certain modifications are permissible within a REMIC, even if they would otherwise fall within the definition of a “significant modification” as described above. In particular, a modification that is “occasioned by default or a reasonably foreseeable default” of the mortgage loan will not be a significant modification for REMIC purposes.
In addition to qualified mortgages, a REMIC may hold certain permitted investments, one such permitted investment being “foreclosure property.” Foreclosure property is defined as property that would qualify under Section 856(e) of the Code as foreclosure property if acquired by a real estate investment trust (REIT) and that is acquired in connection with the default or imminent default of a qualified mortgage held by the REMIC. However, a REMIC cannot acquire property and treat it as foreclosure property under the “default or imminent default” standard if at the time it was acquired by the REMIC there was an intent to foreclose or if the REMIC knew or had reason to know that a default would occur (improper knowledge). If a REMIC were to foreclose on a mortgage loan and the acquired property did not qualify as “foreclosure property”, the REMIC could lose its REMIC status if as a result substantially all of its assets were not “qualified mortgages” or “permitted investments”.
Finally, mortgages contributed to a REMIC after the date of modifications under forbearance programs may, if those modifications were treated as “significant modifications,” have an origination date of the modification, which could trigger a re-testing of whether the mortgage constitutes a “qualified mortgage” as of such date, rather than upon its initial issuance.
Revenue Procedure Conclusion: The prior forbearance (and all related modifications) (i) will not be treated as evidence that a REMIC had improper knowledge of an anticipated default and (ii) and will not be taken into account in determining the origination date of the mortgage loan for REMIC purposes.
Additional REMIC Revenue Procedure Guidance: For mortgage loans held by REMICs, delays and shortfalls in payments associated with or caused by covered forbearances (and any related modifications) described in Section 5.01 of the Revenue Procedure are contingencies that may be disregarded under the REMIC rules and as a result, a REMIC regular interest does not fail to qualify as a regular interest because of such contingencies. Contingencies that may be disregarded include excess fees paid for specially serviced loans, an inability of a servicer to advance funds, or payments that are subject to forbearance not accruing interest.
Question: Will forbearances (and related modifications) to mortgage loans held in investment trusts result in the trust being deemed to have a “power to vary its investment”?
Background: Under the Section 7701 Treasury Regulations, an “investment trust” does not qualify as a trust (and instead may be treated as a corporation or as a publicly-traded partnership taxed as a corporation) if there is a power to vary the investment of the certificate holders of the trust.
Revenue Procedure Conclusion: For mortgage loans held by investment trusts, forbearances (and all related modifications) do not manifest a power to vary the investment of the certificate holders if the forbearances are described in Section 5.01 of the Revenue Procedure or are described in Section 2.07 of the Revenue Procedure and the relief was requested or agreed to between March 27, 2020, and December 31, 2020, and was granted as a result of a borrower experiencing a financial hardship due to the COVID-19 emergency.
While the Revenue Procedure provides much needed relief guidance for COVID-19 emergency-related mortgage forbearance and modifications, it is limited in scope and specifically provides that no inferences should be drawn about whether similar consequences would be obtained if a transaction falls outside the scope of the guidance. Thus, several questions remain unanswered.
Since the guidance applies only to mortgage loans, the IRS does not address whether grantor trusts that hold non-mortgage loan assets receive any relief to “significant modifications” under the Section 1001 Treasury Regulations. In addition, the Revenue Procedure does not address whether the forbearance period of a mortgage loan is included in that loan's delinquency period, which would clarify whether such a loan would be treated as “seriously impaired” under the taxable mortgage pool rules.
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Richard C. LaFalce