Servicers Survival Guide PDF

Servicer
Survival
Guide
2012-2013 Edition
A Practical Guide to Servicing in CMBS
This collection of memoranda provided by Kilpatrick Townsend and Stockton LLP and
its affiliates is for educational and informational purposes only and is not intended and
should not be construed as legal advice.
2012 KILPATRICK TOWNSEND AND STOCKTON LLP
Table of Contents
REMIC Qualification Why Do We Care?. . . . . . . . . . . . . . . . . . . . . . . . 1
Fear of the Unknown The Danger of Holding Unqualified
Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
The Loans (and the Rules) They Are a Changin Modifying
Loans Held by REMICS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Accepting Prepayments and Payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Loan Payoffs vs. Loan Assignments Know the Difference. . . . . . . . 53
Through the Looking Glass: Up is down, down is upAre
Non-recourse Loans Recourse?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Basic Elements of a Repurchase Claim . . . . . . . . . . . . . . . . . . . . . . . . . . 69
REMIC-Based Repurchase Claims Qualified Mortgages
and Foreclosure Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Environmental Issues Facing Special Servicers . . . . . . . . . . . . . . . . . . . 87
Foreclosure Property Extensions When and Where to File. . . . . . 103
Workouts, Cancellation of Indebtedness and IRS Reporting
Requirements: What Borrowers and Special Servicers Need to
Know. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Property Protection Advancing in CMBS. . . . . . . . . . . . . . . . . . . . . . . 121
Financing REO in CMBS:
Some Answers and Some Questions. . . . . . . . . . . . . . . . . . . . . . . . . 135
Deeds in Lieu and Keeping Qualified Mortgages AliveFact
from Fiction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
Multiple Sales of REO: Preserving
Qualified Foreclosure Property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
Is There Hope for A/B Notes?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Federal ReceivershipsWhat You Should Know . . . . . . . . . . . . . . . . 163
Proceeding in Federal Court Borrower Challenges
to Diversity Jurisdiction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
A Primer on Net Income from
Foreclosure Property. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
Defaulted Mortgage Loan Sales
The Purchase Option and Beyond. . . . . . . . . . . . . . . . . . . . . . . . . . . 197
Foreclosure Property Qualification:
Restrictions on Construction of REO. . . . . . . . . . . . . . . . . . . . . . . . 207
CMBS 2.0 (or is it 3.0?)
What does it really mean to me?. . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
Intercreditor Agreements Key Provisions for
Special Servicers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
ii
REMIC Qualification Why Do We Care?
REMIC Qualification Why Do We Care?

Thomas J. Biafore
Background: One of the fundamental rules related to the servicing of loans

held in a REMIC trust is that the servicer must never take an action that
results in the trusts loss of REMIC tax status. This mandate is provided
for in the related pooling and servicing agreements (PSAs) that govern
particular securitizations. For example, most PSAs contain provisions that
prohibit the servicer or special servicer from (i) modifying a performing
loan in a manner that disqualifies the loan, (ii) taking title to property that
is neither qualified foreclosure property nor permitted investments, or
(iii) engaging in activity that is detrimental to the tax-free nature of the
REMIC. While the language may differ from securitization to securitization, the charge for the servicer and the special servicer remains the same:
the trusts REMIC status must be preserved at all times.
A REMIC is the primary vehicle for the securitization of real estate loans.
Properly formed, structured and operated, the REMIC itself is generally not subject to tax. Rather, the tax consequences of the REMIC flow
through to the holders of the REMICs one class of residual interest much
like partners in a partnership or members of limited liability company. If
REMIC status is preserved, each regular interest issued by the REMIC is
treated as debt for tax purposes irrespective of whether this regular interest
would be treated as debt under general tax principles.
Asset Test: An entity that elects REMIC status for federal tax purposes
must satisfy the so-called asset test. The REMIC passes the asset test if,
at all times, substantially all of the REMICs assets are qualified mortgages
or permitted investments. The asset test applies at all times during the life
of the REMIC except for the initial period, from the REMICs startup
day to the end of the third month following the startup day, and the final
period, starting at the time the REMIC adopts a plan of liquidation until
the REMIC is liquidated.
The qualified mortgage element of the asset test limits the REMIC to
acquiring and holding a fixed pool of mortgages. A REMICs activities regarding permitted investments are limited to holding cash flow
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Servicer Survival Guide 2012

investments, qualified reserve assets and foreclosure property. Cash flow
investments allow the REMIC to receive income by investing the proceeds
that the REMIC receives on the REMICs other assets pending distribution
of these proceeds to certificateholders. Addressing the financial management of the REMIC, qualified reserves enable REMICs to have cash on
hand to pay expenses. In connection with a default, REMICs may hold, as
foreclosure property, the real property and incidental personal property
that secures the borrowers obligation under the terms of the defaulted
obligation. Beyond these limited holdings, the asset test restricts the
REMICs activities.
While the timing element of the asset test (at all times substantially all of
the REMICs assets must be qualified mortgages or permitted investments)
may be clear, the quantity element (the substantially all portion of this
test) is open to interpretation. In reality, the scope of the substantially
all requirement may be narrower than some might believe. The Code
defines substantially all as requiring all but a de minimis amount of the
REMICs assets to be qualified mortgages or permitted investments. Under
the regulations this de minimis amount is quantified as 1% of the aggregate tax basis of all of the REMICs assets. If the aggregate tax basis of the
non-qualified assets is less than 1% of the aggregate tax basis of all of the
REMICs assets, then the de minimis test is met and the REMICs tax qualified status will be preserved. If, however, the REMIC holds nonqualified
assets in excess of this 1% safe harbor, the REMICs tax preferred status
may be lost. See Tom Biafore, Fear of the Unknown The Danger of
Holding Unqualified Assets in this Guide for a detailed discussion of the
application of the de minimis test of nonqualified assets.
Interest Test: An additional requirement for an entity that elects REMIC
status is that the entity must limit the types of interests issued to certificateholders. This test, simultaneously applied with the asset test, requires
that all of the REMICs interests be either regular or residual and that there
be only one class of residual interests.
The interest test is another mechanism, like the asset test, for restricting
the activities of the REMIC. By limiting the REMICs interests to regular
and residual interests, the interest test provides clarity for tax treatment.
4
Kilpatrick Townsend & Stockton LLP

All of the REMICs interests must fall into one of these two categories, thus
simplifying the application of the tax consequences to these two types of
interests. The interest test prevents the REMIC from entering into transactions that would create interests that are neither regular nor residual
interests.
The Code defines a regular interest as any interest in a REMIC that is issued
on the startup day and designated as a regular interest. Less specificity is
given to the definition of a residual interest, which is an interest issued
on the startup day that is not a regular interest and that is designated as a
residual interest. Other than these definitions, the Code is silent as to the
meaning of an interest itself. The regulations narrow the scope by excluding from the classification of interests certain types of claims including:
payments for servicing, stripped interests, rights of reimbursement arising
from guarantees of REMIC assets or other credit enhancement contracts,
and rights to acquire mortgages or other REMIC assets.
Importance of REMIC Status: REMICs are structured based on the premise that the REMIC itself will not be subject to tax on the income that the
REMIC receives from the REMICs qualified mortgages and permitted
investments. If the servicer or special servicer takes an action that results
in a loss of REMIC status, the REMIC will be subject to tax. The loss of
REMIC status can be potentially disastrous. Because the REMIC was
structured and priced based on the belief that the REMIC will not be subject to tax, it is likely that a REMIC that is disqualified will lack sufficient
funds to pay REMIC-level taxes and make distributions to certificateholders at levels that satisfy the certificateholders desire to earn a satisfactory
return on their investments in the REMIC.
Caution: It has been suggested that because a REMIC is predominantly
capitalized with regular interests that are treated as debt for tax purposes,
the tax consequences of losing REMIC status are not material. The suggestion is that whether or not the REMIC is subject to REMIC-level tax, the
REMIC would be offsetting, from the REMICs gross income, the interest
that the REMIC pays to certificateholders that hold regular (debt) interests
in the REMIC. The REMICs gross income is generally the interest that
the REMIC receives on the loans that the REMIC holds and any income
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from foreclosure property or permitted investments. Depending on the
specifics of the REMICs capitalization structure, one might suggest that
there would be little if any REMIC-level income left (after paying interest
to regular interest holders) that would be subject to tax at the REMIC level
even if REMIC status is lost.
What is missing from this suggestion is that the REMICs regular interests are treated as debt for tax purposes and the REMIC is entitled to an
interest expense deduction for the interest the REMIC pays to these certificateholders only by virtue of a special REMIC rule. If the REMIC status
is lost, the REMIC would be required to reclassify these regular interests as debt or equity based on fundamental tax principles. If any of the
REMICs regular interests are reclassified as equity for tax purposes, 1 the
consequences to the trust of losing its status as a REMIC will be disastrous.
Rather than deducting, as interest expense, payments made to holders of
regular interests that have been reclassified as equity in the REMIC, the
REMICs payment to certificateholders that are deemed to hold an equity
interest in the REMIC would first be subject to a REMIC-level tax.
Conclusion: The precise economic consequences of a trusts loss of REMIC
status cannot be predicted up front. In the event that the trust loses its status as a REMIC, the trust will become subject to REMIC-level tax and the
REMIC will not be afforded an automatic deduction for interest paid to
holders of regular interests.
The classification of an instrument as debt or equity requires a factual analysis that turns on the individual
circumstances of each scenario. Courts analyze various factors that can identify characteristic differences
between debt and equity including: 1. Was the instrument treated as debt or equity for accounting purposes? 2.
Was there an intention to create debt or equity? 3. Are the indicia related to the instrument common to debt or
equity?
1

For more information, contact:
Thomas J. Biafore
1100 Peachtree Street
Suite 2800
Atlanta, GA 30309-4528
t 404 815 6250
f 404 541 3129
TBiafore@KilpatrickTownsend.com
Fear of the Unknown The Danger of Holding

Unqualified Assets
10
Fear of the Unknown The Danger of Holding

Unqualified Assets
Thomas J. Biafore
Background: A special servicer may consider having a REMIC acquire

property that is other than a qualified mortgage or a permitted investment
as a strategy intended to increase recovery from a defaulted mortgage loan
or foreclosure property.
In the case of a defaulted loan where the related borrower has filed bankruptcy, a special servicer may consider, as a workout strategy, acquiring
claims held by other creditors in the borrowers bankruptcy proceeding.1
In the case where a REMIC trust has foreclosed on a property, a special
servicer may consider acquiring adjacent property (perhaps for access or
parking related to the foreclosure property) so that the property on which
the REMIC has foreclosed maintains or increases in value.
Despite the economic benefit of these arrangements, a special servicer
should think hard before intentionally acquiring property that is neither a
qualified mortgage nor a permitted investment.
REMIC Qualification: As a general matter, for an entity to maintain its
status as a real estate mortgage investment conduit (a REMIC) under the
terms of the Internal Revenue Code of 1986 (the Code), substantially
all of the REMICs assets must be qualified mortgages or permitted
investments within the meaning of the Code. Claims of an unrelated
creditor in a borrowers bankruptcy and adjacent real property that did
not secure the borrowers obligation at the time the REMIC foreclosed on
the collateral are generally neither a qualified mortgage nor a permitted
investment.
The practice of buying other creditors claims to control a debtors bankruptcy and to avoid the undesirable
results of a potential cram down is a common strategy outside of the CMBS setting. While in some circumstances, it is possible for a REMIC to acquire the claims of another creditor (depending on the nature of the
claim acquired and scope of permitted advances detailed in the borrowers loan documents) a special servicer
must take care in analyzing whether a REMIC can acquire another creditors claims without disqualifying the
REMIC. See Tom Biafore and Rex Veal, Property Protection Advances in CMBS in this Guide for a discussion
of the issues related to a servicers advance to acquire bankruptcy claims. Beyond the REMIC tax qualification
issues associated with a REMICs purchase of another creditors claim, the REMICs acquisition of any such
claims presents possible PSA issues related to permissible advances and appropriate reimbursements.
1
11

Issue: Under what circumstances may a REMIC acquire property that is
neither a qualified mortgage nor a permitted investment?
Analysis: The short answer is never. Under the terms of the Code, substantially all (as opposed to all) of a REMICs assets must be qualified
for a REMIC to enjoy transparent (or flow through) tax status. The regulations attempt to provide color to this substantially all test by providing
a safe harbor that concludes that if 99% of the REMICs assets (computed
based on the REMICs tax basis in qualified and unqualified assets) are
permitted investments or qualified mortgages, the REMIC will retain its
status as a REMIC.
The fact that, under the safe harbor, 1% of the REMICs assets may
be comprised of other than qualified mortgages and permitted investments cannot be relied on by a special servicer. Even though a REMIC
initially holds nonqualified assets (such as claims of other creditors in a
borrowers bankruptcy proceeding) that account for less than 1% of the
REMICs assets, the trusts overall holdings diminish as loans pay off or as
the REMIC forecloses on and disposes of REO property. The effect of this
reduction in the REMICs holdings could result in the nonqualified assets
(initially representing less than 1% of the REMICs balance) representing
more than 1% of the REMICs balance at some future date.
Similarly, a special servicer cannot be comfortable with taking any action
that will result in a REMIC holding nonqualified assets even if these assets
make up less than 1% of the REMICs assets because other assets held by
the REMIC might later be discovered to be nonqualified. If the sum of
all of the nonqualified assets exceeds 1%, the REMIC will not fit within
the safe harbor provided for in the regulations. For these reasons, special
servicers should treat this 1% safe harbor for REMIC qualification not as a
planning tool but rather a safety net of last resort.
Beyond the problems caused by the cumulative nature of the substantially
all test and the 1% safe harbor described above, there are other more fundamental problems related to a REMICs knowingly holding property that
is neither a qualified mortgage nor a permitted investment.
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As noted above, the 1% safe harbor provided for in the regulations is not
absolute. While, under the regulations, the Codes substantially all test
will be satisfied if 99% of the REMISs assets are qualified, there is nothing in the Code that concludes that if only 95%, 90% or even 85% of the
REMICs assets are qualified, the Codes substantially all test would not
be satisfied. At first impression, the fact that the Codes substantially all
test for REMIC qualification is not limited by the 1% safe harbor may
make special servicers more comfortable in their decision to have the
REMIC hold a small amount of nonqualified property. This first impression is misleading.
Even if one can assume that the substantially all test for REMIC qualification extends beyond the 1% safe harbor contained in the regulations,
having a REMIC take title to nonqualified property is a dangerous game.
By way of example, assume that a REMIC is discovered to hold nonqualified assets that total 7% of the REMICs total holdings. This could happen,
for example if the special servicer inadvertently failed to get a qualified
foreclosure property extension for REO property. While this 7% is beyond
the 1% safe harbor provided for in the regulations, if the nonqualified asset
was acquired by accident (such as in the case of the special servicers inadvertently failing to apply for a qualified foreclosure property extension), it
may be that the Internal Revenue Service would be willing to concede that
the substantially all test continues to be satisfied and REMIC status will
be preserved. The IRS may be less likely to look the other way if it finds
that the special servicer knowingly acquired a number of nonqualified
assets as a planning tool (e.g., nonqualifying bankruptcy claims, real property adjacent to REO property) in addition to the nonqualified asset that
already totals an amount in excess of the 1% of the REMICs assets.
PSA Issues: In addition to the tax issues associated with the REMICs
acquisition of nonqualified property, the PSA that governs the related
securitization will also limit the special servicers efforts to acquire nonqualified property.
PSAs typically contain several provisions that state that the special servicer
should not acquire nonqualified assets. For example, typical PSAs provide
that in connection with the acquisition of REO property, the REMIC will
13

