Commercial Mortgage Modifications: IRS Issues Guidance Permitting Certain Liens Securing Loans Held in Real Estate Mortgage Investment Conduits to Be ReleasedSullivan & Cromwell LLP - August 18, 2010
On August 17, 2010, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2010-30 (the “Revenue Procedure”), which clarifies the circumstances in which liens securing commercial mortgage loans held by real estate mortgage investment conduits (“REMICs”) may be released.
The Revenue Procedure is a follow-on to final regulations (the “Final Regulations”) that were issued by the IRS and the Treasury Department in September 2009. The Final Regulations provide that the release of a lien on a mortgage loan held in a REMIC will not cause that loan to lose its status as a “qualified mortgage” so long as: (i) the lien release does not result in a “significant modification” to the mortgage loan under either general tax law principles or the special exemptions from the definition of a “significant modification” applicable to REMICs, and (ii) the loan remains “principally secured by real property” after the release of the lien. The latter requirement – that the loan be retested for “principally secured” status after the lien release – created concern because many existing mortgage loans already included in REMICs permit the borrower to obtain a lien release without such retesting.
Under the Revenue Procedure, the IRS will not apply the retesting requirement introduced by the Final Regulations to a “Grandfathered Transaction,” i.e., a lien release that occurs by the operation of the terms of a debt instrument (including the exercise of a unilateral borrower option), if the terms providing for the release are contained in a contract executed on or before December 6, 2010. In addition, the Revenue Procedure provides a relief mechanism from this retesting requirement for a “Qualified Pay-Down Transaction,” under which a “qualified amount” is repaid by the borrower. The Qualified Pay-Down Transaction rules provide considerable flexibility and generally exempt a lien release from the retesting provisions of the Final Regulations in cases where the borrower repays the loan in an amount that is at least equal to the fair market value (or net proceeds available from an arm’s-length sale and / or condemnation) of the property to be released, plus other amounts that are (or in certain cases, are expected to be) received from a tort or insurance award. In addition, a lien release may qualify as a Qualified Pay-Down Transaction if the borrower makes a payment that, in effect, either: (i) repays at least the portion of the loan allocable to the property on which the lien was released (as measured by fair market value at the time the loan was originated), or (ii) repays enough of the loan so the overall degree to which the loan is collateralized by real property is not reduced. Under the Revenue Procedure, however, the release of an “outparcel” that was assigned no value at origination (and accordingly can be released without payment under the terms of the loan) will generally not constitute a Qualified Pay-Down Transaction, and would avoid retesting under the Final Regulations only if it were a Grandfathered Transaction. Accordingly, it may be advisable to assign an appropriate fair market value to an “outparcel” when a mortgage loan is originated so the “outparcel” may be released through a Qualified Pay-Down Transaction.
The Revenue Procedure, like the Final Regulations, applies only to REMICs and not to fixed investment trusts. The Revenue Procedure is effective for lien releases occurring on or after September 16, 2009, the effective date of the Final Regulations.