Borrowers of securitized loans are often frustrated when servicers deny requests for modifications, even when the changes would make perfect sense. The problem is that servicers’ hands are tied by tax rules that limit the activity of the trusts that govern real estate mortgage investment
Treasury Regulations that govern modifications were adopted in 1986 and remained unchanged until the fall of 2009. Over the course of those 23 years, market players developed deeply ingrained habits to deal with loan modifications that would prove hard to break when the rules changed.
Although it has been six years since the new rules were passed, a number of misconceptions about the modification process remain rampant. Let’s break down some of these misconceptions and what can be done about them:
Misconception #1. “The conditions for the borrower’s requested
outparcel release are hardwired into the loan documents.”
That may be true, but it is in most cases no longer relevant to the
REMIC analysis. (The one exception to this is for “grandfathered
transactions,” which are discussed below.)
Borrowers often insert into their loan documents explicit conditions for the REMIC’s release of its lien on an outparcel that makes up part of the collateral property. The motivation for the borrower’s efforts to include these conditions in its loan documents can come from the borrower’s desire to sell or develop the outparcel in the future but at the time the borrower closes its loan the outparcel remains integrated with the overall collateral property and cannot be separated from the collateral property. Some of the conditions the borrower may negotiate into its loan documents to obtain the REMIC’s release of its lien on the outparcel may include: establishing separate tax parcel for the release parcel, updating title to the overall collateral property following the release of the release
parcel, and paying a pre-established release price. The borrower may also assume — incorrectly — that, if it can satisfy the conditions provided for in its loan documents, the REMIC’s release of its lien on the related outparcel will be automatic and will not cause any REMIC issues.
Prior to the enactment of the current REMIC regulations in late 2009, this strategy usually worked because the REMIC test to which the servicer would look depended on whether there would be a “significant modification” of the borrower’s loan as a result of the collateral release. If not, there would be no REMIC issue. To determine whether there would be a “significant modification,” the tax rules looked to see whether the borrower’s right to release the outparcel from the REMIC’s lien was automatic under the loan documents and not dependent on the consent or approval of the REMIC. If so, the right to release was deemed to be “unilateral” for tax purposes and the release of the outparcel would not result in a modification to the borrower’s loan so long as the parties
followed the hardwired conditions provided for in the borrower’s
This meant that the servicer’s main task when reviewing a borrower’s
request for the REMIC to release its lien on an outparcel was to determine whether the borrower’s right to release was in fact “unilateral.” While this often led to questions about whether and to what extent the REMIC could exercise discretion and whether the borrower met the specified conditions in the loan documents, the REMIC analysis under the old REMIC rules was straightforward.
Servicers and borrowers mistakenly continue to take this approach and assume that there are no REMIC issues if the borrower’s right to obtain the REMIC’s release of its lien on an outparcel at the collateral property is unilateral. Under the current tax provisions, however, a REMIC can continue to hold a loan after a release of real property collateral only if the loan continues to be “principally-secured” by an “interest in real property” whether or not the release was unilateral or whether or not there has been a “significant modification” of the borrower’s loan. To meet this “principally secured” test, the borrower’s loan must meet an 80% value-to-loan test (or, to invert the ratio, a 125% loan-to-value test) following the release of the outparcel. Only the real property collateral counts for the “value” component of that fraction. This test is commonly
referred to as the “principally secured test.”
As discussed above, in most cases, the fact that release conditions are unilateral by virtue of being hardwired into the documents is no longer relevant to the REMIC tax analysis. One exception is for “grandfathered transactions.” This exception was in response to the industry uproar that followed the release of the new REMIC regulations in 2009. Borrowers and servicers were upset at that time because, in many cases, a borrower had negotiated specific release provisions based on the understanding that, under the previous REMIC tax rules, the resulting outparcel release would
not cause a REMIC problem. Not only were they now prevented from a release that could have made economic sense for everyone if the “principally secured” test could not be satisfied following the release, but there was a concern that the REMIC would be put in a “damned if you do, damned if you don’t” situation. The latter concern would arise where the borrower had an unqualified right under the loan documents to obtain the REMIC’s release of its lien on an outparcel, but permitting the release would potentially disqualify the REMIC if the remaining real property collateral would not support the “principally secured” (80% value-to-loan) test.
The IRS, on August 17, 2010, did a limited about-face with respect to hardwired loan provisions when it released Rev. Proc. 2010-30, which included a new exception for “grandfathered transactions.” This exception applies only to release provisions in loan documents executed no later than December 6, 2010. If those provisions are hardwired (i.e., the release is automatic, provided the borrower meets specified conditions), the release of a REMIC’s lien from an outparcel will not disqualify the
related loan and the release can be completed without concern that the
REMIC that holds the borrower’s loan will be disqualified. The “grandfathered transaction” exception applies whether or not the “principally secured” test will be met following the release. As we get farther from December 6, 2010, however, the exception for “grandfathered transactions” will be less frequently available as the
number of loans remaining outstanding that predate December 6,
2010 will dwindle over time.