not acquire personal property (e.g., possibly unrelated party bankruptcy
claims) unless,
(i) such personal property is incident to real property; or
(ii) the Special Servicer shall have obtained an Opinion of
Counsel to the effect that the holding of such personal
property by the Trust Fund will not cause the imposition of
a tax on the Trust Fund under the REMIC Provisions.
Similarly, with respect to modifications of loans, most PSAs provide something similar to the following:
Neither the Master Servicer nor the Special Servicer shall
make or permit any modification, waiver or amendment
of any term of any Mortgage Loan that would (A) cause
the REMIC to fail to qualify as a REMIC under the Code
or result in the imposition of any tax on prohibited transactions or contributions after the Startup Day of any
such REMIC under the REMIC Provisions or (B) cause any
Mortgage Loan to cease to be a qualified mortgage within
the meaning of Section 860G(a)(3) of the Code. (emphasis
added)
As a general catch all, most PSAs contain provisions similar to the
following:
The Trustee shall not knowingly or intentionally take any
action that could (i) adversely affect the status of
REMIC I, REMIC II or REMIC III as a REMIC or (ii) result
(subject to the following sentence) in the imposition of a
tax upon REMIC I, REMIC II or REMIC III (including but
not limited to the tax on prohibited transactions as defined
in Section 860F(a)(2) of the Code and the tax on contributions to a REMIC set forth in Section 860G(d) of the Code)
(such event, an Adverse REMIC Event) unless the Trustee
receives an Opinion of Counsel . . . to the effect that the
contemplated action will not, with respect to any REMIC
created hereunder adversely affect such status or, unless
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the Master Servicer, the Trustee, or the Special Servicer,
as applicable determine that the monetary exposure to
REMIC I, REMIC II and REMIC III is not material and in
its or their sole discretion to indemnify, to the extent reasonably acceptable to the Trustee, the Trust Fund against
the imposition of such tax. (emphasis added)
The thrust of each of these PSA provisions is that the special servicer
should not intentionally take actions that could result in the imposition of
tax against or otherwise disqualify the REMIC.
While it is conceivable that under typical PSAs the special servicer could,
on the related REMICs behalf, knowingly obtain nonqualifying property,
the special servicer is typically required to obtain a legal opinion that the
REMICs acquisition of such property will not disqualify the REMIC or
make a determination that any monetary exposure to the REMIC is not
material. Each of these alternatives poses significant problems for the special servicer.
With respect to the requirement that the special servicer obtain a legal
opinion, any legal opinion will likely assume that the REMIC will not be
disqualified as a result of the REMICs acquisition of nonqualified assets
because the total of all of the REMICs nonqualified assets is, and will
always be, less than 1% of all of the REMICs assets. In effect, an opinion of this nature assumes the legal conclusion. This is the case because
the drafter of the opinion (like the special servicer itself) has no way of
knowing which of the REMICs other assets are currently nonqualified
and which of the REMICs assets that are currently qualified might later
become nonqualified. Any opinion that assumes that the REMIC will only
ever hold nonqualified assets in an amount less than the 1% safe-harbor is
of limited efficacy.
The PSA requirement that the REMICs acquisition of nonqualified assets
not have material monetary exposure to the REMIC is also conceptually
difficult for the special servicer to manage. Because the tax-transparent
status of the entire REMIC is at issue should the REMIC acquire nonqualified assets that result in the REMIC failing the substantially all test, it
15

is difficult to conceive how the special servicer could reach a conclusion
that the REMICs acquisition of nonqualified assets would not subject the
REMIC to material monetary exposure. The special servicer will never
know which of the REMICs assets are currently, or in the future will
become, nonqualified.
Conclusion: Taking chances with a REMICs asset test for qualification is a
dangerous game. If the REMIC acquires even a very small (relative to the
REMICs overall holdings) amount of non-qualified property, the entire
REMIC could be disqualified. This risk is too much for a special servicer
to take.
Thomas J. Biafore
Suite 2800
t 404 815 6250
f 404 541 3129
16
The Loans (and the Rules) They Are a Changin

Modifying Loans Held by REMICS
17
18
The Loans (and the Rules) They Are a Changin

Modifying Loans Held by REMICS
Stephen A. Edwards
Thomas J. Biafore
Jennifer OConnor
A frequent task of a servicer whether it be a master or special is deciding whether to modify a loan it services. A borrower on a performing
loan may request that the lender release its lien on an outparcel so that
the outparcel can be sold or may request approval to modify collateral to
accommodate a new tenant. A borrower on a loan that is performing now
but may cease to be in the foreseeable future may want to avoid a default by
extending the term of the loan or reducing the interest rate. A special servicer may seek to transfer the collateral securing a loan to a purchaser that
will only assume the loan if there are substantial changes to the loan terms.
All of these modifications, as well as the many other possible changes to
loans held by a REMIC, are governed by a complex set of tax rules, as well
as the restrictions in the Pooling and Servicing Agreement (or PSA) governing the REMIC. This article discusses those rules and restrictions.
Background
The previous articles (Tom Biafore, REMIC Qualification Why Do
We Care; Tom Biafore, Fear of the Unknown The Danger of Holding
Unqualified Assets) highlighted the requirement that, under the asset
test, substantially all of a REMICs assets must be qualified mortgages
or permitted investments within the meaning of Section 860G(a)(3) of
the Internal Revenue Code (the Code). Most of the assets that will concern servicers are intended to fall into the first category, which requires
that the assets meet several requirements. One is that an obligation, in
order to be a qualified mortgage, must be principally secured by an
interest in real property.1 Another is that the obligation must be acquired
by the REMIC within the three-month period beginning on the REMICs
startup day, which is generally the date on which the REMIC first issues
certificates.
1 Code Section 860G(a)(3)(A).
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For most servicers, the aspect of the definition of qualified mortgage that
creates the most difficulty is the requirement that a loan be acquired by
the REMIC within that three-month period. The difficulty arises because a
significant modification of a loan can cause the loan to be treated for tax
purposes as if the loan was cancelled and a new loan was issued in its place
and acquired by the REMIC at the time of the significant modification.
There are exceptions to this rule that apply to REMICs, but determining
whether a significant modification has occurred and whether the exceptions apply can be challenging for the servicer and its advisors.
To add to the concern, a determination that the mortgage has been disposed of as a result of a significant modification could also subject the
REMIC to the taxes on prohibited transactions (which include the disposition of any qualified mortgage, unless a further exception applies)2 or
taxes on contributions (which apply to any amount that is contributed to
a REMIC after the startup day).3
The 1001 Regulations What is a significant modification?
Whether an obligation has been significantly modified is determined
under Code Section 1001.4 The Treasury has released final regulations
under Code Section 1001 (the 1001 Regulations) to clarify under what
circumstances a modification of a loan will be deemed to be a taxable disposition of that loan. Almost any change to the terms of a loan will result
in a modification of the loan, so the focus of the analysis is typically on
whether the modification is significant. 5 Fortunately for servicers, the
analysis required under the 1001 Regulations can often be avoided by
REMICs as a result of the REMIC-Specific Rules described under subsequent headings of this article.
The 1001 Regulations provide safe harbor guidelines for determining
whether certain types of modifications are considered significant.6 If a
proposed modification does not fall within any of these safe harbor provisions, the modification will be considered to be significant only if,
2
3
4
5
6
Code Section 860F(a)(2)(A).

Code Section 860G(d).
Treas. Reg. 1.860G-2(b).
Treas. Reg. 1.1001-3(b).
See Treas. Reg. 1.1001 3(e)(2)-(6).
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based on all facts and circumstances, the legal rights or obligations that
are altered and the degree to which they are altered are economically
significant.
In making the determination of whether a significant modification has
occurred, all modifications to a debt instrument are considered collectively so that a series of modifications may be significant when considered
together although each modification, if considered alone, would not be
significant.7 Two or more modifications of a debt instrument over any
period of time will constitute a significant modification, however, if, had
the modifications been done as a single change, the change would have
resulted in a significant modification.8 Modifications of different terms of
a debt instrument (e.g., interest rate, time of payment, or security), none of
which separately would be a significant modification, do not collectively
constitute a significant modification.
Subject to the REMIC-Specific Rules and as illustrated in the flow chart
that follows this article, the 1001 Regulations contain the following ground
rules for determining whether a modification of a loan is significant. If
the REMIC-Specific Rules do not apply to a borrowers request, the servicer may look to the safe harbor provisions of the 1001 Regulations as a
last chance to achieve some level of comfort that a borrowers requested
loan modification will not cause a REMIC problem.
Change in Yield
A change in the yield of the payments under a debt obligation is not a
significant modification, unless the new yield varies from the annual yield
on the unmodified obligation (as of the date of the modification) by more
than the greater of (A) 1/4 of one percent (i.e., 25 basis points), or (B) five
percent of the annual yield of the unmodified obligation.9 A commercially
reasonable prepayment penalty for a pro rata prepayment is not consideration for a modification of a debt obligation and is not taken into account
in determining the yield of the modified obligation.10 Of course, virtually
7 Treas. Reg. 1.1001-3(e)(1).
8 Treas. Reg. 1.1001-3(f)(4).
9 Treas. Reg. 1.1001-3(e)(2)(ii).
10 Treas. Reg. 1.1001-3(e)(2)(iii)(B).
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all PSAs do not allow a servicer to alter the amount of timing of payments
due under a performing qualified mortgage, so at least at the master servicer level the change in yield safe harbor is of limited efficacy, except in
the case of specially serviced loans.
Changes in Timing of Payments
In General. A modification that changes the timing of payments on a debt
obligation is a significant modification if it results in the material11 deferral
of scheduled payments. The deferral may occur either through an extension of the final maturity date of the debt instrument or through a deferral
of payments due prior to maturity.
Safe Harbor Period. The deferral of one or more scheduled payments
will not be a material deferral if the deferred payments are unconditionally payable no later than the lesser of (a) five years from the original due
date of the first amount deferred or (b) 50% of the original term of the
instrument,12 determined without regard to any option to extend the original maturity. Deferrals of de minimis payments are ignored.13 As a change
in timing of payments can in certain circumstances alter the yield on the
debt obligation, a change in timing must also satisfy the change-in-yield
test if the deferral is to fall within this safe harbor.
Change in Obligor or Security
Change in Obligor. The substitution of a new obligor on a nonrecourse
debt instrument is not a significant modification.14
Change in Security. A modification that releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or
other form of credit enhancement for a nonrecourse debt instrument is
11 The materiality of the deferral depends on all the facts and circumstances, including the length of the deferral, the original term of the instrument, the amounts of the payments that are deferred, and the time period
between the modification and the actual deferral of payments. Treas. Reg. 1.1001-3(e)(3)(i).
12 Treas. Reg. 1.1001-3(e)(3)(ii).
13 If the period during which payments are deferred is less than the full safe harbor period, the unused portion
of the period remains a safe harbor period for any subsequent deferral of payments on the instrument. Id.
14 Treas. Reg. 1.1001-3(e)(4)(ii). See Treas. Reg. 1.1001-3(e)(4)(i) for the rules on the substitution of a new
obligor on a recourse debt instrument.
22

a significant modification.15 The REMIC-Specific Rules limit the effect of
this provision on REMICs.
Change in Priority. A change in the priority of a debt instrument relative
to other debt of the borrower is a significant modification if it results in a
change in payment expectations.16 For these purposes, a change in payment expectations occurs if, as a result of the transaction,
(1) (a) there is a substantial enhancement of the borrowers capacity
to pay debt service and (b) that capacity was primarily speculative
prior to the modification and is adequate after the modification;
OR
(2) (a) there is a substantial impairment of the borrowers capacity
to pay debt service and (b) that capacity was adequate prior to the
modification and is primarily speculative after the modification.17
Changes in the Nature of the Debt Instrument
Property That Is Not Debt. A modification of a debt instrument that causes
it to be equity for tax purposes (or some other form that is not debt for
federal income tax purposes) is a significant modification.18 Deterioration
in the financial condition of the borrower between the original date of the
debt instrument and the date of modification (as it relates to the borrowers
ability to repay the debt) is not taken into account unless, in connection
with the modification, there is a substitution of a new borrower or the
addition or deletion of a co-borrower.19
15 Treas. Reg. 1.1001-3(e)(4)(iv)(B). A substitution of collateral is not a significant modification, however, if
the collateral is fungible or otherwise of a type where the particular units pledged are unimportant (for example,
government securities or financial instruments of a particular type and rating). In addition, the substitution of
a similar commercially available credit enhancement contract is not a significant modification, and an improvement to the property securing a nonrecourse debt instrument does not result in a significant modification. Id.
See Treas. Reg. 1.1001-3(g), Ex. 7 (construction of an additional building on a parcel of land securing nonrecourse debt is an improvement to the property and does not result in a significant modification).
16 Treas. Reg. 1.1001-3(e)(4)(v).
17 Treas. Reg. 1.1001-3(e)(4)(vi)(A). The obligors capacity includes any source for payment, including collateral, guarantees, or other credit enhancement. Treas. Reg. 1.1001-3(e)(4)(vi)(B).
18 Treas. Reg. 1.1001-3(e)(6). Whether an instrument represents debt or equity for federal income tax purposes requires an analysis of the specific facts related to the instrument. Courts have considered the following
factors, among others: 1. Is the instrument treated as debt or equity for accounting purposes? 2. Was there an
intention to create debt or equity? 3. Are the indicia related to the instrument common to debt or equity? See
Tom Biafore, REMIC Qualification Why Do We Care?
19 Id.
23

Change in Recourse Nature. A change in the nature of a debt instrument from recourse (or substantially all recourse) to nonrecourse (or
substantially all nonrecourse) or from non-recourse (or substantially all
nonrecourse) to recourse (or substantially all recourse) is a significant
modification.20
Accounting or Financial Covenants
A modification that adds, deletes, or alters customary accounting or financial covenants is not a significant modification.21
The REMIC-Specific Rules
The Treasury Regulations governing REMICs (the REMIC Regulations)
and related Revenue Procedures issued by the Internal Revenue Service
(the IRS) contain provisions and exceptions that apply only to REMICs
(the REMIC-Specific Rules) and moderate the effect of the more general rules described above.
The Prior Regulations
Prior to September 16, 2009, the Treasury Regulations governing REMICs
(the REMIC Regulations as they read before the promulgation of the Final
Regulations described below are referred to as the Prior Regulations)
contained the four exceptions to these rules for loans held by a REMIC.
Under the Prior Regulations, such loans would not be treated as having
been significantly modified as a result of:
(i) changes to a loans terms that are occasioned by default or a reasonably foreseeable default;
(ii) assumptions of loans;
(iii) waivers of due-on-sale or due-on-encumbrance clauses; and
(iv) conversions of interest rates pursuant to the terms of a convertible mortgage.
20 Treas. Reg. 1.1001-3(e)(5)(ii)(B).
21 Treas. Reg. 1.1001-3(e)(6).
24

