IRS Issues Guidance on Loan Modifications

In clarification that market participants said will further embolden servicers to modify mortgages that are likely headed for trouble, the Internal Revenue Service on Monday outlined the tax effects on securitized mortgages that have been modified to avoid foreclosures. Under Revenue Procedure 2008-28, the IRS said that it will not challenge the tax status of securitization vehicles when a servicer modifies a loan — even a performing loan — so long as the modification fits within the new scope outlined by the government agency.

The guidance comes as welcome news for servicers and investors in their attempts to implement foreclosure prevention programs for most subprime mortgages; the vast majority of subprime mortgages are securitized, and the implications of loan modifications prior to default a germane issue for the so-called REMIC election.

Many servicers have been looking to work with borrowers proactively, ahead of potential default activity, but have been unsure about whether doing so might jeopardize the favored tax status of a particular securitization trust.

The reason is tied to IRS rules regarding the favorable tax treatment of REMICs, which mandate not only a static pool requirement but a “passive management” requirement that has served to essentially limits servicers’ ability to modify loans to only those situations where a default is deemed imminent — in other words, to those situations where borrowers have already become delinquent on their payments.

In the past, industry consensus was that getting more aggressive with loan modification — such as modifying performing loans likely to default before they became delinquent — would likely have been seen as “active management” of the underlying pool, jeopardizing the favored tax status of the REMIC.

And that is what makes the IRS guidance released Monday so important, at least from a servicers’ perspective. The IRS said it will now allow servicers to freely modify performing loans when “the holder or servicer reasonably believes that there is a significant risk of foreclosure of the original loan,” a sea-change from earlier industry practice.

This new freedom, however, does come with some restrictions: modifications of performing loans must put the holder in a “less favorable” position, and may only be done when less than 10 percent of initial pool aggregate balance is already delinquent.

Servicers must reasonably believe that the modification will result in a “substantially reduced risk of foreclosure,” as well, the IRS said.

The guidance from the IRS dovetails with January clarification from the Securities and Exchange Commission that suggested fast-tracking loan modifications would not jeopardize the so-called QSPE election, which allows the off-balance sheet treatment of REMICs and other securitization trusts.