Since releases pursuant to loan documents executed after December
6, 2010 cannot qualify as grandfathered transactions, is there any reason for a borrower to request that release provisions be included in new loan documents? Although hardwired release provisions will not override the requirement in the current REMIC regulations that the borrower’s loan continue to satisfy the “principally secured” (80% value-to-loan) test after the release, some borrowers nevertheless take comfort in including these release provisions that outline the necessary conditions for the borrower to obtain the REMIC’s release of its lien on the related outparcel in their loan documents. By doing so the borrower establishes the parameters by which the servicer will review and approve the borrower’s
request for a real property collateral release, even though the servicer must still make the 80% value-to-loan analysis under the
“principally secured” test. Because the hardwired conditions will no
longer override the general REMIC requirement, however, all loan
documents executed after late 2009 that contain a real property
collateral release provision should include a “REMIC savings” condition, which states that the release will not be permitted unless the parties verify that the loan continues to satisfy the principally secured (80% value-to-loan) test following the release.
Misconception #2. “The outparcel was given no value in the origination appraisal, so releasing it won’t affect the ‘principally secured’ test.” As noted above, the relevant REMIC inquiry when reviewing a borrower’s request for an outparcel release is whether the loan remains “principally secured” by an interest in real property following the release, not whether the borrower’s loan documents contain conditions that permit the release. Nevertheless, when a borrower has gone to the trouble of including the conditions necessary for a future collateral release in its loan documents, it is not uncommon for the originating lender to exclude the release parcel’s value from the origination appraisal. After all, that to-be-released outparcel may not be around for long, so it is prudent from a credit standpoint to value the release parcel at $0 in determining how much collateral the borrower is pledging at the time the loan is originated.
But how does this affect the REMIC tax analysis when the parcel is released? In short, it does not affect REMIC tax analysis at all. Borrowers may be tempted in these situations to suggest that there has not been a true release of real property collateral because the release parcel was valued at $0 at origination. They should resist that temptation. In all but the rarest of cases, the outparcel does have value. As evidence of that, the borrower may be required to pay a pre-established release price. In other cases, the borrower may be planning to sell the outparcel for a hefty sum.
No value in the release parcel? Hardly.
The only possible benefit of setting the release parcel’s value at $0 in the origination appraisal is that, if and when the borrower attempts to secure the REMIC’s release of its lien on the outparcel, there may be a higher likelihood that there will be ample value in the remaining real property collateral following the release because there was ample value in that real property collateral at the time the loan was originated even attributing a $0 value the release parcel at origination. This would make it easier to satisfy the “principally secured” test at the time the borrower requests
that the outparcel be released from the REMIC’s lien.
Misconception #3. “We required the borrower to put all the
proceeds from the release parcel into a cash reserve. That
should avoid any REMIC tax concerns.” This is an example of servicers and borrowers confusing credit concerns with REMIC tax concerns. While it may make an abundance of credit sense for the servicer to require that sale proceeds go into a reserve to make up for the loss in real property collateral following the release, that maneuver does nothing to resolve the REMIC issue.
As noted above, generally only the real property collateral matters in determining REMIC qualification — not cash reserves that the
borrower has pledged, letters of credit, or any other credit substitutes that are not interests in real property. If, following the release, the loan is not “principally secured” by an interest in real property (that is, the loan does not satisfy the 80% value-to-loan test, taking into account only the real property collateral) the loan will not be a qualified mortgage that the REMIC can hold, irrespective of any substitute credit the servicer negotiated for in exchange for agreeing to the real property release. While other non-real property credit enhancements may help the servicer make its credit decision about releasing its lien on the outparcel, they do nothing for the REMIC tax analysis.
Misconception #4. “The special servicer is requiring that the
assumptor post a debt service reserve of $1 million. Isn’t that a
REMIC problem?” In connection with a borrower’s request to sell
the collateral property and have its loan assumed by the buyer,
the servicer often requires credit enhancements for the loan.
These enhancements can include debt service and other property
maintenance reserves, leasing reserves for tenant improvements,
and even additional personal guarantees (sometimes with limited
full recourse for, say, 10% of the loan’s balance).
Prior to their revision in 2009, the REMIC provisions imposed limitations on the amount and extent of credit enhancements.
Subject to some exceptions, a loan could not be “significantly modified”
without causing that loan to cease to be a qualified mortgage that the REMIC could hold. Altering a “substantial amount” of collateral for a
performing nonrecourse loan (such as the addition of the credit
enhancements discussed above) could have this effect.
After the release of the current REMIC regulations in 2009, adding credit enhancements is no longer a potential REMIC issue. As noted above, the primary REMIC consideration now is only whether the borrower’s loan remains “principally secured” by an “interest in real property.” So long as the real property collateral is not affected, an increase or reduction of other forms of collateral will not cause the borrower’s obligation to fail the “principally secured” test. This is true even in extreme cases: $100,000 loan can now be credit enhanced with a $10 million letter of credit without any concern that an adverse REMIC event will result, provided the real property collateral remains in place.
Conclusion: Pre-2010 assumptions about REMIC principles
persist in the minds of many borrowers and servicers, but these
assumptions may now be wrong. Servicers and borrowers must
remember that, under the current REMIC provisions, REMIC issues
are now generally determined based on a review of the real
property collateral that secures the borrower’s obligation under the
terms of the loan. With REMIC issues it really is “location, location,
location” (the real estate) that matters.