Servicers and borrowers complained for many years that these exceptions,
while useful, did not go far enough and prevented servicers from entertaining reasonable requests from borrowers for loan modifications and
collateral alterations.
Rev. Proc. 2009-45 and Reasonably Foreseeable Defaults
The deterioration of the real estate and credit markets after 2007 resulted
in a sharp increase in the number of defaulted CMBS mortgage loans and,
with that, much fretting in some quarters about how to apply the exception for changes to a loans terms that are occasioned by default or a
reasonably foreseeable default. The view in those quarters was that the
then-current default modification rules needed clarification to allow special servicers greater flexibility to deal proactively with potential defaults of
qualified mortgages. In particular, it was suggested that the default modification rules should expressly allow for a determination of a default that
is reasonably foreseeable based on a borrowers representation that, at
some time in the future, the borrower may not be able to obtain financing
for the collateral property in order to pay off its loan or that the loan may
otherwise default.
After a great deal of pestering on this topic, the IRS issued Revenue
Procedure 2009-45 (Rev. Proc. 2009-45) on September 15, 2009, to provide guidance on the REMIC-Specific Rules and to allow for earlier and
more proactive modifications of loans that might later default. The benefits
of Rev. Proc. 2009-45 are not available if, as of the end of the three-month
period beginning on the REMICs startup day, more than 10% of the stated
principal of the total assets of the REMIC were, at the time they were contributed to the REMIC, overdue by at least 30 days or loans on which a
default was reasonably foreseeable.
A loan to which Rev. Proc. 2009-45 applies can be modified without
concern that the loan may not be considered to be one on which there
is a reasonably foreseeable default, if based on all the facts and circumstances, the servicer reasonably believes that there is a significant risk
of default of the loan at maturity or some earlier date. This belief must be
based on a diligent contemporaneous determination of the default risk
25

and can take into account a factual representation made by the borrower,
provided the servicer does not have reason to know that the representation
is false. In clarifying this standard, the IRS noted that there is no maximum time period for the determination and that, under the appropriate
circumstances, the servicer may reasonably believe that there is a significant risk of default even if the potential default is more than one year in the
future. Finally, the servicer must reasonably believe that the modified loan
presents a substantially reduced risk of default as compared to the loan
prior to the modification.
As with any revenue procedure, Rev. Proc. 2009-45 only reflects the IRSs
position on a legal issue and does not change the law on that issue. Loan
modifications not fitting under the criteria of Rev. Proc. 2009-45 may not
cause REMIC tax problems if these modifications otherwise fall under the
REMIC exception for modifications of loans that are occasioned by the
borrowers default or reasonably foreseeable default.
Did it help?
Rev. Proc. 2009-45 was retroactive to January 1, 2008, apparently reflecting
the IRSs view that the standards set forth in Rev. Proc. 2009-45 expanded
the types of loans in which default is reasonably foreseeable and that
retroactive application of its provisions was necessary in order to avoid
putting at risk many REMIC trusts that modified loans during 2008 under
the rules then in effect. Rev. Proc. 2009-45 therefore seemed to be intended
to provide relief to REMICs, but it also created some potential confusion.
A number of the modifications described in Rev. Proc. 2009-45 may not
cause REMIC tax problems even if the borrowers default is not considered reasonably foreseeable. For example and as discussed above in the
section of this article dealing with the safe harbor rules under the 1001
Regulations, no REMIC tax problem results from an extension of a loans
maturity by the lesser of 50% of the loans original terms or 5 years, regardless of whether a borrowers default is reasonably foreseeable, as such
a modification does not result in a significant modification of the borrowers loan under the safe harbor rules contained in the 1001 Regulations.
Similarly, a change in a loans interest rate that impacts the loans yield by
26

less than the greater of 25 basis points or 5% of the loans original yield will
not cause a REMIC problem under any circumstances.
Defaults in the Real World
Reasonably foreseeable in Practice. The greatest source of confusion arising from the release of Rev. Proc. 2009-45 was whether it was necessary
or useful. Most servicers are satisfied that if the economic realities associated with the borrowers modification request indicate that the borrower
and related property will not support the borrowers loan for the foreseeable future without an abrupt and unanticipated turn in the propertys
economic fortunes, most restructurings of the loan designed to address
these economic difficulties should be covered by the REMIC Regulations
reasonably foreseeable default standard as it existed prior to the release
of Rev. Proc. 2009-45. One would hope that sound tax policy would not
require that the servicer or special servicer exercise prophetic insight in
order to determine whether and when a borrower might default on its
obligations. It would make little sense to allow modifications of troubled
loans only at such time as the borrower and the property are so irreparably
damaged that all hope of financial recovery has been abandoned. The need
for servicers to be flexible and proactive when dealing with troubled loans
is a primary motivation for the REMIC Regulations permissive treatment
of loan modifications occasioned by the borrowers reasonably foreseeable default. In order for a loan modification to be covered by the terms
of the REMIC Regulations, the borrowers default need not be certain,
absolute, apparent or imminent, just reasonably foreseeable.
It would make little sense from a tax policy perspective to prohibit loan
modifications that relate to, and are carefully tailored to address, a pending default of a loan simply because the potential default is too far off in
the future. Provided there is a nexus between the modification and the
borrowers potential default, the timing of the anticipated default should
be of minimal consequence. While the particular economic nuances that
apply in determining whether a borrowers default is reasonably foreseeable may be open to discussion, most servicers (and their counsel) do not
impose a strict timing requirement and do not require that the potential
default be immediately forthcoming.
27

PSA Restrictions. In practice, there are very few loan modifications that
a special servicer is permitted and willing to undertake under a PSA that
would not be permitted under the prior reasonably foreseeable default
standard. Many of the issues that cause the greatest concern for servicers
with respect to proactive modifications of potentially troubled loans are
caused, not by any perceived limitations of the REMIC rules, but rather by
the express limitations in PSAs governing the special servicers duties to
the REMICs certificateholders. Absent amendment, these limitations in
PSAs will continue whether or not the class of permissible default modifications has been expanded for purposes of the REMIC-Specific Rules to
include reasonably foreseeable defaults covered by Rev. Proc. 2009-45 or
even if those rules were changed to allow significant modifications of loans
irrespective of whether there is a potential borrower default. Special servicers cannot, under the terms of a typical PSA, elect to modify loan terms
without economic justification. Under the terms of a typical PSA, actions
taken by the special servicer must be those which result in the highest
return to the REMICs investors. It would be difficult to argue that a special
servicers agreeing to modify a qualified mortgage years in advance of a
potential default is more likely to be in the best interests of, and otherwise
results in a better return to, the REMICs investors than would the other
possible strategies available. Such strategies could include: taking a waitand-see approach, a foreclosure, or a future modification at the time when
borrowers potential default is more concrete, all of which give the special
servicer more certainty about the effect of its actions.
Prohibited Transactions
The Problem. Most PSAs impose two distinct tax-related limitations on
servicers when considering a loan modification. First, the modification
must not cause the loan to cease to be a qualified mortgage and thereby
impact the REMICs tax qualification. Second, the modification must not
result in a prohibited transaction. A curious inconsistency is revealed,
however, when comparing the terms of the REMIC Regulations with the
Codes prohibited transaction rules.
Qualified mortgages that are modified as a result of the borrowers reasonably foreseeable default continue as qualified mortgages. But what of
28

the possibility that such modifications, while not altering the loans qualified mortgage status, will result in a prohibited transaction? Code Section
860F(a)(2)(A)(i) provides that a disposition of a qualified mortgage is a
prohibited transaction unless the disposition results from the borrowers imminent default. Compare Treas. Reg. Section 1.860G-2(b)(3)(i)s
standard for determining significant modifications based on reasonably
foreseeable default.
Is there a possibility that a loan modification could be covered by the
REMIC Regulations reasonably foreseeable default standard in situations
where the borrowers default is not also imminent within the meaning
of Code Section 860Fs prohibited transaction rules? In these cases, does
the loan modification, which does not alter the loans status as a qualified
mortgage, cause a prohibited transaction because the modification was
not accompanied by the necessary level of imminent default? Despite the
inconsistent wording, the answer should be no.
Finding an Answer. How to reconcile the inconsistency noted above where
a loan default is reasonably foreseeable but perhaps not imminent is
not readily apparent from a review of the Code and REMIC Regulations.
The key to solving this statutory and regulatory conundrum may be found
in the definition of a prohibited transaction.
As a preliminary matter, a prohibited transaction results only when there
has been a disposition of a qualified mortgage.22 If a loan modification is
occasioned by a borrowers reasonably foreseeable default, then there is
no disposition of the qualified mortgage in the first instance whether or
not the borrowers default is also imminent. To the extent that all imminent defaults are also reasonably foreseeable defaults (a position that
may be sustainable), then there is no need for the specific exception to the
definition of prohibited transaction related to imminent defaults.
It should also be noted that there is no specific exception to the definition
of prohibited transaction for modifications of loans that result from an
assumption of a loan.23 There is arguably no need for an exception in the
case of loan assumptions because, under the special REMIC-Specific Rule
22 Code Section 860F(a)(2).
23 Code Section 860F(a).
29

described above, there is no significant modification (and therefore no
disposition) of the loan as a result of a transfer of the related collateral
and an assumption of the borrowers obligations.
No Harm No Foul. Fortunately for servicers, the lack of consistency in
the Code and REMIC Regulations noted above should have no material
effect. If a modification of a loan is occasioned by the borrowers reasonably foreseeable default, there is no disposition of the related loan and no
possibility for a prohibited transaction even if the borrowers default might
not otherwise be considered imminent. In these cases, the apparent issue
seems to result from inconsistent language in the REMIC Regulations and
the Code and should simply be chalked up to a drafting oversight.
The Final Regulations
On September 15, 2009 (the same day Rev. Proc. 2009-45 was issued) the
Treasury promulgated final regulations updating the Prior Regulations,
which were effective September 16, 2009 (the Final Regulations). Under
the Final Regulations, the following two exceptions were added to the
four listed above as REMIC-Specific Rules in the discussion of the Prior
Regulations:
Modifications that release, substitute, add or alter a substantial
amount of collateral for, a guarantee on, or other credit enhancement for, the loan; and
Modifications that change the recourse or nonrecourse nature of
the loan.
The Principally Secured Test
The new exceptions came with an important qualification. These modifications are permitted only if the modified loan continues to be principally
secured by an interest in real property following the modification. For
purposes of determining whether a modified loan is principally secured
by an interest in real property, the Final Regulations provide the following
two tests (often referred to collectively as the Principally Secured Test):
30

First, the fair market value (the FMV) of the real property securing the modified obligation must be at least 80% of the loans issue
price as of the date of the modification (the 80% Test); OR
Second, the FMV of the interest in real property that secures the
modified obligation immediately after the modification must equal
or exceed the FMV of the interest in real property that secures
the obligation immediately before the modification (the No
Reduction in FMV Test).
Before the promulgation of the Final Regulations, the Principally Secured
Test was relevant only in connection with the original formation of the
REMIC, so servicers and their advisors had been unconcerned, for the
most part, with that Test. The addition of the Principally Secured Test was
therefore a dramatic change in the servicers role.
The FMV of the interest in real property securing the loan for purposes
of the 80% Test can be based on the servicers reasonable belief that the
modified obligation satisfies the Test, but the belief must be based on a
current appraisal of the property by an independent appraiser, an update
to the origination appraisal that takes into account the passage of time
and changes to the collateral property, the sales price of an interest in real
property, or a catch-all of some other commercially reasonable valuation
method. The FMV of the interest in real property securing the loan for
purposes of the No Reduction in FMV Test must be based on a current
appraisal, an original (and updated) appraisal, or some other commercially
reasonable valuation method. For either the 80% Test or the No Reduction
in FMV Test, the servicer must not actually know, or have reason to know,
that the Principally Secured Test is not satisfied.
Determining what portion of the collateral securing a loan is real property for these purposes can be challenging. The question is much harder
than it may initially seem. In some transactions, almost all of the collateral will be real property for these purposes, but in others a close legal
analysis will be required to make the allocation between real property
and other types of property. Only land and improvements thereon, such
as building or other inherently permanent structures (including items
31

that are structural components of such buildings or structures) can be
included. The local law definition of real property is not controlling, and
the definition for REMIC purposes does not include assets accessory to the
operation of a business, even if those assets are treated as fixtures under
local law. Because of this, the allocation of value to real property is as much
a legal issue as a factual issue and it may not be possible in certain cases to
rely on the valuations in a standard appraisal.
Releasing Liens
The Final Regulations also made a clarifying update to the so-called lien
release rule. Under the Prior Regulations,24 if a REMIC released its lien
on any real property securing a loan, the loan ceased to be a qualified
mortgage unless the release was pursuant to a defeasance or (in the view
of most practitioners) was of an insubstantial amount, was incident to
the borrowers default (or reasonably foreseeable default), or was one the
lender was required to make by the specific terms of the loan documents.
Under the Final Regulations, a release of a lien on real property collateral
will not cause a loan to be other than a qualified mortgage if the release:
does not result in a significant modification of the related loan
or falls under one of the exceptions to significant modifications
found in the REMIC Regulations (related to default or reasonably
foreseeable default, loan assumptions, waivers of due on sale and
due on encumbrance provisions, changes to collateral, and changes
to the recourse nature of the related loan);
AND
the loan continues to be principally secured by an interest in real
property under the Principally Secured Test described above.
Once again, a provision that was ostensibly provided as a relief measure
came with an additional requirement (the Principally Secured Test) that
had not been a concern under the Prior Regulations.
24 Treas. Reg. 1.860G-2(a)(8).
32

Some Answers to Old Problems and the Creation of New Ones
The Final Regulations solved some of the problems that servicers had
wrestled with under the Prior Regulations, but they also created new ones.
One type of problem that had previously vexed servicers was situations
involving modifications that release, substitute, add, or alter a substantial amount of collateral for, a guarantee on, or other credit enhancement
for, a mortgage loan. Examples in which this issue arose included springing recourse mechanisms and changes in carve-out guarantors. The Final
Regulations added a new exception to the REMIC-Specific Rules that provided that, changing the recourse nature of a loan or the addition, release
or substitution of a guarantor will not cause the loan to be something other
than a qualified mortgage, so long as the loan continues to be principally
secured by an interest in real property.
Similarly, under the Prior Regulations, modifications that affected a substantial amount of the collateral (often referred to as the 10% rule) for
a nonrecourse loan could result in a significant modification of that loan,
which could cause the loan to be a qualified mortgage. As a result, for
many years servicers were told by tax lawyers that they could release no
more than 10% (on a cumulative basis) of the collateral for a loan real
property or not without triggering a significant modification. This led
to a great deal of discussion of the application of the 10% rule (which
wasnt a rule at all, because it did not appear in the Code or the REMIC
Regulations and seemed to exist only in the minds of tax lawyers), but at
least servicers didnt have to worry about how much of the collateral was
real property.
The relief provided by the Final Regulations for these situations was offset
by a compensating burden: the addition of the requirement that servicers
determine whether the Principally Secured Test has been met in connection with most modifications. Servicers had always needed to determine
the fair market value of collateral for purposes of the old substantial
amount test when releasing collateral, but the Final Regulations raised
this burden to a much higher level. In many cases, the fair market value
of the real property will be enough to justify a conclusion that it is at least
80% of the loans issue price; in others, that conclusion will not be as clear
33

and the servicer will need to decide how formal a valuation it will require.
Also, because the Final Regulations have no de minimis exception, servicers were now required to make this determination even in response to a
request for a release (or a ground lease) of a small out parcel.
Effect on Special Servicers
The Final Regulations made almost no changes to existing rules dealing
with defaulted loans and REO so the impact of the Final Regulations on
special servicers was minimal and, in some situations, potentially adverse.
The Final Regulations made no changes to the provisions in the REMIC
Regulations that had created serious problems for special servicers, including those related to the grace period for qualified foreclosure property, the
prohibition on impermissible new construction for REO, and the impact of
income from REO that is other than rents from real property. Conversely,
the addition of the restriction on releasing liens in the Final Regulations
potentially prevented a special servicer from releasing a portion of the real
estate collateral for a loan in exchange for a partial paydown. If the value
of the remaining real property collateral after the release does not equal at
least 80% of the issue price of the loan after the paydown, the special servicer could be prevented from permitting the release of the collateral, even
if the loan did not meet the 80% test before the release.
Perhaps the only other impact of the Final Regulations on special servicers
would arise in the uncommon situation of a proposed modification of a
defaulted loan that does not fall under the existing exception for modifications that are occasioned by the loans default or a reasonably foreseeable
default, even under Rev. Proc. 2009-45. In rare cases, special servicers had
difficulty in establishing that, although the loan was in default, the specific
proposed modification was actually occasioned by that default. In these
odd instances, so long as the modification falls under one of the exceptions
added to the REMIC Regulations, no adverse REMIC event would result
even if the modification were not considered to have been occasioned by
the loans default. Of course, the special servicer would have to conclude
that the Principally Secured Test will be met.
34

