Last month, the IRS provided two pieces of guidance that will have a dramatic effect on how servicers deal with commercial mortgage loans. The first addresses requests from industry associations for the modernization of the REMIC rules. The second set of amendments responds to a proposal made by the Real Estate Roundtable to address liquidity concerns. The former guidance expands the list of permitted REMIC loan modifications to include ones that are often made to commercial mortgages outside of a REMIC structure. As it stands, significant changes are treated as a new mortgage issuance unless an exemption is available. Under the old regulations, exemptions included modifications due to a default or a reasonably foreseeable default, assumptions, waiver of due on-sale provisions, and interest-rate conversions as the result of a borrower's exercise of a unilateral option to convert Modifications outside of these exceptions by a REMIC could lead to its disqualification as a pass-through vehicle, resulting in taxation. For this reason, servicers have been very careful to limit modifications. But under the new regulations, additional changes would be permissible without the loan being treated as new debt under two conditions: changes in collateral, guarantees and credit enhancement of an obligation, as well as changes to the recourse nature of an obligation.

The IRS has made the decision making process somewhat clearer, though not all questions have been answered. For example, the final regulations permit collateral changes, including lien releases, as long as a mortgage continues to be principally secured by real property after giving effect to any releases, substitutions, additions or other alterations to the collateral, providing the fair market value equals 80% of the adjusted obligation. While the IRS has provided an alternative methodology for meeting the 80% test by permitting changes that do not decrease the value of the collateral, it requires retesting in the event of lien releases pursuant to a borrower's unilateral loan option. Such an event could create a conflict between the servicer's contractual obligations to the borrower and the tax treatment if declines in the remaining collateral result in a failure to meet the 80% test. The final regulations also expand the methodology a servicer can use to determine if a loan meets the 80% test, or is secured by property of equal value before and after the modification. It also clarifies that changes in the nature of an obligation are permitted as long as the obligation continues to be principally secured by an interest in real property.

Servicers will still be bound by the contractual terms of the loans they administer, which may conflict with the provisions of the new regulations. Furthermore, servicers are restricted by the servicing standard contained in the Pooling and Servicing Agreements (PSA). The standard says special servicers must act in the best interest of all certificate holders in a REMIC, with an aim of achieving maximum recovery on a net present value. This duty will override any modification permitted by the new regulations, which could lead to discontent on the part of borrowers who view the new changes as broadening a servicer's powers. Meanwhile, pending maturities of numerous CMBS in the midst of the liquidity crisis has led the IRS to issue a new revenue procedure expanding the circumstances in which REMIC loans or grantor trust may be modified. While the revenue procedure allows a modification/extension if loan maturity is removed, it does not mandate that a servicer must modify or extend a loan. Servicers will need to develop criteria for judging whether there is a significant risk of default solely based on the projected inability to refinance. The farther a loan is from maturity, the less likely a significant risk of default may exist simply because of potential changes in the commercial lending environment.

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