Background : On November 8, 2007, the Internal Revenue Service (the “IRS”) issued much-anticipated proposed regulations updating the rules related to “significant modifications” of loans held in real estate mortgage investment conduits (or “REMICs”). The changes proposed by the IRS are potentially very important to servicers of securitized loans because a significant modification of such a loan can cause the loan to cease to be a “qualified mortgage,” which could disqualify the REMIC that holds the loan or subject the REMIC to tax (sometimes referred to as an “adverse REMIC event”).

Servicers of securitized loans have long complained that the current rules prevent them from entertaining reasonable requests from borrowers for loan and collateral alterations and that the rules have not kept up with the practical issues associated with servicing commercial real estate loans. The proposed regulations are designed to address these complaints by expanding the class of permitted modifications of securitized loans.

The Current Rules: The current rules contain the following four exceptions to the general rule prohibiting significant modifications of loans held in REMICs: (i) changes to a loan’s terms that are occasioned by default or a reasonably foreseeable default; (ii) assumptions of loans; (iii) waivers of due-on-sale or due-on-encumbrance clauses; and (iv) conversions of interest rates pursuant to the terms of a convertible mortgage.

The Proposed Rules: Under the proposed regulations, the following exceptions would be added:

· Modifications that release, substitute, add or alter a substantial amount of collateral for, a guarantee on, or other credit enhancement for the loan; and

· Modifications that change the recourse or nonrecourse nature of the loan.

The proposed new exceptions come with an important qualification, however.  These modifications are permitted only if the modified loan continues to be “principally secured by” an “interest in real property” following the modification.  The fair market value of the interest in real property securing the loan must be appraised by an independent appraiser to be at least equal to 80% of the outstanding balance of the loan on the date of the modification.

Caution: While the proposed regulations may make possible transactions that are not permissible under the current rules, they speak only to the REMIC issues associated with these transactions. Servicers must continue to abide by the prohibitions and processes contained in the REMIC’s applicable Pooling and Servicing Agreement (or “PSA”) (e.g., special servicer, rating agency and controlling class approval; PSA provisions prohibiting substitutions of material portions of loan collateral; etc.), as these provisions would be unaffected by the proposed regulations.

In addition, investors in a REMIC and the sellers of loans to it typically require the REMIC to maintain its status as a “qualified single purpose entity” under Financial Accounting Standards No. 140 (or “FAS 140”), which strictly limits the amount of discretion the servicer can exercise.  The modifications permitted by the current rules were generally thought not to violate this standard. The proposed regulations appear to allow for more flexibility in modifying loans held by REMICs than is permitted by FAS 140, which may prevent most REMICs from taking full advantage of the new exceptions.

Finally, the proposed regulations will not become effective until adopted by the IRS as final. The IRS will take comments on the proposed regulations from various sources and will hold hearings in 2008 to consider them. This process can be time consuming and, until it is complete, the proposed regulations have no effect. The final regulations could contain very different exceptions or the IRS could decide not to make any changes to the current rules.

What do the proposed regulations mean for you?

Master and Primary Servicers: For servicers dealing with performing loan requests, the biggest impact of the proposed regulations would relate to collateral changes. Under the current rules, modifications that affect a “substantial amount” of the collateral (often referred to as the “10% test”) for a securitized nonrecourse loan could result in a significant modification of that loan. Under the proposed regulations, such a modification would not cause an adverse REMIC event so long as the loan continues to be “principally secured by” an interest in real property following the modification.

A number of technical tax rules relate to the issue of what is an “interest” and what is “real property” for purposes of this test. In general, however, so long as the loan has a loan-to-value ratio of no greater than 125% (or, to use the language in the REMIC regulations, a value-to-loan ratio at least equal to 80%) following the modification, the loan will be considered “principally secured” by an interest in real property. Please contact your REMIC counsel for questions related to whether a modification of a loan causes a loan to cease to be principally secured by an interest in real property for these purposes.  The proposed requirement that this be determined by obtaining an independent appraisal promises to be cumbersome.

Special Servicers. As much as the proposed regulations may be regarded as a huge step forward in servicing performing loans held in REMICs, the impact of the proposed regulations for special servicers dealing with defaulted loans and REO would probably be minimal. Current REMIC rules related to the grace period for qualified foreclosure property, the prohibition on impermissible new construction for REO, and the impact of income from REO that is other than “rents from real property” continue unchanged. Perhaps the only impact of the proposed regulations on special servicers would arise in the uncommon situation of a proposed modification of a defaulted loan that does not fall under the existing exception for modifications that are “occasioned by” the loan’s default or a reasonably foreseeable default. In these odd instances, so long as the modification falls under one of the new exceptions contained in the proposed regulations, no adverse REMIC event would result even if the modification is not be considered “occasioned by” the loan’s default.

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