Caution
While the Final Regulations made possible some transactions that were
not permissible under the Prior Regulations, they speak only to the
REMIC issues associated with those transactions. Servicers must continue to abide by the prohibitions and processes contained in the REMICs
applicable PSA (e.g., special servicer, rating agency, and controlling class
approval; PSA provisions prohibiting substitutions or releases of material portions of loan collateral; etc.), as these provisions are unaffected by
the Final Regulations. Also, a number of PSAs prohibit a servicer from
modifying a performing loan in any manner that would be deemed significant under the provisions of Code Section 1001. This provision was
designed to make certain that the servicer did not jeopardize the REMICs
tax status. Under the Final Regulations, it is now possible to make certain
modifications to a loan in a manner that would be significant under the
provisions of Code Section 1001 without affecting the REMICs tax status.
The issue for servicers will be whether the servicer can, under the terms of
the PSA, agree to a modification that results in a significant modification
of the related loan in violation of the express wording of the PSA but in a
manner that does not in any way impact the REMICs tax status. A careful review of the applicable PSA provisions by any servicer considering a
modification of a loan under the new rules is strongly recommended.
Rev. Proc. 2010-30
The Final Regulations created consternation in the servicing industry
because, as numerous commentators (including this firm) observed, the
Final Regulations made it difficult or impossible for a REMIC to release
property in situations where the value of the real property collateral had
declined, even where the original loan documents gave the borrower the
unilateral right to demand the release. Because there is no relief in the
Final Regulations from the Principally Secured Test in such a case, a servicer could potentially be placed in a difficult position where a borrower
had a legal right to release a lien but doing so would cause the loan not to
be principally secured by the remaining real estate collateral. Similarly,
the Final Regulations contain no exception for defaults. As a result, a special servicer could be prevented from releasing collateral for a defaulted
35

loan in exchange for a partial pay-down of the loan if the loan would not
meet the Principally Secured Test after the release, even if the transaction were in the best financial interests of the REMIC. Finally, the Final
Regulations have no de minimis exception and thereby require that the
servicer establish the value of the remaining real property collateral that
secured the loan even if as little as one square inch of the real property collateral was released.
In response to numerous complaints about these potential situations, the
IRS issued Revenue Procedure 2010-30 (Rev. Proc. 2010-30), on August
17, 2010, establishing safe harbors under which a REMIC can release
property from the lien of a mortgage securing a loan held by the REMIC.
Rev. Proc. 2010-30 did not modify the Final Regulations themselves but
protected REMICs from enforcement of the literal terms of the Final
Regulations by providing that the IRS will not challenge the status of a
loan as a qualified mortgage as the result of releases of liens in transactions
that fell within those safe harbors.
Rev. Proc. 2010-30 applies to grandfathered transactions (i.e., those that
were in effect prior to December 6, 2010) and transactions that are classified as qualified pay-down transactions. It was effective immediately and
applied only where the REMIC could not meet the Principally Secured
Test as required by the Final Regulations.
Grandfathered Transactions
The first safe harbor is for a grandfathered transaction, in which (1)
the lien release occurs by operation of the terms of the loan documents;
and (2) the terms providing for the lien release are contained in a document executed no later than December 6, 2010. This provision is designed
to permit releases where the borrower has a unilateral right in the loan
documents.
This safe harbor can be useful, but several points of caution must be raised.
First, if the lien release is permitted only as a result of an amendment to
the loan documents that was made prior to December 6, 2010 (as opposed
to having been included in the original transaction), REMIC counsel
will need to carefully analyze whether the transaction fits within the safe
36

harbor. Second, the transaction must be truly unilateral. There must be no
requirement of consent or waiver by the servicer, and any conditions must
be based on objective standards. If, for example, the documents require
that a certain debt service ratio be met prior to the release, the servicer
cannot waive even a small variance from that ratio. Third, if a loan that
originally contained release provisions is modified after December 6, 2010,
there is a significant question as to whether the release provisions are entitled to the benefit of the grandfathered transaction safe harbor, even if
the original release provisions were not themselves modified after that
date.
Qualified Pay-Down Transactions
The second safe harbor in Rev. Proc. 2010-30 is for a qualified pay-down
transaction, where the lien release is accompanied by a payment by the
borrower resulting in a reduction in the adjusted issue price (generally,
the unpaid principal balance, or the UPB) of the loan. The amount of the
pay-down must equal one of the following:
1. Net Proceeds. The sum of the net proceeds from (a) an
arms-length sale of the property to an unrelated person, (b)
a condemnation award with respect to the property, and (c) an
insurance or tort settlement with respect to the property (if there is
also an arms-length sale or a condemnation); OR
2. FMV Ratio at Origination. An amount required under the loan
agreement that equals or exceeds the product of (a) the UPB of the
loan, multiplied by (b) the ratio of (i) the FMV of the released real
property to (ii) the FMV of all of the real property that secured the
loan immediately before the lien release (the FMV in each case
being determined at the time of the origination of the loan); OR
3. FMV of Released Property. The FMV of the released real property
(at the time of the release), plus any tort or insurance settlement
that is expected to be received with respect to the property (unless
such settlement is already included in the FMV); OR
37

4. LTV Ratio at Release. An amount that results, immediately after
the release, in the ratio of the UPB of the loan to the FMV of the
real property (the LTV) that continues to secure the loan being
no greater than what that ratio was immediately before the release.
The FMVs in paragraphs 3 or 4 can be based on the servicers reasonable
belief but must be based on a current appraisal of the property, an update
to the origination appraisal that takes into account the passage of time
and changes to the collateral property, the sales price of an interest in real
property, or a catch-all of some other commercially reasonable valuation
method. In addition, a reasonable belief does not exist if the servicer
has reason to know that the loan is, in fact, not principally secured by an
interest in real property.
Interpretive Issues in Qualified Pay-Down Transactions
In practice, the easiest of these alternatives and therefore the one most
likely to be used is the first (i.e., the Net Proceeds alternative), but there
could be obstacles to using this alternative. The borrower may not be
enthusiastic about giving up all of the proceeds of the sale of a parcel. There
is also the question of what amounts to the net proceeds for a particular
sale. Rev. Proc. 2010-30 provides that the net proceeds equal the amount
realized from the transaction under Code Section 1001, but that is a concept with its own interpretive issues. For example, Code Section 1001 itself
does not specifically address the issue of whether expenses incurred in the
release and disposition of the real property reduce the amount realized
from the transaction, which raises the question of how to address such
worthwhile expenses as attorneys fees, sales brokerage commissions, and
advertising expenses. Except where the seller is a dealer in real property
(which could conceivably be the case for some borrowers), those expenses
should reduce the net proceeds, but the determination of what constitutes
net proceeds will require that the servicer and its counsel coordinate
with the seller/borrower to make certain that its tax treatment of these
expenses is consistent with the REMICs characterization.
The requirement in the first safe harbor that the sale be to an unrelated
person could also create problems, since the definition of an unrelated
38

person for tax purposes will probably differ from the affiliated party definitions in most loan documents. The rules are fairly broad and complex,
but in the case of most corporations, partnerships, or other business entities, a very general summary is that, if one entity owns more than 50% of
another entity, they are related.
Assumptions of loans in which only a portion of the real property collateral is being acquired will also raise difficult issues. For example, if a loan
collateralized by multiple parcels is in default and the servicer wishes to
have only the portion of the loan that is collateralized by a single parcel
assumed by a third party (e.g., because that parcel is more easily marketable or because of differences in enforcement laws among the jurisdictions
in which the parcels are located), we believe that, as to the existing loan,
the amount assumed with respect to the released parcel can be treated
as net proceeds. As to the new loan (i.e., the portion of the loan that
has been assumed by the third party), a portion of the collateral has been
released (i.e., the other parcels that formerly secured the entire loan), but
we believe that the new loan should also satisfy the Net Proceeds exception
in appropriate circumstances if the assumption was by a bona fide third
party.
The second safe harbor, which turns on the FMV of the property at the
time of origination, raises the issue of the meaning of that term where
a refinancing or modification of a loan has taken place after the initial
advance of funds. The Rev. Proc. gives us no guidance on this point.
Each of the four safe harbors requires that the entire paydown amount
go to reduce the UPB of the loan. In some cases, the servicer could prefer to put all or a portion of the net proceeds in a reserve rather than
applying them to principal. Moreover, depending upon the provisions
of the relevant PSA, the servicer may elect or be required to apply
the cash received to satisfaction of other liabilities (e.g., property protection advances). Finally, the servicer may want or may be required to apply
some of the proceeds to accrued but unpaid interest on the loan. Accrued
but unpaid interest is not typically included in the adjusted issue price of
the loan and is not an otherwise sanctioned use of proceeds in a qualified pay-down transaction. The requirement of this safe harbor is that the
39

pay-down amounts reduce the principal owed by the borrower, not that
the REMIC book the cash received in a certain manner, but the servicer
will need to take care not to apply the pay-down amount in a manner that
creates inconsistencies between its legal relationship with the borrower
and its payment obligations under the PSA.
If the prepayment has not been contemplated in the loan documents, a
question could also arise in each of the safe harbors as to whether payments of debt service must be reamortized or principal must be applied to
reduce the final principal payments. Prepayments are usually not permitted in loans held by REMICs, because purchasers of interests in REMICs
typically demand that their cash flows be predictable. It is rare, for example, for loan documents to require that 100% of the proceeds received in a
condemnation be applied to principal on the loan; rather, these proceeds
are typically applied differently depending on the size of the condemnation, requirements to restore, and other factors specific to the transaction.
Finally, there will be questions raised in connection with releases of property from cross-collateralization provisions and releases of multiple parcels
where the servicer needs to use separate forms of qualified pay-down
transactions in order take advantage of Rev. Proc. 2010-30.
Drafting Issues
The interpretive issues described above will arise most frequently where
the loan documents do not contemplate the partial release or the borrowers right to the release is not truly unilateral. Where the loan is newly
originated (or, where a modification of the loan documents is permissible),
the drafters of the loan documents can avoid some of these issues, but they
must be very careful not to inadvertently permit a release of real property
that is not otherwise permitted by Rev. Proc. 2010-30. Some drafters are
currently avoiding the issue by simply providing that any release must
be permitted by the REMIC Regulations, but this approach becomes less
acceptable once the loan is included in a securitization and borrowers
are likely to insist that they have certainty about when and how they can
obtain a release of a collateral property. Because these provisions require
legal as well as factual conclusions, no partial release should be permitted
40

without first obtaining a legal opinion from counsel well versed in the
REMIC provisions.
Crafting provisions that adequately reflect all of the requirements of Rev.
Proc. 2010-30 can be tricky. Transactions including Rev. Proc 2010-30
compliant release provisions can require several pages of definitions and
several more of operative provisions. As the foregoing discussion suggests,
definitions that require particular attention include those for the adjusted
issue price, net proceeds, real property, and related party. The specifics of those provisions will depend on such things as whether the parties
wish to include stated release prices for individual parcels or properties
(which can be used only if the release prices are at least as much as the
amounts specified in Rev. Proc. 2010-30) and whether the lender insists
that other requirements must be met in connection with any release (such
as whether debt service coverage ratios will be met after the release). In
every case, though, great care must be taken in order to avoid permitting a
release in violation of Rev. Proc. 2010-30.
A Graphical Summary
The following flowchart illustrates in graphic form the analysis required
by the Final Regulations and Rev. Proc. 2010-30, as just described. The
analysis under the Prior Regulations ended after the first page and a half
of the chart. The following page and a half is what was added by the Final
Regulations and Rev. Proc. 2010-30.
As it did under the Prior Regulations, the analysis begins with the question, has there been a modification to the loan and, if so, is it significant?
To this, the Final Regulations added, Is there a release of collateral and,
if so, does the loan meet the Principally Secured Test? Finally, Rev. Proc.
2010-30 added, If you cant meet the Principally Secured Test, is it a grandfathered transaction or a qualified pay-down transaction?
41

Stephen A. Edwards
Suite 2800
t 404 815 6278
f 404 541 3191
SEdwards@KilpatrickTownsend.com
Thomas J. Biafore
Suite 2800
t 404 815 6250
f 415 576 0300
Jennifer OConnor
Suite 2800
t 404 815 6284
f 404 541 3324
JOConnor@KilpatrickTownsend.com
42
43
44
45
46
Accepting Prepayments and Payoffs
47
48
Accepting Prepayments and Payoffs

Thomas J. Biafore
Introduction: It is often said that in the world of commercial mortgage

backed securities (CMBS) investing, the typical investor does not want
returns on investment early or late. Rather, CMBS investors want returns
when they are scheduled to receive them.
In most fixed rate securitizations, the applicable Pooling and Servicing
Agreement (the PSA) underscores this point by prohibiting the servicer
from accepting a prepayment of a performing loan, or by requiring that
the servicer not waive any lock-out period, defeasance requirement or
prepayment and yield maintenance charges associated with a requested
prepayment, unless specific circumstances (such as a borrowers default or
reasonably foreseeable default) exist.
REMIC Issues: Even if the servicer has determined that a payoff of a particular loan in advance of maturity is permitted under the specific terms
of the PSA and, further, that such a payoff would be in the best interests
of the certificateholders, the servicer would be prohibited from accepting
a borrowers prepayment of its related loan if this prepayment would disqualify the REMIC or otherwise subject the REMIC to tax. PSAs require
that the servicer not undertake any action that would result in the loss of
REMIC status or that would otherwise subject the related REMIC to tax.
See Tom Biafore, REMIC Qualification Why Do We Care? in this
Guide for a discussion of the tax consequences of REMIC status.
Issue: Whether a REMICs consent to a waiver of prepayment, yield maintenance charges or a lock-out period in connection with the payoff of a
loan will adversely impact the tax qualified status of a REMIC depends
on whether the prepayment results in the REMICs holding property that
is neither a qualified mortgage nor a permitted investment within
the meaning of the Internal Revenue Code of 1986 (the Code). One of
the requirements for REMIC qualification under the Code is the asset
test in Code Section 860D(a)(4), which provides that substantially all
of a REMICs assets must consist of qualified mortgages or permitted
investments.
49

In general, a borrowers prepayment of a loan will not result in the REMICs
holding assets that are neither qualified mortgages nor permitted investments within the meaning of the Code. Code Section 860D(a)(4). For
example, assume that prior to prepayment, a REMIC holds a loan that is
considered a qualified mortgage within the meaning of Code Section
860G(a)(3). Under Code Section 860G(a)(3), a qualified mortgage is
any obligation which is principally secured by an interest in real property
that is transferred to the REMIC within the 90-day period starting on the
REMICs startup day.
Treas. Reg. Section 1.860G-2 provides two tests for determining whether
an obligation is principally secured by an interest in real property. One
test is met if the fair market value of the real property securing the
related loan is at least equal to 80 percent of the adjusted issue price of
the obligation at the time the obligation was originated ... [or] at the time
the sponsor contributes the obligation to the REMIC. Treas. Reg. Section
1.860G-2(a). The alternative test provided for in the regulations states
that a loan is a qualified mortgage if substantially all of the proceeds of
the obligation were used to acquire or to improve or protect an interest
in real property that, at the origination date, is the only security for the
obligation.
After a borrower prepays a qualified mortgage, the REMIC holds cash. The
cash received upon the borrowers payoff of the loan is considered a permitted investment. Section 860G(a)(5) states that a permitted investment
includes any cash flow investment. A cash flow investment, according to
Treas. Reg. Section 1.860G-2(g)(1), is an investment of payments received
on qualified mortgages Furthermore, Treas. Reg. Section 1.860G-2(g)
(l)(ii) states that payments received on qualified mortgages include
payments of interest and principal on qualified mortgages, including prepayments of principal.
Prohibited Transactions: If the settlement of a loan pursuant to prepayment results in a prohibited transaction within the meaning of Code
Section 860F(a)(2)(A), the REMIC would be subject to tax on such transaction irrespective of whether the transaction resulted in the REMICs
holding assets that were other than qualified mortgages or permitted
50

investments. Under Code Section 860F(a), a prohibited transaction
generally includes the disposition of any qualified mortgage. The legislative history related to the Code provisions applicable to REMICs, however,
expressly provides that payment by the obligor on a debt instrument is not
considered a disposition of a qualified mortgage for purposes of the prohibited transactions tax, whether or not the loan is performing. See Conf.
Rep. No. 841, 99s Cong 2d Sess. at 11-231 n. 11 (1986),1986-4 C. B. 231.
Accordingly, a borrowers prepayment of an obligation held by a REMIC
does not result in a prohibited transaction within the meaning of Treas.
Reg. Section 860F(a)(2)(A).
Conclusion: Typically, there are no adverse REMIC tax consequences to
the REMICs accepting a prepayment of a loan and its related waiver of
prepayment or yield maintenance charges or a lock-out period. While the
REMIC tax consequences are straightforward, however, the applicable PSA
is often the limiting factor in detemining whether, and under what circumstances, the trust can accept a prepayment from the borrower. Before a
servicer agrees to accept a prepayment or payoff of a loan held by the trust,
a thorough review of the applicable PSA must be undertaken. If the PSA
allows for the payoff of the loan under the particular circumstances, there
should be no REMIC tax issues that would otherwise prevent the servicer
from accepting the prepayment.
Thomas J. Biafore
Suite 2800
t 404 815 6250
f 404 541 3129
51
52
Loan Payoffs vs. Loan Assignments Know the

Difference
53
54
Loan Payoffs vs. Loan Assignments Know the

Difference
Stephen A. Edwards
Background: Occasionally, a borrower intending to pay off a loan held by a

