The Internal Revenue Service (IRS) issued Revenue Procedure 2020-26 on April 13, 2020, providing relief to certain securitization vehicles, including investment trusts and real estate mortgage investment conduits (REMICs), from consequences associated with the coronavirus (COVID-19) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).


Under the CARES Act, borrowers of federally backed mortgage loans and multifamily mortgage loans that are experiencing a financial hardship because of the COVID-19 emergency may be entitled to a forbearance, in many instances suspending payments for as long as a year without penalty. Moreover, mortgage loans that are not federally backed may be eligible for state-mandated loan forbearance programs or voluntary forbearance provided by loan servicers. Forbearance terms may differ depending on the specific nature of the loan, but will generally involve some alteration of the parties' contractual rights under the original loan obligation. These may include a waiver of fees and penalties, as well as waiving interest beyond the amounts scheduled or calculated under the original loan terms, thus treating the borrower as if he or she made all contractual payments on time and in full under the terms of the mortgage contract.


Tax Uncertainty Caused by Modifications to Mortgage Loans


Because many mortgage loans are held through securitization vehicles, the potential alteration of legal rights raises important and consequential issues for federal tax purposes. Generally, any alteration of a legal right or obligation of the issuer or holder of a debt instrument is considered a "modification" for federal income tax purposes. A "significant" modification is treated as a deemed exchange of the original debt instrument for a new debt instrument, potentially causing taxable gain to be recognized by the issuer or holder of the debt instrument.


One or more significant modifications of loans held by a REMIC could cause the entity to lose its status as a qualifying REMIC on the basis that substantially all of the entity's assets are no longer comprised of qualified mortgages. To qualify as a REMIC, there must be one or more "regular" interests whose terms are fixed on the startup day, and the principal amount of a regular interest in the REMIC generally may not be contingent. An interest issued after the startup day does not qualify as a regular REMIC interest. Moreover, a mortgage loan is not treated as a qualifying mortgage for REMIC qualification purposes unless it is transferred to the REMIC on the startup day. REMICs are taxed on 100 percent of the net income derived from the disposition of a qualified mortgage (i.e., a "prohibited transaction") unless the disposition is pursuant to 1) substitution for a qualified mortgage, 2) incident to foreclosure, default or imminent default, 3) bankruptcy or insolvency of the REMIC, or 4) a qualified liquidation. Because forbearances granted in the current COVID-19 crisis cause modifications to the mortgage obligations, there is uncertainty whether such forbearances cause a deemed disposition of mortgage loans for newly issued mortgage obligations, cause obligations to no longer represent qualified mortgages or cause REMIC interests to not qualify as regular interests.


Similarly, although used less often since the emergence of REMICs, an investment trust used as a securitization vehicle could become taxable as a stand-alone entity as a result of the significant modification of obligations held by the trust. Under entity classification regulations issued by the Treasury Department and IRS, an "investment" trust will not be classified as a business entity that is separately subject to federal income tax so long as there is no power under the trust agreement to vary the investment of certificate holders. Because forbearances granted on underlying mortgage loans could affect the investment return of certificate holders, an issue arises whether forbearances could cause an investment trust to become taxable as a nontrust business entity.


Safe Harbors Under the IRS Revenue Procedure


In Revenue Procedure 2020-26, the IRS describes safe harbors under which modifications to certain loans resulting from the ongoing COVID-19 emergency shall not be treated as 1) replacing the unmodified obligation with a newly issued obligation, 2) giving rise to prohibited transactions, or 3) manifesting a power to vary the investment of certificate holders. Further, a safe harbor is provided under which certain securitization vehicles will not be treated as having improper knowledge of an anticipated default on the grounds that they acquired a mortgage loan that was subject to a qualifying forbearance program. These safe harbors are intended to ensure that the securitization vehicle's status as a REMIC or investment trust will not be adversely affected by forbearances arising from the COVID-19 emergency. The safe harbors also enable a REMIC to acquire a mortgage loan that has received a prior forbearance without triggering adverse consequences to its status as a qualified mortgage loan.


The safe harbors provided in Revenue Procedure 2020-26 apply to mortgage loans held by a REMIC or investment trust subject to the following:

  • forbearances of any federally backed mortgage loans or federally backed multifamily mortgage loans provided under Sections 4022 or 4023 of the CARES Act, respectively, and all related modifications, and
  • forbearances, including all related modifications, provided by a holder or servicer of a mortgage loan (whether federally backed or not) under forbearance programs for borrowers experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency, requested or agreed to by the borrower between March 27, 2020, and Dec. 31, 2020

For qualifying mortgage loans held by REMICs, Revenue Procedure 2020-26 provides that forbearances and all related modifications:

  • are not treated as resulting in a newly issued mortgage loan
  • are not prohibited transactions under Internal Revenue Code Section 860F(a)(2), and
  • do not result in a deemed reissuance of the REMIC regular interests


Although the REMIC rules look to the Treasury Department regulations under Section 1001 to determine whether there are significant modifications to debt instruments, Revenue Procedure 2020-26 does not directly alter the application of the deemed exchange rules under Section 1001(c). Rather, Revenue Procedure 2020-26 concludes that, even if the modifications are significant under the rules of Section 1001(c) and Treasury Regulation Section 1.1001-3, they are not treated as resulting in a deemed exchange of obligations for purposes of the REMIC rules.


Revenue Procedure 2020-26 further confirms that delays and shortfalls in payments are contingencies that can be disregarded under Treasury Regulation Section 1.860G-1(b)(3)(ii). As a result, an interest in a REMIC does not fail to be a regular interest because of such contingencies.


Moreover, for forbearance loans acquired by a REMIC after March 27, 2020, the prior forbearance will not be treated as evidence that the REMIC had improper knowledge of an anticipated default under Treasury Regulation Section 1.856-6(b)(3), and will not be taken into account in determining the origination date of the mortgage loan for purposes of Treasury Regulation Section 1.860G-2(a)(1). This ensures that prior forbearance loans may qualify as permitted investments without jeopardizing REMIC status.


For qualifying mortgage loans held by investment trusts, Revenue Procedure 2020-26 provides that forbearances and all related modifications do not manifest a power to vary the investment of certificate holders. Thus, forbearances arising from the COVID-19 crisis do not adversely affect the trust's status as an investment trust for U.S. federal tax purposes.


Conclusion


The IRS has previously provided relief to securitization vehicles because of economic crisis. During the financial crisis of 2008, the IRS issued Revenue Procedure 2008-28 describing conditions under which modifications of certain residential mortgage loans would not cause the IRS either to challenge the tax status of REMICs and investments trusts that hold the loans or to assert that those modifications create a liability for tax on a prohibited transaction. The IRS issued Revenue Procedure 2009-45 to provide a safe harbor allowing REMICs to modify certain commercial mortgage loans without causing negative tax consequences to the REMIC. Revenue Procedure 2020-26 adopts a consistent approach to this prior guidance and provides welcome relief to the mortgage industry during the COVID-19 emergency.


For additional information or questions on the IRS Revenue Procedure 2020-26, contact the author or another member of Holland & Knight's Taxation Team.


DISCLAIMER: Please note that the situation surrounding COVID-19 is evolving and that the subject matter discussed in these publications may change on a daily basis. Please contact your responsible Holland & Knight lawyer or the author of this alert for timely advice.