[Federal Register Volume 74, Number 178 (Wednesday, September 16, 2009)]
[Rules and Regulations]
[Pages 47436-47439]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-22215]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9463]
RIN 1545-BG77


Modifications of Commercial Mortgage Loans Held by a Real Estate 
Mortgage Investment Conduit (REMIC)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains final regulations that expand the list 
of permitted loan modifications to include certain modifications that 
are often made to commercial mortgages. Changes to the regulations are 
necessary to better accommodate evolving practices in the commercial-
mortgage industry. These changes will affect lenders, borrowers, 
servicers, and sponsors of securitizations of mortgages in REMICs.

DATES: Effective Date: These regulations are effective on or after 
September 16, 2009.
    Applicability Date: For date of applicability, see Sec.  1.860A-
1(b).

FOR FURTHER INFORMATION CONTACT: Diana Imholtz or Susan Thompson Baker 
at (202) 622-3930 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this final regulation 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-2110. The collection of information 
in this final regulation is in Sec.  1.860G-2(b)(7). This information 
is required in order to show that certain modifications to mortgages 
permitted by this final regulation will not cause the modified mortgage 
to cease to be a qualified mortgage. The collection of information is 
voluntary to obtain a benefit.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
OMB control number.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains amendments to 26 CFR part 1 under section 
860G of the Internal Revenue Code (Code). In Notice 2007-17 (2007-1 CB 
748 (March 19, 2007)), the IRS and the Treasury Department requested 
input on whether the present REMIC regulations should be amended to 
permit additional types of modifications incurred in connection with 
commercial mortgage loans. See Sec.  601.601(d)(2)(ii)(b). The IRS and 
the Treasury Department received several comments in response to this 
request (the Notice 2007-17 Comments). After consideration of the 
Notice 2007-17 Comments, the IRS and the Treasury Department published 
in the Federal Register (72 FR 63523) on November 9, 2007, proposed 
regulations (REG-127770-07) that would expand the list of permitted 
loan modifications to include certain modifications that are often made 
to commercial mortgages. The IRS and the Treasury Department received 
additional comments in response to the proposed regulations (the 
Proposed Regulation Comments). A public hearing was requested and was 
held on April 4, 2008 (73 FR 12041). After consideration of the 
Proposed Regulation Comments, the proposed regulations are adopted as 
revised by this Treasury decision.

Summary of Comments and Explanation of Provisions

    Except as specifically provided in Sec.  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 Sec.  
1.860G-2(b)(1). For this purpose, the rules in Sec.  1.1001-3(e) 
determine whether a modification is ``significant.'' See Sec.  1.860G-
2(b)(2). Because of when it is treated as having been acquired in the 
deemed exchange, a significantly modified obligation generally fails to 
be a qualified mortgage. Section 1.860G-2(b)(3), however, contains a 
list of modifications that are expressly permitted without regard to 
the section 1001 modification rules.
    The final regulations expand this list of permitted exceptions to 
include changes in collateral, guarantees, and credit enhancement of an 
obligation and changes to the recourse nature of an obligation. These 
changes are permitted so long as the obligation continues to be 
principally secured by an interest in real property. The final 
regulations also clarify when a release of a lien on real property 
securing a qualified mortgage does not disqualify the mortgage.
    The Proposed Regulation Comments included requests for 
clarification and recommendations relating to the following: (i) The 
lien release rule; (ii) the requirement to retest the collateral value; 
(iii) the appraisal requirement; (iv) changes in the nature of an 
obligation from nonrecourse to recourse; (v) investment trusts; and 
(vi) other proposals set forth in the Notice 2007-17 Comments that were 
not included in the proposed regulations.