REMIC may request that the REMIC assign the related note and mortgage
to the lender providing replacement financing. The motivation for this
request is usually the potential savings of transaction expenses, such as
mortgage recording or other taxes that would be incurred if the note were
paid off, the mortgage released and a new lien created. This is a common
practice in New York (where the mortgage recording tax can be as high as
2.8% for loans over $500,000) and, to a lesser extent, Florida, Minnesota,
Colorado and Oklahoma. The servicer must decide whether it is prudent
to accommodate a request to structure a transaction this way.
Discussion: Virtually all Pooling and Servicing Agreements (PSAs) contain provisions prohibiting servicers from engaging in any action that
would constitute a prohibited transaction for federal tax purposes. As
a corollary to this prohibition, PSAs prohibit dispositions of mortgages
but permit mortgage payoffs in accordance with the related loans terms.
The difficulty for the servicer is that the mechanics of a note and mortgage
assignment can resemble those of a loan disposition or note sale.
Under the relevant Internal Revenue Code provisions, the disposition of
a qualified mortgage is a prohibited transaction, unless the disposition is
pursuant to (i) the substitution of a qualified replacement mortgage for a
qualified mortgage, (ii) the foreclosure, default or imminent default of the
mortgage, (iii) the bankruptcy or insolvency of the REMIC or (iv) a qualified liquidation of the REMIC. Code Section 860F(a)(2)(A).
The statutory restrictions on prohibited transactions, like the overall limitations on REMIC activities generally, derive from the fundamental tax
policy that REMICs should not actively trade in trust assets and should
limit their activities, subject to carefully delineated exceptions, to the collection of income from REMIC assets. Fortunately, the drafters of the
statute recognized that in certain circumstances mortgage assignments
that are essentially loan repayments are simply another means of collecting
55

revenue from mortgage assets and should not result in a prohibited transaction. See Conf. Rep. No. 841, 99th Cong., 2d Sess at II-231 n. 11 (1986),
1986-4 (Vol. 4) C.B. 231 (payment by obligor on debt instrument is not
considered disposition of that instrument for purposes of prohibited
transaction tax). There is, however, no express exception in Code Section
860F(a)(2)(A) for dispositions of loans incident to the borrowers payoff
of the obligation. Nevertheless, a REMICs assignment of a mortgage and
loan incident to the borrowers payoff should not be considered a prohibited transaction, provided that the transaction is treated for tax purposes
as a payoff.
The critical issue for servicers to consider is whether an assignment of a
note and mortgage incident to the borrowers payoff of an obligation is
considered a payment by the obligor of the obligation (and therefore
not a prohibited transaction) rather than a disposition or sale of the
obligation by the REMIC. The answer to this question is found in the circumstances related to the borrowers request.
As a general rule, note and mortgage assignments should be considered
loan payoffs and should not result in any adverse consequences to the
REMIC if some of the following conditions are present:
Mortgagor has the right under the terms of the note to its requested
payoff (whether or not there is a premium/penalty amount) at the
time in question;
Mortgagor has, independent of the REMIC and servicer, negotiated with the new lender the terms of any replacement financing;
The proceeds from any assignment equal those that would have
been realized from any note payoff rather than some negotiated
fair market price for the note; and
Following the assignment, the new lender materially modifies the
terms of the note to reflect the terms of the refinancing.
From a federal tax standpoint, the relevance of materially new terms
for the replacement lenders loan is that a new debt is being created that
56

extinguishes the old debt. Also, while not an absolute requirement, the
creation of a new debt instrument as a result of the replacement lenders
modification of the assigned loan is a helpful fact. This provides independent confirmation that the assignment of the note and mortgage
constitutes a payoff of the loan held by the REMIC.
Negotiated assignments in which the borrower has no legal right to cause
a note payoff (such as instances where the loan is locked out) or situations
in which the REMIC requires that a premium be paid to accommodate the
assignment request may not satisfy the conditions noted above. In these
cases, the assignment looks less like the borrowers payoff of the loan and
more like the REMICs sale of the loan in the open market.
The IRS has approved mortgage assignments in several private letter
rulings. In these rulings, the IRS has placed reliance on the presence of
additional factors, unrelated to federal income tax considerations, which
point toward characterization of transactions as assignments rather than
payoffs. One such factor acknowledged by the IRS is avoidance of the
New York State mortgage recording tax. In principle, there is no reason
to limit REMIC assignments of loans to New York or to other states that
impose similar taxes. Even so, a borrower will be well-advised to establish
the non-federal tax savings or benefits that could be realized by using an
assignment rather than a payoff.
Conclusion: The IRS private ruling position regarding mortgage assignments is based on sound principles, but the IRS has yet to adopt this as
its official position on this issue. Accordingly, care is in order before proceeding with any mortgage assignment to ensure that this informal IRS
position has not been altered and that it applies to the specific assignment.
57

Stephen A. Edwards
Suite 2800
t 404 815 6278
f 404 541 3191
58
Through the Looking Glass: Up is down, down is

upAre Non-recourse Loans Recourse?
59
60
Through the Looking Glass: Up is down, down is

upAre Non-recourse Loans Recourse?
Susan Tarnower
Non-recourse Guarantees
Non-recourse guarantees emerged with the advent of conduit lending.
With a non-recourse guarantee, the lender agrees, subject to certain carveout obligations, to take action against the property to recover for defaults
on the loan rather than taking action against the borrower or guarantor.
In non-recourse lending, the theory is that the borrower (and, derivatively,
the guarantor) can satisfy its obligation under the terms of the nonrecourse loan in one of two ways: first, by making the required payments
due under the terms of the loan; or second, by returning the collateral
that secured the borrowers obligation to the lender. As a result, in nonrecourse lending, the lender, rather than the borrower, bears the risk that
the collateral property will depreciate. Consistent with this approach, the
borrowers tax reporting of a foreclosure or a deed in lieu of foreclosure
for a non-recourse loan reflects that the borrowers obligations are completely satisfied simply by the borrowers returning the collateral property
back to the lender without the creation of any cancellation of indebtedness
income. (See Tom Biafore, Workouts, Cancellation of Indebtedness and
IRS Reporting Requirements in this Guide for a discussion of tax reporting for foreclosures.) The availability of non-recourse lending, as well as
the limited scope of guaranteed obligations for the guarantor, influenced
many borrowers to select conduit lending programs to finance their commercial real estate loans.
Most non-recourse guarantees contain carve-out provisions. Carve-out
provisions, sometimes referred to as recourse or springing recourse provisions, describe actions that, if taken by a borrower or guarantor, will cause
the loan to become a full or partial recourse obligation. Carve-out provisions, known as bad boy clauses, often include prohibitions against fraud
and other illegal activities. Carve-out provisions are not, however, limited
to such conduct. They can include prohibitions against actions that appear
harmless to the borrower or guarantor. For example, a typical non-recourse
61

guarantee includes a carve-out provision requiring the borrower to operate
as a single purpose entity. This generally means the borrower is obligated
solely to the lender with respect to the non-recourse loan and owns only
the related collateral property, subject to limited exceptions. Other common carve-out provisions include prohibitions against the borrowers
obtaining subordinate debt, filing a petition for bankruptcy, transferring
the property securing the indebtedness, or allowing liens to be filed against
the property. Violations of these provisions can either trigger liability for
the losses associated with a specific action or make the loan full recourse.
As seen in the cases below, the mere occurrence of an event prohibited by
a carve-out provision can be sufficient to make the guarantor responsible
for the entire obligation even if the violation was cured or caused no harm.
Two recent, well-publicized decisions in Michigan seemingly have turned
this well-established paradigm of non-recourse lending and carve-out
guarantees on its head for the moment. What this means for special servicers in the current market is unclear; however, special servicers and their
counsel should keep these cases in mind as they determine the appropriate
course of resolution for a defaulted loan.
When determining what events of default have occurred and how a lender
should respond, both special servicers and their counsel must begin with a
review of the language in the applicable loan documents. This means looking at the borrowers covenants and representations and warranties, as well
as the events of default and remedies, and reviewing the specific wording of any guarantee. They must also review the recourse language to see
whether partial or full recourse has been triggered by the borrowers, and
potentially the guarantors, actions. Are there any SPE requirements that
the borrower is not following? Is the cash flow from the property being
handled appropriately after default? Are all the reporting requirements
being met? Is there waiver language in the guarantee that allows the lender
to pursue the guarantors even if the lender has lost its right to pursue the
borrower? Is there a cap on the amount owed under, or a time limit for, the
guarantee? The cases below give some ideas of additional areas to examine.
Once the special servicer and its counsel have determined what events
have occurred and what type of recourse may have been triggered, they
62

are in a better position to negotiate with the borrower and guarantor(s)
because they know what liability the borrower or guarantor may incur.
This information gives the special servicer better leverage in its negotiations because case law certainly supports lenders in actions taken against
guarantors.
The decision as to how to proceed against a borrower or guarantor is a
practical one as well. It is helpful to run current asset searches against the
individuals involved, as well as to request that they provide current financial reports. While these individuals may have had decent balance sheets
and liquidity at the time of the loan closing, their current status may have
changed significantly. Are other properties they own heavily leveraged
now? Have they lost cars, boats, or other assets recently? What can the special servicer realistically expect to recover in an action against any of these
individuals? How much will such an action cost and how long will it take?
What are the alternatives in the state where the property securing the loan
is located? These are all factors to consider when approaching negotiations
with the borrower and guarantor and in deciding whether or not to take
legal action against them.
The small number of reported cases in this area (some of which are discussed below) indicates that most of these defaulted loan issues appear
to be resolved through negotiations rather than litigation. Lenders have
been highly successful in these cases, so both borrower and guarantors are
generally inclined to resolve these issues, where possible, before going to
court.
Recent Cases on the Enforcement of Non-recourse Guarantees
Courts tend to strictly enforce the contractual agreements expressed in
guarantees against guarantors. Most of the decisions below focus on the
specific terms in the applicable loan documents and the borrowers sophistication in the marketplace and representation by knowledgeable counsel
in enforcing these guarantees. The two recent Michigan cases, known as
Cherryland and Chesterfield, have taken this trend to an extreme.
In a very recent case, Inland Mortgage Capital Corp. v. Chivas Retail
Partners LLC, et al., case number 1:11-CV-06482, on August 3, 2012, in
63

U.S. District Court for the Northern District of Illinois, a U.S. District
Court judge granted summary judgment to the lender, finding the guarantors liable for the deficiency after a foreclosure sale even though a Georgia
court had refused to confirm that foreclosure sale of the property. The
Georgia court determined that Inlands credit bid of $7 million was not a
fair value for the property, a retail shopping center in Gwinnett County.
Chivas Retail Partners LLC and two related trusts, the guarantors, argued
that the Georgia courts failure to confirm the foreclosure erased the
underlying debt, thereby releasing the guarantors. The U.S. District Court
judge found that the very specific waiver language in the guarantee, which
gave the lender the right to pursue the guarantors in spite of the loss of any
right to pursue the borrower and had the guarantors agreeing to pay the
deficiency even if the foreclosure sale price was less than the value of the
property, meant the guarantors were liable for the deficiency even if the
fair market value was not achieved at the foreclosure sale.
In Wells Fargo Bank NA v. Cherryland Mall Limited Partnership, et al., ___
N.W. 2d ___, 2011 WL 678593, (Mich. App. 2011), the Michigan Court of
Appeals affirmed imposition of a deficiency liability of more than $2 million against a guarantor after the foreclosure by lender on a non-recourse
loan. The court held the borrowers violation of a non-recourse carve-out
provision relating specifically to its solvency violated the SPE provisions
and triggered full recourse against the borrower and, ultimately, against
the guarantor. Ironically, the evidence used to demonstrate borrowers
insolvency was the borrowers inability to pay off this non-recourse loan
due to a changed marketplace, not any action by the borrower. In 51382
Gratiot Avenue Holdings Inc. v. Chesterfield Development, 2011 US Dist.
LEXIS (E.D. Mich. 2011), a U.S. District Court judge issued a $12.2 million judgment against a guarantor in connection with a loan default on a
similar basis.
In March 2011, New York Supreme Court, New York County granted summary judgment for the plaintiff in UBS vs Garrison.pdf (www.practicelaw.
com/2-505-3426). That court held that the nonrecourse guarantee was
an instrument for the payment of money only and not an unenforceable
penalty or a violation of public policy relating to bankruptcy. In that case,
the lenders claim under the guarantee was triggered by a bankruptcy filing
64

by the borrowers during a forbearance period after the loan was in default.
This case seems to be inconsistent with the ING case mentioned below.
The court in 111 Debt Acquisition LLC v. Six Ventures, LTD, 2009 U.S. Dist.
LEXIS 11851 (S.D. OH 2009), reached a similar decision to that of the
court in UBS (above) based on a borrowers bankruptcy filing. In this case,
the borrower filed for bankruptcy, a violation of one of the carve-out provisions contained in the loan guarantees. The guarantors argued that since
the bankruptcy petition was eventually dismissed, the guarantors liability
under the carve-out provision had not been triggered. The Court found it
was irrelevant that the bankruptcy petition was dismissed. The debtors act
of filing for bankruptcy triggered the carve-out provision and made the
guarantors fully liable for the debt. Other courts have also found recourse
provisions prohibiting the filing of a bankruptcy petition enforceable. See
First National Bank v. Brookhaven Realty Assocs., 223 A.D.2d 618 (N.Y.
App. Div 1996); FDIC v. Prince George Corp., 58 F.3d 1041 (4th Cir. 1995).
In CSFB 2001-CP-4 Princeton Park Corporate Center, LLC v. SB Rental I,
LLC 980 A2d 1 (N.J. Super. 2009), the court strictly construed a carve-out
provision requiring the borrower to obtain lender approval of any subordinate financing. The borrower secured subordinate financing without
bank approval but paid off the subordinate loan eighteen months prior to
defaulting on the primary loan. The guarantors and the borrower argued
that their liability under the carve-out provision should not be enforced
because the default was cured and the lender was not harmed. The court
held it did not matter that the lender had suffered no damages as a result
of this prohibited action.
In LaSalle Bank N.A. v. Mobile Hotel Props., 367 F. Supp. 2d 1022 (E.D. La.
2004), the borrower amended its original articles, changing its name and
its purpose. The mortgage stated that the loan would become full recourse
if the borrower failed to maintain its status as a single purpose entity. The
court found the articles had been amended making the borrower, technically, no longer a single-purpose entity; therefore, the recourse provision
had been triggered.
65

The one case that goes against this trend of lenders prevailing against
guarantors is ING Real Estate Finance (USA) LLC v. Park Avenue Hotel
Acquisition LLC, 2010 Westlaw 653972 (02/24/10) (Unpublished). In that
case, the court narrowly construed the full recourse language in the guarantee in favor of the guarantors. The court focused on an inconsistency
between language found in the cure provisions of the loan agreement and
language found in the carve-out provisions. The court held it was necessary to reconcile the cure provided in the default clause with the lack of a
cure period in the bad boy carve-out provisions. The court also noted
that New York would not attempt to collect on a tax lien for at least a year,
so the lenders lien position was never in jeopardy, and ultimately ruled
that the guarantee was not triggered. As mentioned above, however, the
recent decision in Garrison appears to have put lenders back in their position of strength in regard to the enforcement of commercial real estate
loan guarantees against guarantors.
One case that was recently filed in Missouri demonstrates the need to
know guarantors and their net worth and how guarantees may be used by
lenders in negotiations with guarantors to ratchet up pressure for a resolution. In Bremen Bank and Trust Co. v. North Meramec Investors LLC et al.,
case number 125L-CC02915, filed in the Twenty-First Judicial Circuit of
the State of Missouri, the bank sued an investor group backed by celebrities
such as Marshall Faulk, Nelly and Darius Miles for the deficiency resulting
after a default and foreclosure on two commercial properties. The banks
attorney commented on the reluctance of these individuals who appear to
have great personal wealth to enter into appropriate discussions with the
bank and to pay money owed under the guarantee. A spokesman for Mr.
Faulk said they were in discussions with the bank regarding the situation.
Conclusion
What should special servicers do given these cases and the portfolios of
loans they are handling? They should carry on as usual, while examining the loan-specific language of the assets they are servicing as the need
arises. Any determination to pursue a guarantor or borrower for full
recourse is very fact-specific and document-driven. A business review
66

of the guarantors assets and the likelihood of recovery should be made
carefully and deliberately, with an eye on expenses and length of time of
recovery.
Susan Tarnower
214 North Tryon Street
Suite 2500
Charlotte, NC 28202-2381
t 704 338 5008
f 704 371 8270
STarnower@KilpatrickTownsend.com
Suite 2800
t 404 745 2543
STarnower@KilpatrickTownsend.com
67
68
Basic Elements of a Repurchase Claim
69
70
Basic Elements of a Repurchase Claim

