The deterioration of the real estate and credit markets has resulted in a marked increase in the number of defaulted CMBS mortgage loans. As of January 2009, the percentage of CMBS mortgage loans in default increased to 1.15% - a low rate, but a sharp increase from a default rate of 0.43% in September 2008. The increased default rate has resulted in a corresponding increase in the number of mortgage loans being transferred from master to special servicers – an action which may lead to a rise in foreclosures. After foreclosure, the foreclosure property is considered “REO” (real estate owned) and the “real estate mortgage investment conduit” (“REMIC”) holding the REO must sell the REO as its exit strategy.
The increase in the number of defaulted mortgage loans and inventories of REO has resulted in efforts by special servicers to be creative, as they seek relief from restrictions imposed by the Internal Revenue Code (the “Code”) and Treasury Regulations applicable to a REMIC that prohibit a REMIC from financing or otherwise originating a new loan in connection with the sale of REO. The REMIC restrictions prohibit REMICs from providing seller financing with respect to the disposition of REO that the REMIC holds. Against this backdrop, the American Special Servicers Association (“ASSA”) proposed changes to the REMIC provisions to permit a purchaser of REO to buy the REO subject to a continuing “qualified mortgage” for REMIC tax purposes even if the REMIC had foreclosed on the related collateral property and the original “qualified mortgage” no longer exists.
What follows is an examination of the problems currently facing REMIC trusts and servicers, together with a brief summary of ASSA’s proposal and the issues and potential questions that this proposal presents.
Issues under the Current System
Sections 860A - 860G of the Code provide that an entity satisfying specific requirements will qualify as a REMIC and will be treated as a pass-through entity for tax purposes (i.e., income passes through the REMIC to certificateholders without paying tax at the REMIC trust level). In order to maintain its tax-free status, substantially all of the REMIC’s assets throughout the REMIC’s lifetime must be “qualified mortgages” or “permitted investments.” This test is commonly referred to as the “asset test” for REMIC qualification. Generally speaking, a “qualified mortgage” is an obligation that is principally secured by an interest in real property that is transferred to the REMIC by the end of the third month following the REMIC’s startup day.
In the event of a foreclosure, a defaulted mortgage loan ceases to exist for purposes of the asset test for REMIC qualification. At the time of foreclosure, the qualified mortgage is converted to “foreclosure property” (a “permitted investment”) for purposes of applying the “asset test” for REMIC qualification. A REMIC is allowed to hold foreclosure property until the end of the third taxable year following the year the REMIC acquires the foreclosure property, which period can be extended for up to an additional three years upon written request to the IRS. In the current environment, during this holding period, the REMIC (through the special servicer) will seek to sell the foreclosure property to a cash purchaser for the highest price in order to minimize any losses to the REMIC’s bondholders.
Under current market conditions, any purchaser of the foreclosure property faces a difficult task in securing financing for its purchase – a situation that severely limits the universe of potential purchasers in an already challenging real estate environment. The REMIC is not allowed to originate new loans to assist in the purchaser’s acquisition of the foreclosure property and the pooling and servicing agreement (the “PSA”) governing the formation and operation of the REMIC generally requires that the special servicer sell the REO for cash only. The limited pool of potential purchasers, combined with an increasing supply of REO, has driven down purchase prices. This problem will likely worsen as commercial real estate fundamentals continue to deteriorate in the U.S. amid the worldwide economic downturn. ASSA’s proposal attempts to address this difficult issue.
Summary of ASSA’s Proposal
ASSA’s proposal seeks to allow a purchaser of REO to buy foreclosure property subject to a continuing “qualified mortgage” for REMIC tax purposes whether or not the original qualified mortgage was extinguished at the time the REMIC foreclosed on the related REO. Under the terms of the proposal, the REMIC would be permitted to treat the date of the purchase (and thus the date of the seller financing) as relating back to the date of the REMIC’s acquisition of the original qualified mortgage. By treating the original mortgage loan, the foreclosure and the subsequent purchase of REO as a single transaction, the mortgage loan would, under ASSA’s proposal, continue to be a “qualified mortgage” much the way an assumption of a mortgage loan incident to a purchaser’s acquisition of the collateral property from the current borrower is treated.
The transaction advocated by ASSA, however, is different from a mortgage loan assumption in at least one way. The terms of the seller financing with respect to the REO may differ significantly from the terms of the original mortgage loan. This raises an issue under Section 1001 of the Treasury Regulations, which provides that a “significant modification” of a mortgage loan is treated as an exchange of the old mortgage loan for a new mortgage loan. Such a deemed exchange of qualified mortgages has the same adverse tax consequences to a REMIC as an actual exchange of a mortgage loan. The REMIC regulations, however, provide an exception for modifications that are occasioned either by a default or a reasonably foreseeable default. While ASSA’s proposal recognizes that such changes may be “significant” under the Treasury Regulations, ASSA correctly asserts that any such change would be consistent with significant modifications of qualified mortgages in connection with a defaulted mortgage loan or a loan for which default is reasonably foreseeable.
While ASSA has attempted to address significant and growing concerns in the CMBS community, ASSA’s proposal only addresses the REMIC qualification issue and leaves unanswered a number of questions resulting from a REMIC providing seller financing for REO. For example:
Even if the IRS and Treasury agreed to ASSA’s proposal, there are a number of issues under the PSAs governing the formation and operation of the REMIC that holds the REO that arise due to the fact that existing PSAs were not drafted to allow the REMIC to finance the sale of REO. Those issues include:
Other questions not addressed by ASSA’s proposal include: What impact would financing REO have on any pending repurchase claims arising from representation and warranty breaches or the QSPE status of the REMIC trust? If FASB does away with the QSPE concept, what effect would this have on the consolidation analysis?
ASSA argues that adopting its proposal will increase the pool of potential purchasers of REO dramatically, enable REMICs to sell REO at a higher price, and reduce potential losses to CMBS investors. By providing a method by which a REMIC could effectively maintain its pool of loans rather than having to liquidate REO at fire-sale prices, rising default rates may become less of a concern. ASSA’s proposal does not, however, address many of the issues that would naturally flow from a REMIC providing seller financing of REO. In order to address the turmoil in the current market, all parties in the CMBS industry need to work together to develop solutions to the problems and current challenges.
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