1. The Lien Release Rule

    The proposed regulations would provide that a lien release pursuant 
to certain changes in collateral would not cause a qualified mortgage 
to cease to be a qualified mortgage on the date the lien is released. 
Commentators indicated that, as drafted, the proposed regulations could 
be interpreted to prohibit other types of lien releases, including lien 
releases that are occasioned by a default or reasonably foreseeable 
default under Sec.  1.860G-2(b)(3)(i) and lien releases that are 
permitted pursuant to the terms of the mortgage loan and are not 
modifications for purposes of Sec.  1.1001-3. In response

[[Page 47437]]

to these comments, the final regulations clarify that a release of a 
lien on real property that does not result in a significant 
modification under Sec.  1.1001-3 (for example, a release or 
substitution of collateral pursuant to the borrower's unilateral option 
under the terms of the mortgage loan) is not a release that 
disqualifies a mortgage loan, so long as the mortgage continues to be 
principally secured by real property after giving effect to any 
releases, substitutions, additions, or other alterations to the 
collateral. Similarly, the final regulations clarify that a lien 
release occasioned by a default or a reasonably foreseeable default is 
not a release that disqualifies the mortgage, so long as the 
principally-secured test continues to be satisfied.

2. The Requirement To Retest the Collateral Value

    Section 1.860G-2(a)(1) of the regulations provides that an 
obligation is principally secured by an interest in real property if 
the fair market value of the real property that secures the obligation 
equals at least 80 percent of the adjusted issue price of the 
obligation. The regulations require the 80-percent test to be satisfied 
either at the time the obligation was originated or at the time the 
sponsor contributes the obligation to the REMIC. After the startup day, 
the regulations do not require ongoing satisfaction of the 80-percent 
test.
    Because certain types of modifications permitted by the proposed 
regulations could affect the value of the collateral securing the 
mortgage loan, the proposed regulations would require the 80-percent 
test to be satisfied at the time the mortgage loan is modified with 
respect to changes in collateral, guarantees, and credit enhancement of 
an obligation or with respect to changes to the recourse nature of an 
obligation. Commentators indicated that retesting should be required 
only when the modification could cause a decrease in the value of real 
property collateral relative to the mortgage loan amount. For this 
reason, commentators further indicated that changes in guarantees, 
credit enhancements or the recourse nature of an obligation, as well as 
the addition of collateral, do not have the effect of decreasing the 
value of the real property securing the mortgage loan and, therefore, 
these types of changes should not require retesting.
    To ensure that a modified mortgage loan continues to be principally 
secured by an interest in real property, the IRS and the Treasury 
Department continue to believe that it is appropriate to retest at the 
time of the modification. Accordingly, the final regulations retain the 
retesting requirement, but amend the proposed standards for satisfying 
the principally secured test as described in section 3 in this 
preamble. In addition, to provide a more flexible standard for changes 
that do not decrease the value of real property securing the mortgage 
loan, the final regulations provide an alternative method for 
satisfying the principally secured test.
    For these types of changes (for example, a change from recourse to 
nonrecourse, or vice versa), the final regulations provide that a 
modified mortgage loan continues to be principally secured by real 
property if the fair market value of the interest in real property that 
secures the loan immediately after the modification equals or exceeds 
the fair market value of the interest in real property that secured the 
loan immediately before the modification. This alternative test is 
consistent with the general rule that a decline in the value of 
collateral does not cause a mortgage loan to cease to be principally 
secured by real property. The final regulations provide an example to 
illustrate the application of this alternative method for satisfying 
the principally secured test.
    The final regulations also require retesting with respect to a lien 
release that is not a significant modification for purposes of Sec.  
1.1001-3 (for example, a release of real property collateral pursuant 
to the borrower's unilateral option under the terms of the mortgage 
loan). Here as well, the principally secured test is satisfied if 
either the 80-percent test is satisfied based on the current value of 
the real property securing the mortgage or the value of the real 
property collateral after the modification is no less than the value of 
the real property collateral immediately before.
    For purposes of retesting with respect to alterations to real 
property collateral, the transaction causing the alteration is looked 
at in its entirety in determining the value of the real property 
collateral. For example, if, as part of an overall plan to make 
improvements to real property collateral that secures a mortgage loan, 
a borrower demolishes an existing building and constructs a new 
building on that real property, the fair market value of the real 
property collateral is determined by taking into account both the 
demolition of the existing building and the construction of the new 
building.