Rex R. Veal
Background: This article identifies the basis by which a REMIC may have
a loan repurchased by a Mortgage Loan Seller (or Depositor, as applicable) based on a breach of a representation and warranty or document
defect provided for in the REMICs Pooling and Servicing Agreement (the
PSA) or the related Mortgage Loan Purchase Agreement (the MLPA).
For ease of reference, we have referred to the Mortgage Loan Seller in
the discussion below. In some transactions, the responsible party will be
the Depositor rather than a Mortgage Loan Seller. There may also be a
guarantor (usually an affiliate of the responsible party) for the repurchase
obligations. Generally, the Mortgage Loan Seller will have a right to cure
any breach or document defect. This article assumes that such a cure is
impossible or is not completed. The party charged with pursuing repurchase claims may vary by PSA, (e.g., master servicer for performing loans
and special servicer for specially serviced loans). For ease of reference,
and because it is most often the case, we refer to the special servicer as the
applicable party.
Threshold Requirements: As with any inquiry, the analysis of whether a
repurchase claim exists starts with a detailed review of the applicable PSA
or MLPA and any problem or defect related to the loan. Repurchase claims
are most often identified as the result of a condition or circumstance which
surfaces once a servicing transfer event has occurred and the special servicer begins analyzing its options. Usually this means there has been a
default of some kind and the special servicer has begun the process of
determining the best course of action to pursue with respect to work-out
or liquidation of the loan. Because repurchase claims may be prejudiced
by actions taken by the special servicer, it is important that the repurchase
analysis be part of the special servicers initial review and strategy process. Issuers sometimes believe that servicers and investors use repurchase
claims to solve what are really credit issues. In reality, the special servicer
should conduct a review of potential repurchase claims at the outset in
order to avoid prejudicing legitimate claims while at the same time pursuing appropriate remedies against the borrower. All repurchase claims are
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subject to specific standards and threshold requirements. Understanding
those standards and requirements is the first step in the review process.
What Can Be Put Back?: While this might at first blush appear to be a
straight-forward question, in practice the wording and structure of some
PSAs and MLPAs can be less than clear.
The definitions and repurchase provisions of the applicable PSA or MLPA
will control. The repurchase provisions must be reviewed carefully along
with the specific defined terms used in those provisions. Are REO and
REO loans clearly covered? What about modified (worked-out) loans?
What may fit the provisions in one agreement may be excluded by another
and questionable or unclear in yet another. There is no substitute for an
initial review of the documentation. Even if the PSA or MLPA is not clear,
the later discovery of facts or defects even after foreclosure may still provide a claim for repurchase. Most MLPA and PSAs provide that repurchase
is the only remedy. This raises the question of whether a claim for damages
is available (i.e., the difference between the liquidation proceeds and the
repurchase price). Most repurchase claims have either been abandoned or
settled. There is very little case law or even interim decisions (e.g., a court
opinion with respect to the measure of damages or admissable evidence
relating to damages). As one would expect, the more egregious the defects
or breaches, especially if essentially incurable, the more likely a court is to
find a remedy even for fully liquidated loans.
Preserving the Claim: In order to avoid prejudice of a possible repurchase
claim, the special servicer must ascertain whether its actions, such as foreclosing on collateral and subsequently selling the collateral, if taken, will
limit or destroy a repurchase claim. The answer to this inquiry often lies
in the definition of Mortgage Loan. It is not uncommon for a PSA or
MLPA to speak in terms of a breach or document defect with respect to
a Mortgage Loan and the repurchase of a Mortgage Loan. Better drafted
documents will either include REO Loans in the definition of Mortgage
Loan or will provide for the repurchase of REO Loans. The clearest language will provide that a claim for the difference between Liquidation
Proceeds and Purchase Price will exist even after a sale of an REO property. Regardless of whether such language exists within the PSA or MLPA,
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there are arguments relative to damage mitigation which may carry the
day in the particular circumstances, but the special servicer should understand the risks before proceeding.
The Effect of Workouts: A second inquiry is whether a restructure or workout prejudices a repurchase claim. Because the definition of Mortgage
Loan typically does not address this issue, but rather usually simply refers
to a list or schedule of mortgage loans, unless the restructure or work-out
is so radical as to completely change the Mortgage Loan or exacerbate
the problem for which the repurchase is sought, a Mortgage Loan Seller
should not be able to avoid repurchase of a restructured Mortgage Loan.
The issue is not, however, entirely free from doubt. This doubt is substantially increased if the work-out modifications are done without having
made a repurchase claim.
Third Party Sales: Unless the PSA or MLPA specifically addresses the
question, it should be assumed that once an REO Property is sold to a
third party, the repurchase claim disappears. While this is not necessarily
the case, it is the prudent way in which to approach the analysis. A typical
PSA or MLPA will provide that the repurchase claim is the sole remedy for
breaches of representations and warranties or document defects. If there
is nothing to repurchase, an election of remedies may have occurred.
There is a fairly strong argument that if a Mortgage Loan Seller breaches its
obligation to repurchase a Mortgage Loan, damages for the breach of that
obligation, as opposed to the actual breach upon which the claim is made,
should be available. This is particularly true where it can be shown that
failure to proceed to liquidate the Mortgage Loan will likely only increase
the loss to the Trust or the Mortgage Loan Seller. Litigated repurchase
claims have been few and this is an untested area. The prudent approach
is to assume that sale of the REO Property will end the repurchase claim,
to complete all of the necessary repurchase claim analysis prior to such
a sale and, if the prudent course of action is to consummate such a sale,
to explore whether or not an agreement with respect to the sale can be
reached with the Mortgage Loan Seller.
Similarly, the sale of a Mortgage Loan may raise questions. Under the
terms of most MLPAs, third party purchasers of loans generally cannot
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receive the benefit of the representations and warranties provided by the
Mortgage Loan Seller. The sale should be viewed as a liquidation of the
Mortgage Loan establishing the Trusts loss. The limitation of remedies
language in most MLPAs may have more effect where the Trust no longer holds any asset. Additionally, the mechanism for the sale of loans in
transactions closed from 2001 to 2009 (i.e., the limitation of sales via the
purchase option) may raise questions regarding whether mitigation was
adequate.
Notice: In most PSAs and MLPAs, there will be specific provisions related
to notices or demands. Some PSAs provide a right of first refusal to the
Depositor under certain circumstances. These provisions should be followed to the letter. The more specific a PSA or MLPA is, the clearer the
path to be taken is, but the greater the potential problem that will arise if
the special servicer strays from that path.
Material and Adverse: Almost all PSAs and MLPAs will require that the
breach of representation or warranty or document defect that is being put
forth as the basis for a repurchase claim result in a material and adverse
effect. It will be insufficient if the breach or defect is of a material magnitude but does not have an adverse effect. Likewise it will not matter that
the breach or defect is adverse if the effect is not material. Normally, neither material nor adverse will be specifically defined. While adverse
is sufficiently defined by general usage, material is less so. What may
be material to a small loan may not be material to a large loan. What is
material to subordinate certificateholders may not be to investment-grade
certificateholders. It is important to apply the material and adverse standard to the requirements of the PSA or MLPA.
Typical Standards: Standards include material and adverse to: (a) the
value of the Mortgage Loan, (b) the value of the Mortgage Loan or the
Mortgaged Property, (c) the interests of the Certificateholders, (d) the
interests of the Certificateholders in the Mortgage Loan, (e) the interests
of the Certificateholders, or any of them, (f) the value of the Mortgage
Loan or the interests of the Certificateholders in the Mortgage Loan, (g)
the value of the Mortgage Loan, or the interests of the Certificateholders,
including any economic interest, in the Mortgage Loan, (h) the value of
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the Mortgage Loan or the interests of the Trust or the Certificateholders
in the Mortgage Loan, and (i) the value of the Mortgage Loan, the
value of the Mortgaged Property or the interests of the Trustee or the
Certificateholders, or any of one of them, including any economic interest.
The variations are many and must be examined.
Stacking: There may be some instances where there is a stacking of standards. For example, a representation and warranty may provide that a
property is in material compliance with certain requirements. In such an
instance, there is only a breach if the non-compliance is itself material and
there will only be a repurchase claim if such material non-compliance has
a material adverse effect on the value or interests specified in the PSA or
MLPA. Alternatively, some MLPAs may say that the representations and
warranties are true and correct in all material respects, which has the effect
of imposing a stacked standard.
Conclusion: The document delivery requirements and representations
and warranties with respect to Mortgage Loans are important provisions
designed to assure that the Trust receives what is necessary or appropriate to allow it to realize upon the Mortgage Loans, and to assure that the
Mortgage Loans meet the standards promised investors when the transaction was closed. The initial analysis by a special servicer should always
include a review of any document defects, potential breaches of representations and warranties and the provisions in the PSA and MLPA dealing
with their cure, or failing a cure, the repurchase of the Mortgage Loans.
Rex R. Veal
Suite 2800
t 404 815 6240
f 404 541 3430
RVeal@KilpatrickTownsend.com
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REMIC-Based Repurchase Claims Qualified

Mortgages and Foreclosure Property
77
78
REMIC-Based Repurchase Claims Qualified

Mortgages and Foreclosure Property
Thomas J. Biafore
Background: In general, REMICs are required to hold only qualified mortgages and permitted investments. Pooling and Servicing
Agreements (PSAs) and related Mortgage Loan Purchase Agreements
(MLPAs) may require a depositor or mortgage loan seller to repurchase a loan if the loan is not a qualified mortgage. A representation and
warranty covering the qualification of mortgages contained in a REMIC
includes:
Each Mortgage Loan is a qualified mortgage within the
meaning of section 860G of the Code and does not contain
any provision that would render it not to qualify as a qualified mortgage.
Principally Secured: Section 860G(a)(3) of the Internal Revenue Code of
1986 (the Code) provides generally that a qualified mortgage is any
obligation which is principally secured by an interest in real property that
is transferred to the REMIC by the end of the three month period following the REMICs startup day.
Treas. Reg. Section 1.860G-2 provides two tests for determining whether
an obligation is initiallyprincipally secured by an interest in real property.
If either test is satisfied, a loan will be considered a qualified mortgage.
The first test provided in the regulations states that to be principally
secured by an interest in real property, the fair market value of the real
property securing the borrowers obligation under the terms of the related
loan must be:
[a]t least equal to 80 percent1 of the adjusted issue price
[generally the UPB or face amount] of the obligation at the
time the obligation was originated ... [or] at the time the
sponsor contributes the obligation to the REMIC. Treas.
Reg. Section 1.860G-2(a).
1 The 80% value-to-loan test for establishing that a loan is principally secured by an interest in real property is
equivalent to a loan-to-value test of not greater than 125%. The inverse of 80% is 125%, not 120%.
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The alternative test provided in the regulations states that an obligation is
principally secured by an interest in real property,
if substantially all of the proceeds of the obligation were
used to acquire or to improve or protect an interest in real
property that, at the origination date, is the only security
for the obligation.
The Purpose: The qualified mortgage representation is not to guarantee
a minimum fair market value of the collateral that secures the borrowers obligation. Rather, the representation is designed to ensure that the
REMIC does not hold nonpermitted assets that could give rise to a prohibited transaction or disqualify the REMIC.
The depositor (or loan seller) is not afforded a reasonable belief defense
under the REMIC rules as to whether a loan is a qualified mortgage.
The regulations create a safe harbor for the REMIC where there is no
knowledge that a mortgage loan is not a qualified mortgage; however, the
regulations provide that the REMIC must dispose of the related obligation
within a 90-day period starting on the date that the REMIC discovers that
the obligation is not qualified, if the REMIC is to avoid any adverse consequence from holding the nonqualified loan.2 The REMIC is not permitted
to continue holding an obligation that is discovered to be nonqualified
despite the fact that the REMIC initially had no knowledge that the loan
was not qualified.
Defining Real Property: The relevant statutory and regulatory materials do not address the issue of whether certain intangible assets (such as
historic occupancy rates and going concern attributes) would be included
in the value of the real property for purposes of applying the 80 percent test described above. Applying basic real estate fundamentals, a fully
leased building that has a significant operating history will be given a
greater appraised value than an identically constructed and similarly situated building that is historically only 50 percent occupied. The issue that
remains unaddressed is how these intangibles (historic occupancy rates,
2 Treas. Reg. Section 1.860G-2(a)(3)(iii) underscores this conclusion and provides that, if despite the sponsors
reasonable belief ... the REMIC later discovers that the obligation is not principally secured by an interest in real
property the obligation loses its status as a qualified mortgage.
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going concern value and the like) affect the value of the real property for
purposes of applying the 80 percent test.3
When reviewing an appraisal to determine whether the 80 percent test
has been satisfied, the depositor should exercise care to examine the value
attributed to personal property, intangible property and real property.
Only the value attributable to the real property should be used when
applying the 80 percent value-to-loan test.
Origination Dates: Treas. Reg. Section 1.860G-2(b) provides a special rule
for purposes of determining when a loan is originated when applying
the principally secured test noted above. In general,
If an obligation is significantly modified in a manner or
under circumstances other than those described in paragraph (b)(3) of this section then the modified obligation
is treated as one that was newly issued...for the unmodified obligation that it replaced. Consequently...if such a
significant modification occurs before the obligation is
contributed to the REMIC, the modified obligation will be
viewed as having been originated on the date the modification occurs for purposes of the [principally secured] tests.
Treas. Reg. Section 1.860G-(b)(1) (emphasis added).
For these purposes, subsection (b)(3) provides that:
3 The IRS has included certain intangible factors when valuing real property for other tax purposes. GCM
39607 (relating to Rev. Rul. 86-99) is illustrative. In that GCM, the IRS considered whether grazing privileges
could be treated as real property rather than personal property for estate tax valuation purposes. The taxpayer operated a ranch, which consisted of a 6,200-acre parcel of grazing land. The taxpayer also used a 4,500acre parcel of adjacent land under a federal grazing permit issued by the Forest Service of the Department of
Agriculture. The two parcels were used by the taxpayer as a single integrated unit. The IRS noted that although
the federal statutes authorizing grazing permits state that grazing permits do not create any right, title, or interest in federal lands, grazing permits in many cases are continually renewed and remain a valuable asset enhancing the value of adjoining farmland. When a farmer sells his farm, he waives his grazing rights. Nevertheless, the
IRS was of the opinion that, for purposes of Section 2032A of the Code, the grazing permits should be regarded
as an integral component part of the taxpayers adjacent real property. The IRS noted that this conclusion is
more in line with current provisions in the Treasury Regulations and specifically cited Treas. Reg. Sections
1.856-3(b), (c), and (d) (the sections of the regulations that are relevant for our purposes), which, the IRS
believed, give broad definitions of real property.
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for purposes of [determining the origination date of a
loan] the following changes in the terms of an obligation
are not significant modifications ... (i) changes in the term
of the obligation occasioned by default or a reasonably
foreseeable default.
Other Issues: Most PSAs and MLPAs provide as a threshold condition to
the depositors (or loan sellers) obligation to repurchase a loan that the
related breach materially and adversely affect items such as the value of
the related mortgage loan or the interests of the certificateholders therein.
With respect to a claim based on a loans failure to qualify as a qualified
mortgage, it may be suggested that, even if the value of the related collateral did not satisfy the 80 percent test described above, the breach does
not materially and adversely affect the value of the related mortgage loan
or the interest of the certificateholders therein. A technical reading of this
language might suggest that the breach itself is not material and adverse
to the certificateholders interest in the loan and would have no impact on
the value of the loan or the related collateral. We believe, however, that
this result would be contrary to the fundamental purpose of the representation and warranty (i.e., to protect the REMICs status as a REMIC), and
that breaches of the qualified mortgage representation are fundamentally
material and adverse, because the REMICs tax-preferred status is at issue.
Qualified Foreclosure Property: Most PSAs and MLPAs also contain a
representation and warranty designed to ensure that, in the event a borrower defaults, the related collateral that secures the borrowers obligation
under the terms of the loan would be considered qualified foreclosure
property for REMIC qualification purposes. The following is an example
of this type of representation and warranty:
The Depositor has no intention to foreclose on any
Mortgaged Property and has no knowledge or reason to
know that any Mortgage Loan will not be paid in full and
the property securing each Mortgage Loan would be considered foreclosure property within the meaning of the
REMIC Provisions if acquired by the REMIC.
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The Purpose: The qualification of collateral as foreclosure property is
significant, because only collateral that qualifies as foreclosure property
is counted as a permitted investment when applying the asset test for
REMIC qualification. In theory, REMICs are supposed to be passive trusts
that hold mortgages (and occasionally REO following a borrower default)
but do not actively engage in an ongoing business.
The drafters of the Code provisions applicable to REMICs wanted to prevent depositors from intentionally contributing loans into a REMIC where
borrower defaults were anticipated so that the REMIC could be used to
work out these loans. The drafters believed that the use of a REMIC as
a work-out vehicle was inconsistent with the intended passive nature of
REMICs and should be prohibited.
To accomplish this, the drafters provided a rule that prevents related collateral from being REMIC qualified foreclosure property (and thereby
prohibiting the REMIC from realizing on this property) if the facts and
circumstances indicate that, as of the REMICs startup day, the borrowers
default on its obligations under the terms of the related loan was likely.
Improper Knowledge: The REMIC regulations borrow from the Codes
REIT (Real Estate Investment Trust) provisions for purposes of determining if collateral qualifies as foreclosure property. In general, the REIT
rules provide that collateral will not be foreclosure property if the mortgage that was secured by the collateral was acquired by the REMIC at a
time when the REMIC knew or had reason to know (so-called Improper
Knowledge) that the borrower would default.
The IRS addressed the Improper Knowledge standard in PLR 9640003. In
that letter ruling, the FDIC requested guidance from the IRS as to whether
Improper Knowledge existed with respect to four loans. With respect to
each loan, the IRS considered whether the existence of one or two negative critical factors caused the REMIC to have Improper Knowledge with
respect to the related loan. The factors considered were:
Loan 1
The borrower was delinquent on real property

