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In Revenue Procedure 2020-26, the IRS has provided safe harbors for real estate mortgage investment conduits (REMICs) and investment trusts that hold mortgage loans for which borrowers have participated in forbearance programs created in response to the COVID-19 emergency.

Background

Forbearance programs

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provides, among other things, that borrowers with federally-backed mortgage loans and multifamily borrowers with federally-backed multifamily mortgage loans experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency may, during a specified period (the covered period), request and obtain forbearance on their loans.

The Treasury Department observed that many holders and servicers of mortgage loans that are not federally-backed mortgage loans or federally-backed multifamily mortgage loans (non-federally-backed mortgage loans) intend to provide, through state loan forbearance programs, forbearances for the next three to six months to borrowers experiencing a financial hardship due, directly or indirectly, to the COVID-19 emergency. The scope of these programs may also include related modifications to the loan in addition to the forbearance itself.

REMICs and investment trusts

Many federally-backed mortgage loans, federally-backed multifamily mortgage loans and non-federally-backed mortgage loans are held in REMICs and investment trusts, whose federal tax classification is subject to certain requirements under the Internal Revenue Code.

Modified obligations. To qualify as a REMIC, substantially all of an entity's assets generally must consist of qualified mortgage loans and permitted investments. Under Reg. Section 1.860G-2(b), a significant modification¹ of an obligation held by a REMIC can cause the obligation to be treated as a newly issued obligation on the modification date. One or more significant modifications of obligations held by a REMIC could thus jeopardize the entity's qualification as a REMIC if the modified loans are no longer treated as qualified mortgages. Under Reg. Section 1.860G-2(b)(3)(i), however, a mortgage loan modification that is "occasioned by default or a reasonably foreseeable default" is not treated as a significant modification for purposes of Treas. Reg. Section 1.860G-2(b)(1).

Prohibited transactions. Under IRC Section 860F(a)(1), a tax is imposed on REMICs equal to 100% of the net income derived from "prohibited transactions," including certain dispositions of qualified mortgages.

Power to vary. An investment trust is not classified as a trust, under Reg. Section 301.7701-4(c), if there is a power under the trust agreement to vary the investment of the certificate holders, which may occur as a result of a significant modification of a debt instrument held by the trust.

Safe harbors

Revenue Procedure 2020-26 provides a safe harbor in connection with mortgage loans that are held by REMICs or investment trusts and subject to forbearances in connection with the economic relief provided under the CARES Act or certain similar programs. It also provides a safe harbor in connection with the direct or indirect acquisition by a REMIC on or after March 27, 2020, of certain mortgage loans for which the borrower requested a forbearance under the CARES Act or certain similar programs.

Specifically, Revenue Procedure 2020-26 provides that, for mortgage loans held by REMICs, forbearances and related modifications described in the revenue procedure: (1) will not be treated as resulting in a newly issued mortgage loan for purposes of Reg. Section 1.860G-2(b)(1); (2) are not prohibited transactions under IRC Section 860F(a)(2); and (3) do not result in a deemed reissuance of the REMIC regular interests.

Similarly, for mortgage loans held by investment trusts, forbearances and related modifications described in the revenue procedure do not give rise to a prohibited power to vary the investment of the certificate holders if the forbearance relief was requested or agreed to between March 27, 2020, and December 31, 2020, and granted as a result of a borrower experiencing a financial hardship due to the COVID-19 emergency.

For certain forbearance loans acquired by a REMIC, the revenue procedure specifies that: (1) the prior forbearance and related modifications are not treated as evidence that the REMIC had improper knowledge of an anticipated default under Treas. Reg. Section 1.856-6(b)(3); and (2) the prior forbearance and related modifications are not taken into account in determining of the origination date of the mortgage loan for purposes of Treas. Reg. Section 1.860G-2(a)(1).

Finally, Revenue Procedure 2020-26 states that, for mortgage loans held by REMICs, delays and shortfalls in payments associated with or caused by forbearances and related modifications described in the revenue procedure are contingencies under Treas. Reg. Section 1.860G-1(b)(3)(ii) that can be disregarded.

Implications

The safe harbors provided by Revenue Procedure 2020-26 provide welcome relief by ensuring that the tax status of REMICs and investment trusts will not be impacted as a result of holding mortgage loans that are modified due to the borrowers' financial hardships from the COVID-19 emergency. The guidance appears explicitly limited to residential mortgage loans, however, and does not address any impact on the tax classification status of securitization vehicles holding other types of debt investments (e.g., commercial mortgage loans, auto loans, student loans). Further guidance is needed to address other structured debt investment vehicles.

The guidance resolves tax issues as to the tax classification status of the securitization vehicles but fails to address other significant tax accounting impacts (e.g., potential recognition of phantom income/gain, status of interest as qualified stated interest) that can arise from the loan modifications. Further, the CARES Act generally describes the expected relief to be provided by forbearance programs² and appears to leave the specific terms of forbearance agreements to be negotiated by the individual loan servicers. Thus, resulting loan modifications and the attendant tax consequences to investors in mortgage-backed securities are likely to vary from servicer to servicer and state to state.

An investor in a mortgage pool that is represented by a GSE-backed fully guaranteed security, e.g. a Fannie Mae or Freddie Mac, should receive scheduled principal and interest payments, so its cash receipts should not be directly impacted by a loan forbearance.

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ENDNOTES

¹ See Treas. Reg. Section 1.1001-3(e).

² The CARES Act provides that, during the period of forbearance, no fees, penalties or interest beyond the amounts scheduled or calculated as if the borrower made all contractual payments on time and in full under the terms of the mortgage contract shall accrue on the borrower's account.