3. The Appraisal Requirement

    For purposes of retesting as of the date of modification, the 
proposed regulations would require a current appraisal determined by an 
independent appraiser. Several commentators indicated that requiring a 
formal appraisal in connection with a loan modification is a stricter 
standard than is currently required for satisfying the 80-percent test 
at the startup day. See Sec.  1.860G-2(a)(3). For a number of business 
reasons, commentators indicated that servicers need more flexibility in 
complying with this retesting requirement and, therefore, requested 
that the proposed regulations be amended to permit servicers to use 
other types of reasonable valuation methods.
    In response to these comments and to make the retesting requirement 
more consistent with the current rules for satisfying the 80-percent 
test at the startup day, the final regulations provide that the 
principally-secured test will be satisfied if the servicer reasonably 
believes that the modified mortgage loan satisfies the 80-percent test 
at the time of the modification. The final regulations provide that a 
servicer must base a reasonable belief upon a commercially reasonable 
valuation method. The final regulations set forth a nonexclusive list 
of commercially reasonable valuation methods that can be used by 
servicers for retesting purposes. These same commercially reasonable 
methods can be used under the alternative test to establish that the 
value of the real property collateral immediately after the 
modification is no less than the value of the real property collateral 
immediately before it.

4. Changes in the Nature of an Obligation From Nonrecourse to Recourse

    The final regulations clarify that changes in the nature of an 
obligation from nonrecourse (or substantially all nonrecourse) to 
recourse (or substantially all recourse) are permitted so long as the 
obligation continues to be principally secured by an interest in real 
property.

5. Investment Trusts

    Section 301.7701-4(c) of the Procedure and Administration 
Regulations provides that an investment trust is not classified as a 
trust if there is a power under the trust agreement to vary the 
investment of the certificate holders. The IRS and the Treasury 
Department understand that changes to the terms of commercial mortgage 
loans held by investment trusts may raise issues as to whether a 
``power to vary'' is present, and commentators recommended that the 
scope of the regulation project be expanded to permit investment trusts 
to modify

[[Page 47438]]

commercial mortgage loans in the same manner as REMICs. To avoid a 
significant delay in the publication of these final regulations, their 
scope has not been expanded to include modifications of mortgage loans 
held by investment trusts. In a separate notice to be published in the 
Internal Revenue Bulletin contemporaneously with these final 
regulations, the IRS and the Treasury Department intend to request 
comments on this issue.

6. Other Proposals Set Forth in the Notice 2007-17 Comments

    In the Proposed Regulation Comments, commentators requested that 
the IRS and the Treasury Department reconsider other proposed loan 
modifications that were set forth in the Notice 2007-17 Comments but 
that were not included in the proposed regulations. For the reasons 
indicated in the preamble to the proposed regulations, the IRS and the 
Treasury Department determined that the remaining changes requested by 
commentators should not be included in the final regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to this regulation.
    It is hereby certified that the collection of information 
requirement in this regulation will not have a significant economic 
impact on a substantial number of small business entities. This 
certification is based on the fact that the REMICs affected by this 
regulation will not be classified as small business entities. According 
to the Small Business Administration definition of a ``small 
business,'' 13 CFR 121.201, a REMIC is classified under Sector 52 
(Finance and Insurance), Subsector 525 (Funds, Trusts and Other 
Financial Vehicles) under the category ``Other Financial Vehicle'', 
NAICS code 525990, and is only considered a small business entity if it 
accumulates less than 6.5 million dollars in annual receipts. REMICs 
affected by this regulation generally hold pools of commercial mortgage 
loans with an average loan size of 18.1 million dollars, and have 
greater than 6.5 million dollars in annual receipts. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required.
    Pursuant to section 7805(f) of the Internal Revenue Code, the 
notice of proposed rulemaking preceding this regulation was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Diana Imholtz of the 
Office of Associate Chief Counsel (Financial Institutions and 
Products). Other personnel from the IRS and the Treasury Department 
participated, however, in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of the Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *.
    Section 1.860A-0 also issued under 26 U.S.C. 860G(e).
    Section 1.860G-2 also issued under 26 U.S.C. 860G(e). * * *


0
Par. 2. Section 1.860A-0 is amended by revising the entry for Sec.  
1.860G-2(a)(8) and adding an entry for Sec.  1.860G-2(b)(7) to read as 
follows:


Sec.  1.860A-0  Outline of REMIC provisions.