taxes on the startup day.
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Loan 2
Loan 3
Loan 4
The underlying collateral had a high vacancy

rate on the startup day, but the loan was fully
performing.
The borrower failed to make its balloon payment prior to the startup day but continued to
make principal and interest payments pursuant
to the amortization schedule in the loan documents without regard to the balloon payment.
The loan was modified once before the startup
day and the borrower had requested a further
modification.
The IRS found that the type of default referenced in Treas. Reg. Section
1.856-6(b)(3) that supports a finding of Improper Knowledge is the type
of default that would ordinarily give rise to foreclosure (although the IRS
left unaddressed the issue of what constitutes a default that would ordinarily lead to foreclosure). Based on this analysis, the IRS concluded that the
facts presented with respect to each of the four loans noted above were
insufficient to give rise to Improper Knowledge with respect to any of the
four loans examined.
Other Issues: As discussed above, many PSAs and MLPAs provide as
a threshold condition to the depositors (or loan sellers) obligation to
repurchase a loan that the related breach materially and adversely affect
the value of the mortgage loan and the interests of the certificateholders
therein. As with a claim based on a loans qualified mortgage status, the
related depositor may suggest that, even if the property does not qualify as
foreclosure property because of the presence of Improper Knowledge,
the breach does not materially and adversely affect the value of the related
mortgage loan or interest of the certificateholders therein. We note that if
collateral securing a defaulted mortgage loan is not considered foreclosure property for REMIC qualification purposes, the REMIC may not
take title to this property and may be limited to taking a discounted payoff
or effecting a third-party sale of the loan as the REMICs sole means to
realize value from the collateral.
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Conclusion: When considering whether to make a breach claim against
a mortgage loan seller, servicers and special servicers should examine the
representations and warranties related to the qualified nature of the loan
and the collateral that secures the borrowers obligations under the loan.
While alleged breaches based on the position that a loan is not a qualified mortgage or that the related collateral is not foreclosure property
require a technical examination of the Code and the related regulations,
if the facts support such a claim, a breach claim by the REMIC on these
bases may be sustainable.
Thomas J. Biafore
Suite 2800
t 404 815 6250
f 404 541 3129
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Environmental Issues Facing Special Servicers
87
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Environmental Issues Facing Special Servicers

Susan H. Richardson
Environmental issues necessarily concern servicers of commercial

mortgage loans because the security for those loans is real property.
Environmental problems may exist at a mortgaged property at origination
or may develop after origination. Even if a problem doesnt exist, a servicer
may need to take environmental risks into account if a borrower asks for
consent to certain types of loan modifications. If a loan is in default, environmental conditions may prevent the special servicer from taking title to
the mortgaged property and may trigger a repurchase obligation, either
under the Pooling and Servicing Agreement (PSA) or under an environmental insurance policy.
This article examines environmental issues relating to taking title to
defaulted mortgage loans, repurchase claims under the PSA, and environmental insurance. It also discusses environmental issues relating to
performing loans, focusing on the installation of fueling centers, which
have increased in popularity over the past few years.
I. Realization on Defaulted Mortgage Loans: The Environmental
Standard
PSAs contain an environmental standard governing realization upon
defaulted mortgage loans. That provision typically contains a two-prong
economic test for taking title on behalf of the REMIC Trust. A typical provision looks like this:
(c) [ T]he Special Servicer shall not [] take title to a
Mortgaged Property [] if, as a result of any such action,
the Trustee, on behalf of the Certificateholders, would
be considered to hold title to, or [] to be an owner or
operator of such Mortgaged Property within the meaning of CERCLA or any comparable law, unless [] the
Special Servicer has previously received an Environmental
Assessment in respect of such Mortgaged Property []
determining that:
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(i) the Mortgaged Property is in compliance with applicable environmental laws or, if not, that acquiring such
Mortgaged Property and taking such actions as are necessary to bring the Mortgaged Property in compliance
therewith is reasonably likely to produce a greater recovery to Certificateholders [] than not acquiring such
Mortgaged Property and not taking such actions; and
(ii) there are no circumstances or conditions present at the
Mortgaged Property relating to the use, management or
disposal of Hazardous Materials for which investigation,
testing, [] clean-up or remediation could be required
under any applicable environmental laws and regulations or, if such circumstances or conditions are present
for which any such action could be required, that acquiring such Mortgaged Property and taking such actions
[] is reasonably likely to produce a greater recovery to
Certificateholders [] than not acquiring the Mortgaged
Property and not taking such actions.
While this standard is not the model of clarity, it appears to establish an
economic test that first requires the Special Servicer to order and review
a Phase I Environmental Site Assessment.1 After that review, if the Special
Servicer determines that the Mortgaged Property is in compliance with
applicable environmental laws and there are no circumstances or conditions present at the Mortgaged Property relating to the use, management
or disposal of Hazardous Materials for which investigation, testing, []
clean-up or remediation could be required under any applicable environmental laws and regulations, the Trust may take title to the mortgaged
property.
It is worth noting that the Phase I may not reveal all important environmental issues relating to a mortgaged
property. For example, at light industrial properties, environmental compliance issues, such as permitting and
other operational problems, may not be revealed by a Phase I. In recent years, partially developed properties
present stormwater liability issues where such properties have not been stabilized to prevent erosion and sedimentation runoff. In some circumstances, those issues could result in liability for the lender and such liability
may not be subject to lender liability protections afforded by the Comprehensive Environmental Response,
Compensation and Liability Act of 1980 or similar cleanup laws.
1
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If the Special Servicer determines either or both standards are not met, it
may still take title if it determines that, after taking into account the cost
of bringing the mortgaged property into compliance or performing the
required actions, the REMIC trust would do better economically than if it
abandoned the mortgaged property. Importantly, however, nothing in the
PSA requires that the Special Servicer actually cure the problem after taking title. Indeed, because many environmental cleanup laws exempt even
foreclosing lenders from liability, the REMIC trust may not be required to
do anything with respect to the environmental problems.
That said, the mortgaged propertys marketability and other similar considerations should heavily influence whether the Special Servicer actually
takes title. Despite the environmental standard and lender liability protections that insulate the REMIC trust from liability, if no buyer will touch
the mortgaged property, the Special Servicer may not wish to take title.
Further, there may be alternative avenues of recovery, such as environmental insurance and loan repurchase obligations, that counsel against
taking title. When evaluating environmental issues at a mortgaged property securing a defaulted mortgage loan, the Special Servicer should give
special consideration to the question of whether taking title truly makes
economic sense, even if it determines that it can under the PSAs pliant
standard.
For various reasons not related to the contamination itself, a contaminated property may not be attractive to the Special Servicer. In some
instances, environmental issues may be a silver lining, allowing the Special
Servicer to recover on the site without taking title to the mortgaged property. Under some PSAs, these issues can raise repurchase obligations. In
other instances, the lender may own environmental insurance covering the
mortgaged property.
II. Loan Repurchase Obligations
A. Put Claims
Loan repurchase obligations can arise from breaches of representations
and warranties related to the environmental condition of the underlying collateral. Although prosecuting a claim based on an environmental
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repurchase obligation will require coordinated, individualized assessments
of the facts by environmental professionals and legal counsel, it is possible
to make some threshold generalizations that will indicate whether an asset
is a good candidate for an environmental put claim.
In broad terms, an environmental put claim will require the convergence
of several factors. First, the governing PSA must contain the obligation to
provide a remedy for breach of an environmental representation. Second,
the underlying real property must suffer from a condition existing at pool
formation that is bad enough to qualify as a material breach within the
meaning of the PSA or the related Mortgage Loan Purchase Agreement
(the MLPA). Third, the evidence demonstrating the breach will need to
be strong enough to sustain the claim.
In general, more recent PSAs are less generous in terms of environmental
put rights. Older PSAs often provided fertile ground for repurchase obligations based on environmental conditions. For example, in older PSAs,
loan Sellers often represented and warranted that no Hazardous Materials
have been incorporated in or stored on any Mortgaged Property or buried
below the surface of the lands of any Mortgaged Property. Such representations and warranties were so broad that any of a number of relatively
common (and relatively benign) environmental conditions could trigger a
repurchase obligation.
Even newer PSAs, which have more narrow environmental representations and warranties, may contain repurchase obligations. If a property is
contaminated, a closer look at the PSAs language and the environmental
condition may reveal a possible put claim where a more casual review may
not. Newer PSAs (or MLPAs, as discussed below) may contain a representation like the following:
A Phase I environmental report has been conducted by
an independent environmental engineer with respect
to each Mortgaged Property. No Phase I environmental report indicated the presence of any condition which
would materially and adversely affect the interests of the
Certificateholders. The Depositor has received no notice
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of any material violation of any environmental statute or
regulation with respect to any Mortgaged Property.
Under a representation like this, a put claim could be based on an
improperly performed environmental report secured at the time of loan
origination that missed potential contamination that it should have seen.
For example, originators will often authorize Phase II (subsurface) investigation if the Phase I indicates a potential for impacts. But, the Phase II
may not properly test all areas of potential impacts disclosed in the Phase
I report. In such a case, the Phase I could have indicated the possibility
of a condition that would materially and adversely affect the interests of
Certificateholders, the improperly performed Phase II would have missed
the impacts, and the loan could still have been originated based on the
deficient Phase II. Thus, even a newer PSA may contain repurchase obligations, although a put claim based on a newer PSA may be more difficult
and a closer question.
B. Secured Creditor Environmental Insurance Policies
In many of the most recent PSAs, loan sellers have tried to avoid environmental repurchase liability altogether. One way to avoid such liability
but still provide the risk mitigation demanded by investors is to buy environmental insurance, either in the form of blanket coverage for an entire
REMIC Pool or for particular, problem properties. Especially in a climate
in which defaults may be on the uptick, Special Servicers should have at
least a basic understanding of the primary type of environmental insurance covering securitized commercial mortgage loans.
The three primary types of environmental insurance are (i) Pollution Legal
Liability, (ii) Remediation Cost Cap and (iii) Secured Creditor Liability.
Pollution Legal Liability insurance primarily covers property owners or
operators against personal injury, property damage and cleanup costs
when there are triggering pollution conditions. Remediation Cost Cap
insurance mitigates against cost overruns during environmental remediation projects.
The third type of environmental insurance, Secured Creditor Insurance, is
designed to replace the put claim in the case of environmental problems at
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a Mortgaged Property. Typically, Secured Creditor insurance requires the
insurance company to purchase the mortgage loan from the REMIC Trust
when, during the term of the policy, there is a (i) default under the loan
documents and (ii) a discovery of pollution conditions at the mortgaged
property. Thus, it functions similarly to a traditional put claim, with the
insurance company assuming the risk of a problem.
Secured Creditor Insurance was popular from the late 1990s through the
middle of the 2000s and was offered by a number of insurance companies, including affiliates of AIG, Zurich, Kemper and XL. These policies
were often written for huge pools of assets with little or no environmental
underwriting. As these policies were designed to pay off loan amounts
with the simple trigger of the discovery of environmental contamination
and a default under the loan documents, the insurance companies started
experiencing huge losses on these policies and pulled out of the market
in the mid-2000s. These policies are still available, but typically only for
individual assets with significant environmental underwriting and a governmental cleanup requirement trigger as a prerequisite to coverage.
However, as many of the earlier policies were written for very long coverage periods (twenty years or more). An understanding of Secured Creditor
policies continues to be relevant.
Different Secured Creditor policies defined Pollution Conditions differently, but most required contamination at a Mortgaged Property above
state or federal limits. Policy coverage is triggered when there is a Pollution
Condition and a default under the loan documents. Significantly, these
policies did not require a cleanup requirement to be imposed on the lender
to obtain coverage, which ensures coverage despite the fact that most environmental laws provide broad liability exceptions for lenders. As a result,
the lender could recover the remaining balance on the loan without any
governmental or other legal requirement requiring cleanup at the property.
While Secured Creditor policies can provide an opportunity for recovery
on defaulted loans with environmental problems, Special Servicers face
a few challenges in obtaining coverage. One of the biggest problems is
that of notice. In most states, insureds must make prompt notice of claims
or triggering conditions to insurers, as required by the policy. Even if an
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insurer is not prejudiced by the late notice, failure to notify promptly can
void coverage. Thus, Special Servicers should ensure that they provide
notice of default and the presence of pollution conditions to the insurance company as soon as possible. It is important to note that many of the
Secured Creditor policies from the early to mid 2000s had very long policy
periods, with some policies extending twenty years or more. As a result, it
is imperative to search the file and background documents to determine
whether an environmental insurance policy exists and, if so, to provide
prompt notice to the insurance company.
Environmental policies can often cover preexisting conditions. In fact,
Loan Sellers often obtain secured creditor coverage because of conditions
known at origination. However, these preexisting conditions can result in
late notice problems. Because environmental reports disclosing environmental problems delivered at origination reside in the Trustees files, and
the Trustee and the Special Servicer, as the Trustees agent, may be deemed
to have knowledge of these preexisting conditions. Upon default, both of
the policys triggering conditions are met: a default under the loan documents and covered pollution conditions preexisting the default. Because
notice requirements are strict, any delay could jeopardize coverage.
Thus, when the Special Servicer takes over a file, it should search the file
for environmental insurance. If the mortgaged property is covered by a
Secured Creditor policy, the Special Servicer should submit a notice of
default to the insurance company immediately, even in the absence of a
new Phase I report. After giving notice, the Special Servicer can then move
to determine whether any environmental conditions existed at the time
of origination, thus triggering the policy, or if new conditions exist. Such
a practice would reduce the likelihood of a late notice problem based on
environmental conditions existing at the time of origination.
C. Issue Spotting for Put Claims and Environmental Insurance
1. Various Representations and Warranties
PSAs also differ materially on the requirement of knowledge about the
environmental problem at the time of pool formation. The oldest PSAs
often had no knowledge qualifiers, and repurchase obligations were
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triggered no matter when the condition was discovered. As time went by,
Depositors and Loan Sellers learned their lessons and added knowledge
qualifiers. More recent PSAs often contain language requiring that a condition was known or be so patent that it should have been known as of the
date of the securitization. In such a case, if a condition existed but was not
discovered, and environmental investigation was required but not performed or incompetently performed, the Special Servicer may construct
an argument that the Depositor or Loan Seller should have known about
the condition.
Many PSAs contain representations and warranties that, although they
may not form the basis of an environmental put claim standing alone,
nonetheless may support a claim based primarily on other provisions.
NO DEFAULTS. Often, for example, loan documents contain
blanket prohibitions on the use, storage, disposal or handling of
hazardous materials at the Mortgaged Property. Combined with
a no defaults representation in the PSA, a violation of such a
clause could trigger a repurchase obligation. Thus, if the underlying mortgage has such a default condition, the mere presence of a
dry cleaning facility, quick-lube facility or gasoline station on the
property may support a put claim.
GENERAL NO DAMAGE REPRESENTATION. Although not
specifically related to environmental conditions on the property,
no damage representations may trigger repurchase obligations. Arguably, the presence of contamination on the Mortgaged
Property is damage within the terms of such a representation. Of
course, if the representation is limited to improvements, it may not
cover soil or groundwater contamination. The presence of mold
may also constitute damage. Thus, careful examination of the
PSAs language and the loan documents is imperative.
KNOWN ENVIRONMENTAL PROBLEM NOT LISTED ON
SCHEDULE OF EXCEPTIONS. Discovery of an environmental condition on the Mortgaged Property invites a review of the
schedule of exceptions. If the condition is not on the Schedule of
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Exceptions, it merits further investigation because it may be a sign
of fraud or a breach of one of the representations and warranties
described above.
ASSIGNED RIGHTS FROM MORTGAGE LOAN PURCHASE
AGREEMENT OR LOAN DOCUMENTS. In addition to rights
created in the PSA itself, many PSAs contain assigned rights from
the MLPA or loan documents. Often, representations and warranties contained in these documents can provide the basis for a
put claim. A repurchase obligation may arise based on these factors and, as always, careful review of all of the documents in the
loan file is required to determine whether an enforceable put right
exists.
2. Underlying Property Uses
In addition to considering language in the PSA, Special Servicers should
be aware of certain property uses that have a higher than normal likelihood of giving rise to adverse environmental conditions, and repurchase
obligations based on those conditions. Although these uses are not absolute indicators of an environmental problem, the rate of environmental
problems with these uses is high enough to warrant closer investigation.
DRY CLEANERS. Dry cleaners cause one of the most frequent
environmental issues faced by REMIC Trust. The most common
dry cleaning solvent, perchloroethylene (PCE or perc), is subject to extensive regulation, is easily released into the environment,
and is extremely difficult to clean up due to its physical properties.
Thus, cleanups of dry cleaner contamination can easily exceed six
figures, and costs above a half million dollars are not unheard of.
Most obviously, a retail-use mortgaged property currently occupied by a dry cleaner should be investigated further. A Phase I
environmental report should also note whether a retail property
has ever been the location of a dry cleaner, to determine the likelihood of historic impacts. Furthermore, significant numbers of
current drop-off locations once operated as on-site cleaners, so
the mere fact that a location is now a drop-off point should not
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end the inquiry. In addition, many hotels and motels provided onsite dry cleaning services in the past. In sum, dry cleaners should
raise a red flag for the Special Servicer, and often give rise to put
claims.
PROPERTIES WITH OLD SERVICE STATIONS. Properties
with gasoline or service stations also often have a higher than average rate of environmental problems. In practice, environmental
impacts at properties with service stations first built after about
1990 are less common, but environmental issues at older service
stations are fairly common. This is especially true at sites where
tanks were removed prior to 1986, because many states did not
require cleanup at the time of tank removal. Special Servicers
should also note that many current gasoline stations are built on
the site of old stations, and thus should not immediately rule out
impacts at new stations. If an old service station operated on the
property, the Special Servicer should take care to rule out an environmental problem, or, if one exists, review the PSA and other file
documents to determine whether a put claim is available.
OLDER REDEVELOPED SITES. Another indication of a possible environmental concern is whether the propertys use has
changed over time. Many historically commercial or even industrial properties have been re-developed for residential or retail use.
Specifically, if the redevelopment occurred prior to approximately
1990, it may be an indication of the possibility of undisclosed environmental issues.
NON-RESIDENTIAL SEPTIC SYSTEMS. Commercial sites that
operated septic systems are often associated with environmental
contamination. Often, commercial or light industrial operators
simply sent contaminant-laden wastewater directly into the septic system without treatment. Therefore, Special Servicers should
be especially cognizant of sites where septic systems handled the
wastewater from commercial users.
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The foregoing list of the likely sources for environmental put claims is not
exclusive. Viable put claims can arise from almost any type of property
that secures a loan held by a REMIC trust. The uses listed above do often
provide the best toe-hold for instituting a put claim. The viability of the
put claim depends less on the magnitude of the underlying problem than
it does on the clarity of the evidence fitting the claim into the relevant representations and warranties. Thus, it is possible to leverage relatively small
environmental issues into complete repurchase obligations and equally
possible that some truly significant environmental issues will not sustain
a put claim.
While much of the analysis of whether a given claim is viable requires
matter-by-matter review, a handful of threshold considerations can help
narrow the inquiry. A Special Servicer should first determine from which
entity the repurchase obligation runs. It is not uncommon for the broadest
representations and warranties to be given by the party with the least economic ability to back them up. Thus, sometimes the repurchase obligation
belongs only to the originator, which often has little in the way of working capital but, instead, relies on conduit sources for financing.
Second, most environmental put claims require a showing that the environmental condition existed at the time the REMIC pool was formed
(usually, but not always, around the time of origination). Thus, the best
claims stem from conditions that are clearly dated prior to pool formation. Conversely, if the offending environmental condition stems from an
ongoing operation, it can be difficult to determine whether the problem is
the result of pre-origination or post-origination contamination.
Third, as suggested earlier, whether a given environmental issue crosses
the materiality threshold may depend on the degree of regulatory compulsion. For instance, the clearest breach claims stem from circumstances in
which government authorities would compel investigation and clean up.
Conversely, if the environmental regulators show little interest in a problem, it may be difficult to prevail in showing that the problem would cause
a material adverse effect on value.
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Finally, there is a question of leverage. Put claims can be expensive and
time consuming to pursue. Thus, the most successful claims tend to come
from assets where the defaulted debt is much greater than the current
value of the underlying real estate. On the other hand, if the debt is only
marginally higher than the underlying real estate value, it may be wiser to
attempt to work out even significant environmental issues, rather than risk
the possibility of a failed put effort, which could leave the Special Servicer
having to explain why an environmental issue that formed the basis of an
attempted breach claim should not cause a further discount when the loan
is sold to a prospective purchaser.
III. Modifications to Add Fueling Operations
While non-performing loans always implicate the environmental standard
contained in PSAs, even performing loans may require considerations of
environmental issues. For example, collateral substitutions and additions
require the review of environmental due diligence to ensure that the new
or substituted collateral does not pose a significant environmental risk to
the REMIC trust. Additionally, in the past few years, anchor Tenants, such
as grocery stores and wholesale clubs, have gotten into the fuel business by
installing fuel centers at outparcels near their locations. These Tenants are
typically the biggest source of cashflow for borrowers, and keeping them
happy ensures that a mortgage loan remains performing.
However, a Servicer responding to a loan modification request is dutybound to minimize risk to the REMIC trust relating to the fuel center.
While adding the fuel center could reduce credit risk, it could increase
regulatory risk and collateral risk. When handled correctly, though, fuel
center transactions can benefit the borrower, and thus the REMIC trust,
while minimizing environmental risks. Importantly, any consent or modification allowing the installation of the fueling station should ensure that
the borrower exercises oversight and control over the Tenants construction and operations and that the Tenant (or its principal if the Tenant is a
an SPE) indemnifies both the borrower and the REMIC trust.
Federal and state laws require the owner of underground storage tanks
(USTs) to obtain financial assurance, such as participation in state trust
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funds or the purchase of insurance policies, to cover cleanup costs and
third-party claims related to the USTs. The REMIC trusts consent should
require not only that the tenant have financial assurance in place, but
also provide evidence of it to the borrower annually and name the borrower and REMIC trust beneficiaries of it to the extent allowed by law. The
consent should also require that the lease between borrower and tenant
require continued compliance with environmental laws and a method to
audit such compliance. The consent should also require that the borrower
and tenant agree to an environmental indemnity in favor of the REMIC
trust covering any and all claims related to or arising from the installation and operation of the USTs and fueling station and covering any of the
REMIC trusts liabilities or losses relating to the USTs or fueling operations, whether caused by Tenant or not. The consent should also require
that the Tenant keep responsibility for the USTs from cradle to grave. It
should fix responsibility for UST closure, removal and post-closure corrective action on the Tenant. In that way, the Tenant is fully responsible
for the USTs, even if its lease is terminated or it otherwise vacates the site.
IV. Conclusion
Because servicers of REMIC trusts deal with real property, they will
inevitably encounter environmental issues. The PSA itself contains an
environmental standard that is triggered when a loan is in default. Careful
review of that environmental standard will help a servicer determine
whether it can take title, but an analysis of the totality of the circumstances
surrounding the loan and mortgaged property will determine whether
the servicer should take title. Contamination at mortgaged properties
may give rise to repurchase obligations under the PSA or under an insurance policy covering the loan. Servicers should be aware of the issues
surrounding those rights and obligations, as they can help bring value
to an otherwise worthless asset. Finally, even performing loans may raise
environmental issues, especially when a servicer is asked to consent to fuel
center activities at the mortgaged property.
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Susan H. Richardson
Suite 2800
t 404 815 6330
f 404 541 3366
SuRichardson@KilpatrickStockton.com
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Foreclosure Property Extensions When and

