SECTION 1. PURPOSE

This revenue procedure describes the conditions under which modifications to certain mortgage loans will not cause the Internal Revenue Service (Service) to challenge the tax status of certain securitization vehicles that hold the loans or to assert that those modifications give rise to prohibited transactions.

No inference should be drawn about whether similar consequences would obtain if a transaction falls outside the limited scope of this revenue procedure. Furthermore, there should be no inference that, in the absence of this revenue procedure, transactions within its scope would have impaired the tax status of securitization ve

hicles or would have given rise to prohibited transactions.

SECTION 2. BACKGROUND—COMMERCIAL MORTGAGE LOANS

.01 Under the terms of many commercial mortgage loans, all or a large portion of the original stated principal is due at maturity. Typically, at the time of loan origination, both the borrower and the lender expected the borrower to obtain funds to satisfy the large payment at maturity by obtaining a new mortgage loan secured by the same underlying interest in real property.

.02 The current situation in the credit markets is affecting the availability of financing and refinancing for commercial real estate. In particular, borrowers under many of the commercial mortgage loans that will mature in the next few years are concerned that they will encounter great difficulty in obtaining refinancing for these loans. Because they had always anticipated using the proceeds from refinancing to satisfy the principal balance due at maturity, these borrowers are often at risk of defaulting when their loans mature. This

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difficulties for a mortgage loan well in advance of any actual payment default.

.05 Many industry participants have concluded that the monitoring procedures that have been adopted and the level of experience of those implementing the procedures make it possible to assess with substantial accuracy whether particular commercial mortgage loans present an unacceptably high risk of eventual foreclosure. It may be possible to foresee this risk of foreclosure even when no payment default has yet occurred and when the event of default may not occur until the maturity of the loan.

.06 Many industry participants have also concluded that it is possible to predict with a reasonable degree of accuracy whether proposed modifications will allow mortgage loans to continue to perform (and so avoid the necessity of property foreclosure). Modifications that may be considered include interest rate changes, principal forgiveness, extensions of maturity, and alterations in the timing of changes to an interest rate or to a principal amortization schedule. In many cases, modifications that include extensions of the maturity and, thus, postpone the need for refinancing, may reduce the risk of foreclosure.

.07 Often the complexity of the mortgage loans themselves and the consequent complexity of modifications to them necessitate a substantial period prior to any expected payment or maturity default for the negotiation of any such modifications.

SECTION 3. BACKGROUND—REMICS

.01 REMICs are widely used securitization vehicles for mortgages. REMICs are governed by sections 860A through 860G of the Internal Revenue Code.

.02 For an entity to qualify as a REMIC, all of the interests in the entity must consist of one or more classes of regular interests and a single class of residual interests, see section 860D(a), and those interests must be issued on the startup day, within the meaning of § 1.860G–2(k) of the Income Tax Regulations.

.03 A regular interest is one that is designated as a regular interest and whose terms are fixed on the startup day. Section 860G(a)(1). In addition, a regular interest must (1) unconditionally entitle the holder

to receive a specified principal amount (or other similar amount), and (2) provide that interest payments, if any, at or before maturity are based on a fixed rate (or to the extent provided in regulations, at a variable rate).

.04 An interest issued after the startup day does not qualify as a REMIC regular interest.

.05 Under section 860D(a)(4), an entity qualifies as a REMIC only if, among other things, as of the close of the third month beginning after the startup day and at all times thereafter, substantially all of its assets consist of qualified mortgages and permitted investments. This asset test is satisfied if the entity owns no more than a de minimis amount of other assets. See § 1.860D–1(b)(3)(i). As a safe harbor, the amount of assets other than qualified mortgages and permitted investments is de min- imis if the aggregate of the adjusted bases of those assets is less than one percent of the aggregate of the adjusted bases of all of the entity’s assets. § 1.860D–1(b)(3)(ii).

.06 With limited exceptions, a mortgage loan is not a qualified mortgage unless it is transferred to the REMIC on the startup day in exchange for regular or residual interests in the REMIC. See section 860G(a)(3)(A)(i).

.07 The legislative history of the REMIC provisions indicates that Congress intended the provisions to apply only to an entity that holds a substantially fixed pool of real estate mortgages and related assets and that “has no powers to vary the composition of its mortgage assets.” S. Rep. No. 99–313, 99 ^th Cong., 2 ^d Sess. 791–92, 1986–3 (Vol. 3) C.B. 791–92. .08 Section 1.1001–3(c)(1)(i) defines a “modification” of a debt instrument as any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. Section 1.1001–3(e) governs which modifications of debt instruments are “significant.” Under § 1.1001–3(b), for most federal income tax purposes, a significant modification produces a deemed exchange of the original debt instrument for a new debt instrument.

.09 Under § 1.860G–2(b), related rules apply to determine REMIC qualification. Except as specifically provided in

§ 1.860G–2(b)(3), if there is a significant modification of an obligation that is held by a REMIC, then the modified obligation is treated as one that was newly issued in exchange for the unmodified obligation that it replaced. See § 1.860G–2(b)(1). For this purpose, the rules in § 1.1001–3(e) determine whether a modification is “significant.” See § 1.860G–2(b)(2). Thus, even if an entity initially qualifies as a REMIC, one or more significant modifications of loans held by the entity may terminate the qualification if the modifications cause less than substantially all of the entity’s assets to be qualified mortgages.

.10 Certain loan modifications, however, are not significant for purposes of § 1.860G–2(b)(1), even if the modifications are significant under the rules in § 1.1001–3. In particular, under § 1.860G–2(b)(3)(i), if a change in the terms of an obligation is “occasioned by default or a reasonably foreseeable default,” the change is not a significant modification for purposes of § 1.860G–2(b)(1), regardless of the modification’s status under § 1.1001–3.

.11 Discussions between a holder or servicer and a borrower concerning a possible modification of a loan may occur at any time and need not begin only after the loan is in default or there is a reasonably foreseeable default.

.12 The Service understands that many industry participants believe that a loan modification necessarily fails to be “occasioned by default or a reasonably foreseeable default” unless the loan is not performing or default is imminent.

.13 Section 860F(a)(1) imposes a tax on REMICs equal to 100 percent of the net income derived from “prohibited transactions.” The disposition of a qualified mortgage is a prohibited transaction unless the “disposition [is] pursuant to—(i) the substitution of a qualified replacement mortgage for a qualified mortgage . . ., (ii) a disposition incident to the foreclosure, default, or imminent default of the mortgage, (iii) the bankruptcy or insolvency of the REMIC, or (iv) a qualified liquidation.” Section 860F(a)(2)(A).

.14 Under section 860C(b)(1), “The taxable income of a REMIC shall be determined under an accrual method of accounting . . . except that— . . . (C) there shall not be taken into account any item of

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among the exceptions listed in section 860F(a)(2)(A)(i)-(iv); .03 The Service will not challenge a securitization vehicle’s classification as a trust under § 301.7701–4(c) on the grounds that the modifications manifest a power to vary the investment of the certificate holders; and

.04 The Service will not challenge a securitization vehicle’s qualification as a REMIC on the grounds that the modifications result in a deemed reissuance of the REMIC regular interests.