* * * * *


Sec.  1.860G-2  Other rules.

    (a) * * *
    (8) Release of a lien on an interest in real property securing a 
qualified mortgage; defeasance.
* * * * *
    (b) * * *
    (7) Test for determining whether an obligation continues to be 
principally secured following certain types of modifications.
* * * * *

0
Par. 3. Section 1.860A-1 is amended by adding paragraph (b)(6) to read 
as follows:


Sec.  1.860A-1  Effective dates and transition rules.

* * * * *
    (b) * * *
    (6) Exceptions for certain modified obligations. Paragraphs 
(a)(8)(i), (b)(3)(v), (b)(3)(vi), and (b)(7) of Sec.  1.860G-2 apply to 
modifications made to the terms of an obligation on or after September 
16, 2009.

0
Par. 4. Section 1.860G-2 is amended by:
0
1. Revising paragraphs (a)(8), (b)(3)(iii) and (b)(3)(iv).
0
2. Adding paragraphs (b)(3)(v), (b)(3)(vi) and (b)(7).
    The additions and revisions read as follows:


Sec.  1.860G-2  Other rules.

    (a) * * *
    (8) Release of a lien on an interest in real property securing a 
qualified mortgage; defeasance. If a REMIC releases its lien on an 
interest in real property that secures a qualified mortgage, that 
mortgage ceases to be a qualified mortgage on the date the lien is 
released unless--
    (i) The REMIC releases its lien in a modification that--
    (A) Either is not a significant modification as defined in 
paragraph (b)(2) of this section or is one of the listed exceptions set 
forth in paragraph (b)(3) of this section; and
    (B) Following that modification, the obligation continues to be 
principally secured by an interest in real property as determined by 
paragraph (b)(7) of this section; or
    (ii) The mortgage is defeased in the following manner--
    (A) The mortgagor pledges substitute collateral that consists 
solely of government securities (as defined in section 2(a)(16) of the 
Investment Company Act of 1940 as amended (15 U.S.C. 80a-1));
    (B) The mortgage documents allow such a substitution;
    (C) The lien is released to facilitate the disposition of the 
property or any other customary commercial transaction, and not as part 
of an arrangement to collateralize a REMIC offering with obligations 
that are not real estate mortgages; and
    (D) The release is not within 2 years of the startup day.
* * * * *
    (b) * * *
    (3) * * *
    (iii) Waiver of a due-on-sale clause or a due-on-encumbrance 
clause;
    (iv) Conversion of an interest rate by a mortgagor pursuant to the 
terms of a convertible mortgage;
    (v) A modification that releases, substitutes, adds, or otherwise 
alters a substantial amount of the collateral for,

[[Page 47439]]

