Treasury Issues New Rules to Encourage CMBS Workouts

September 17, 2009

On September 16, 2009, the Internal Revenue Service released final regulations governing the U.S. federal income tax treatment of collateralized mortgaged-backed securities ("CMBS") held in a real estate mortgage investment conduit ("REMIC") vehicle. Treasury described the new rules as a response to concerns raised by the commercial real estate industry concerning the difficulties of modifying distressed mortgages prior to the occurrence of a borrower default. These regulations mitigate some traditional roadblocks to pre-default workouts that previously would have prevented the modified loans from qualifying as "qualified mortgages" that may be held by a REMIC.

"Significant Modifications"

With certain exceptions, if a loan held by a REMIC undergoes a "significant modification" for U.S. federal income tax purposes, the loan will no longer constitute a "qualified mortgage." The final regulations provide additional exceptions to this rule by permitting changes in collateral and guarantees, credit enhancement of an obligation, and changes to the recourse nature of an obligation, as long as the mortgage continues to be principally secured by real property after the modification.

The "Principally-Secured" Test

The requirement that the loans be "principally secured" by real property has been amended to remove certain obstacles to debt workouts. Mortgages held by a REMIC must be secured by real property with a fair market value equal to at least 80% of the security’s adjusted issue price. This loan-to-value test must be satisfied either at the time the security is originated or at the time the security is contributed to the REMIC. If the loan is later modified, the test must also be satisfied at the time of that modification.

The new regulations provide for an "alternative test" in the context of a modification of the security. If a loan is modified but the underlying property is no longer valued at 80% of the adjusted issue price of the security, the loan will still be considered "principally secured" if the fair market value of the real property interest after the modification equals or exceeds its pre-modification value. In other words, as long as the value of the secured interest is not impaired by the loan restructuring, the REMIC securities will continue to satisfy the "principally-secured" test regardless of whether the value of the real property interest securing the loan has depreciated. Satisfaction of this alternative test must be substantiated in accordance with the regulations.


Under prior proposed regulations, the determination of the value of a real property interest at the time of a significant modification required a current appraisal by an independent appraiser. The final regulations relax this requirement in order to permit workouts to proceed on an expedited and cost-effective basis. The new regulations provide more flexibility in substantiation of value, providing that the "principally-secured" test will be satisfied if there is a reasonable belief that the modified mortgage loan satisfies the 80-percent test at the time of the modification. A reasonable belief may be based on a commercially reasonable valuation method. Such methods include, but are not limited to, a current appraisal by an independent appraiser, an appraisal obtained in connection with the origination of the obligation that has been appropriately updated for the passage of time and for other relevant changes, and the sales price of the real property interest in the case of a substantially contemporary sale in which the buyer assumes the seller’s obligations under the mortgage.

Pre-Default Negotiations

Most significantly, a newly-released IRS Revenue Procedure provides that modifications of loans held by REMICs may be pursued in connection with deteriorating, yet technically-performing, mortgage loans. Modifications may be pursued by the servicer and a borrower not only if there has been a default, but also, if there is a "reasonably foreseeable default." Whether a default is reasonably foreseeable is based on the totality of the circumstances, and the servicer must conduct due diligence sufficient to show a "significant risk of default." Depending on the circumstances, a servicer may demonstrate a significant risk of default even if the loan presents no imminent signs of non-performance.

Accordingly, if a servicer reasonably believes that the modified loan presents a "substantially reduced risk of default", even if the loan presents no imminent signs of non-performance, the loan may be modified without disqualifying the mortgages.


The final regulations reflect an awareness of the realities of today’s challenging commercial real estate market. With many mortgaged properties threatened by foreclosure and debtholders left holding depreciating securities, the new regulations provide borrowers and lenders with greater leeway to restructure securitized loans without jeopardizing the favorable tax treatment of the CMBS pool. Though borrowers and junior creditors are clearly in favor of Treasury’s move, many servicers are worried about the added pressure to balance the interests of senior debtholders, who may want to foreclose on the loan, and those of junior debtholders, who may want to continue the bet with a modified obligation.[1]


[1] Lingling Wei, New Rules Ease the Restructuring of CMBS Loans, Wall Street Journal, September 16, 2009, at C6.

 Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher’s Real Estate Practice Group and Tax Practice Group are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you work, or any of the following:  

Andrew Lance – Real Estate Group, New York (212-351-3871, [email protected])
Jesse Sharf – Co-Chair, Real Estate Group, Los Angeles (310-552-8512, [email protected])
Romina Weiss – Tax Group, New York (212-351-3929, [email protected])

© 2009 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.