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New IRS Tax Rules Will Promote Ability to Modify CMBS Loans

Real Estate Alert Thomas A. McCarthy

The IRS has issued new tax rules, set forth in Revenue Procedure 2009-45, that are intended to help enable borrowers that obtained securitized commercial real estate loans to modify their loans prior to the occurrence of a loan default. The primary effect of the rule change will be to provide borrowers with the ability to proactively contact their loan servicer to try to negotiate a modification of the loan terms, including, when appropriate, an extension of the maturity date of the loan, prior to a loan being in default. As a consequence of previous IRS tax rules, borrowers often had no opportunity even to attempt to modify their securitized loans until after their loans were in default.

The new IRS tax rules will primarily affect commercial real estate loans that were packaged together by investment banks and later sold as securities that are commonly referred to as commercial mortgage-backed securities ("CMBS"). CMBS are securities backed by a pool of commercial real estate loans. After a commercial real estate loan is packaged into a CMBS, a real estate mortgage investment conduit ("REMIC") or investment trust holds legal title to all of the mortgages, and the borrower makes its payments to a loan servicer. Under previous IRS rules, if the loan servicer modified a CMBS loan prior to the CMBS loan being in default, the loan servicer put the entire REMIC or investment trust at risk for significant tax penalties. Consequently, a loan servicer would not allow any loan modifications unless and until there was a default under a loan.

Example:

The following scenario is an example of a situation that demonstrates the intended benefits of the new IRS rules. On December 1, 2005, a borrower obtained a $10 million loan secured by a mortgage on an office building. The loan was pooled with other loans and ended up as collateral for a CMBS. The borrower has complied with the terms of the loan and made every loan payment on time, but the loan matures on December 1, 2010, and the remaining balance of the loan on December 1, 2010 is expected to be $9.5 million. The current credit crisis has affected the ability of the borrower to refinance its loan, and the borrower thinks there is a strong likelihood that it will not be able to refinance the loan or pay off the remaining $9.5 million on December 1, 2010. Under the old IRS tax rules, the loan servicer would not have been able to modify the loan prior to an actual default, which likely would not have occurred until the loan matured on December 1, 2010. Under the new IRS tax rules, the loan servicer and borrower can immediately negotiate and modify the terms of the loan, including an extension of the maturity date. By proactively modifying the loan and extending the maturity date, it increases the likelihood that the borrower will be able to refinance the loan without incurring a payment default.

For more information about the new IRS tax rules and the most effective techniques for negotiating modifications with loan servicers, please contact Tom McCarthy at 312-715-5061 / thomas.mccarthy@quarles.com, Ann Comer at 414-277-5509 / ann.comer@quarles.com, Matt Mehr at 602-229-5288 / matthew.mehr@quarles.com or your Quarles & Brady attorney.