a guarantee on, or other form of credit enhancement for, a recourse or 
nonrecourse obligation, so long as the obligation continues to be 
principally secured by an interest in real property following the 
release, substitution, addition, or other alteration as determined by 
paragraph (b)(7) of this section; and
    (vi) A change in the nature of the obligation from recourse (or 
substantially all recourse) to nonrecourse (or substantially all 
nonrecourse), or from nonrecourse (or substantially all nonrecourse) to 
recourse (or substantially all recourse), so long as the obligation 
continues to be principally secured by an interest in real property 
following such a change as determined by paragraph (b)(7) of this 
section.
* * * * *
    (7) Test for determining whether an obligation continues to be 
principally secured following certain types of modifications. (i) For 
purposes of paragraphs (a)(8)(i), (b)(3)(v), and (b)(3)(vi) of this 
section, the obligation continues to be principally secured by an 
interest in real property following the modification only if, as of the 
date of the modification, the obligation satisfies either paragraph 
(b)(7)(ii) or paragraph (b)(7)(iii) of this section.
    (ii) The fair market value of the interest in real property 
securing the obligation, determined as of the date of the modification, 
must be at least 80 percent of the adjusted issue price of the modified 
obligation, determined as of the date of the modification. If, as of 
the date of the modification, the servicer reasonably believes that the 
obligation satisfies the criterion in the preceding sentence, then the 
obligation is deemed to do so. A reasonable belief does not exist if 
the servicer actually knows, or has reason to know, that the criterion 
is not satisfied. For purposes of this paragraph (b)(7)(ii), a servicer 
must base a reasonable belief on--
    (A) A current appraisal performed by an independent appraiser;
    (B) An appraisal that was obtained in connection with the 
origination of the obligation and, if appropriate, that has been 
updated for the passage of time and for any other changes that might 
affect the value of the interest in real property;
    (C) The sales price of the interest in real property in the case of 
a substantially contemporary sale in which the buyer assumes the 
seller's obligations under the mortgage; or
    (D) Some other commercially reasonable valuation method.
    (iii) If paragraph (b)(7)(ii) of this section is not satisfied, the 
fair market value of the interest in real property that secures the 
obligation immediately after the modification must equal or exceed the 
fair market value of the interest in real property that secured the 
obligation immediately before the modification. The criterion in the 
preceding sentence must be established by a current appraisal, an 
original (and updated) appraisal, or some other commercially reasonable 
valuation method; and the servicer must not actually know, or have 
reason to know, that the criterion in the preceding sentence is not 
satisfied.
    (iv) Example. The following example illustrates the rules of this 
paragraph (b)(7).

    Example. (i) S services mortgage loans that are held by R, a 
REMIC. Borrower B is the issuer of one of the mortgage loans held by 
R. The original amount of B's mortgage loan was $100,000, and the 
loan was secured by real property X. At the time the loan was 
contributed to R, property X had a fair market value of $90,000. 
Sometime after the loan was contributed to R, B experienced 
financial difficulties such that it was reasonably foreseeable that 
B might default on the loan if the loan was not modified. 
Accordingly, S altered various terms of B's loan to substantially 
reduce the risk of default. The alterations included the release of 
the lien on property X and the substitution of real property Y for 
property X as collateral for the loan. At the time the loan was 
modified, its adjusted issue price was $100,000. The fair market 
value of property X immediately before the modification (as 
determined by a commercially reasonable valuation method) was 
$70,000, and the fair market value of property Y immediately after 
the modification (as determined by a commercially reasonable 
valuation method) was $75,000.
    (ii) The alterations to B's loan are a significant modification 
within the meaning of Sec.  1.1001-3(e). The modification, however, 
is described in paragraphs (a)(8)(i) and (b)(3) of this section. 
Accordingly, the modified loan continues to be a qualified mortgage 
if, immediately after the modification, the modified loan continues 
to be principally secured by an interest in real property, as 
determined by paragraph (b)(7) of this section.
    (iii) Because the modification includes the release of the lien 
on property X and substitution of property Y for property X, the 
modified loan must satisfy paragraph (b)(7)(i) of this section 
(which requires satisfaction of either paragraph (b)(7)(ii) or 
paragraph (b)(7)(iii) of this section). The modified loan does not 
satisfy paragraph (b)(7)(ii) of this section because property Y is 
worth less than $80,000 (the amount equal to 80 percent of the 
adjusted issue price of the modified mortgage loan). The modified 
loan, however, satisfies paragraph (b)(7)(iii) of this section 
because the fair market value of the interest in real estate (real 
property Y) that secures the obligation immediately after the 
modification ($75,000) exceeds the fair market value of the interest 
in real estate (real property X) that secured the obligation 
immediately before the modification ($70,000). Accordingly, the 
modified loan satisfies paragraph (b)(7)(i) of this section and 
continues to be principally secured by an interest in real property.
* * * * *

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 5. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


0
Par. 6. Section 602.101, paragraph (b) is amended by adding the entry 
in numerical order to the table to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control no.
------------------------------------------------------------------------
 
                                * * * * *
1.860G-2................................................       1545-2110
 
                                * * * * *
------------------------------------------------------------------------


    Approved: September 9, 2009.

Linda M. Kroening,
Acting Deputy Commissioner for Services and Enforcement.
Michael Mundaca,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E9-22215 Filed 9-15-09; 8:45 am]
BILLING CODE 4830-01-P