Where to File
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Foreclosure Property Extensions When and

Where to File
Thomas J. Biafore
Background: Ensuring the continued qualification of REO (Real Estate

Owned) property as REMIC-qualified foreclosure property is one of the
special servicers express duties under the terms of virtually all Pooling
and Servicing Agreements (PSAs). Only REO property that qualifies as
foreclosure property is counted as a permitted investment when applying the asset test for REMIC qualification. As a REMIC can generally only
hold qualified mortgages and permitted investments (one of which
is foreclosure property), a REMICs tax-transparent status may be lost
should the REMIC hold property that is neither a qualified mortgage nor
a permitted investment.
REO property ceases to qualify as foreclosure property on the last day
of the third tax year following the tax year in which the foreclosure took
place. A REMIC may apply to the IRS to receive one, and only one, threeyear extension of this period. Given the restriction on the time period for
holding foreclosure property (called the grace period), special servicers
should always apply for an extension long before the expiration of the
applicable grace period. If the REMIC holds collateral after the expiration
of the applicable grace period, the property will not be REMIC-qualified
foreclosure property, and the REMICs tax-transparent status may be lost.
Timing: The good news is that the REMIC will automatically receive a
requested three-year extension of the grace period provided the REMIC
files its extension request at least 60 days prior to the expiration of the current grace period. For example, for foreclosures that took place in 2010, the
grace period expires on December 31, 2013. The grace period will automatically be extended through December 31, 2016, so long as an extension
request is filed before October 31, 2013. But what if the extension request
was not filed at least 60 days prior to the expiration of the grace period?
Late Filings: When the REMIC fails to file its extension request at least
60 days prior to the expiration of the grace period, the grace period is
not automatically extended. Rather, the regulations provide that, in such
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instances, an extension of the grace period will be granted only if the
REMIC establishes to the satisfaction of the District Director that there
was reasonable cause for failure to file the extension request within the
prescribed time, and the extension request is filed within such time as the
District Director considers reasonable. There is no indication from the
regulations as to what is a reasonable cause for the REMICs failure to file
its extension request before October 31.
As a preliminary matter, the position of District Director has been
eliminated. Accordingly, there is confusion both as to where to file the
delinquent extension request and who makes the determination that the
REMIC had reasonable cause for missing the October 31 deadline.
Where to File: Based on discussions with the IRS National Office, we had
previously been informally advised to file grace period extensions with
the Internal Revenue Service, Industry Director-Financial Services and
Healthcare (LM:FSH), 290 Broadway, 12th Floor, New York, NY 10007.
Recently the IRS has more formally announced that any grace period
extension request should now be filed with the Internal Revenue Service,
1973 North Rulon White Boulevard, Mail Stop 6552, Ogden, Utah 84404.
Information Included: In addition to the requirements noted above and
related to the circumstances associated with the REMICs delay in filing the extension request, the grace period extension application should
always include the following information:
The name, address and taxpayer identification number of the
REMIC trust;
The date the foreclosure property was acquired;
A statement as to whether previous extensions of the grace period
have been requested;
A brief statement as to why the grace period should be extended;
and
A description of the efforts that have been made to dispose of the
property prior to the expiration of the current grace period.
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While the regulations limit the information that a special servicer must
include in a grace period extension request to the five points noted above,
in practice the IRS currently requires that a REMIC include its most
recently filed tax return with its application as well as statements related to
the nature and operation of the foreclosure property. Please consult with
your REMIC counsel for a complete listing of information that the IRS has
been requesting when processing grace period extension requests.
Thomas J. Biafore
1100 Peachtree Street Suite 2800
t 404 815 6250
f 404541 3129
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108
Workouts, Cancellation of Indebtedness and IRS

Reporting Requirements: What Borrowers and
Special Servicers Need to Know
109
110
Workouts, Cancellation of Indebtedness and IRS

Reporting Requirements: What Borrowers and
Special Servicers Need to Know
Thomas J. Biafore
Background: Borrowers and Special Servicers seldom appreciate the

tax consequences of a workout or foreclosure. These consequences can
upset a negotiated workout or friendly foreclosure at the eleventh hour
when the borrower realizes it may have a substantial tax liability to the
IRS even though the borrowers liability to the lender has been resolved.
IRS reporting requirements, together with the applicable provisions of the
relevant PSA, require servicers to report to borrowers and the IRS transactions that generate cancellation of indebtedness (COD) or gain on sale
income. This article examines the tax consequences of typical settlements
of defaulted loans.1
Reporting Requirements: Under the Internal Revenue Code of 1986 (the
Code), an entity that discharges at least $600 of indebtedness during the
calendar year is required to file an information return, commonly known
as a Form 1099. A Form 1099-A-Acquisition or Abandonment of Secured
Property, must be filed where, in full or partial satisfaction of the debt,
the lender acquires an interest in the property that secures the borrowers
obligations under the terms of a defaulted loan. The lender reports on the
Form 1099-A the principal balance of the loan outstanding and the fair
market value (FMV) of the collateral acquired. As is discussed below
and despite the name on the Form 1099-A (Acquisition on Abandonment
of Secured Property), a lender is required to file a Form 1099-A in many
cases even when the lender does not ever take title to the collateral property (e.g., short sale, loan assumption on modified loan terms). A lender
files a second form, Form 1099-C-Cancellation of Debt, when all or a portion of a debt the borrower owes is forgiven. When the lender accepts a
discounted payoff of a defaulted loan, the borrower experiences a discharge of indebtedness that requires the Special Servicer to file a Form
1099-C. The amount reported is the amount of debt canceled or forgiven.
For purposes of this article, we have referred generally to the Special Servicers reporting obligation. Note
that under some PSAs the Master Servicer retains all 1099 reporting obligations.
1
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Cancellation of Indebtedness: After a Special Servicer determines that
a transaction results in a settlement or discharge of the loan, the Special
Servicer must determine whether the transaction resulted in income for
the borrower.
Special Servicers typically face three common resolutions when dealing
with a nonrecourse loan:
Assumptions/Loan Sales: The borrower may transfer the collateral
to a third party that assumes the defaulted loan or the lender may
sell the defaulted loan to a third party. Though there has been a sale
of the underlying collateral in the first instance and a sale of the
loan in the second, the obligations of the borrower (or the assumptor) under the terms of the loan continue and the obligor continues
to owe the full amount of the debt. In this transaction, there is no
settlement of the loan or COD (unless the Special Servicer agrees
to write down the loan in the hands of the new borrower/assumptor) and the Special Servicer would file neither a 1099-A nor a
1099-C although the borrower may have gain or loss on the sale of
the collateral.
Foreclosures/Deeds in Lieu: The borrower may transfer the collateral
to the lender by deed in lieu of foreclosure or as part of a formal
foreclosure. Here, if the debt is nonrecourse, the debt will be canceled by the foreclosure, but the borrower realizes no COD income
irrespective of the value of the collateral at the time of foreclosure.
With nonrecourse lending, the borrower is obligated to repay the
loan according to the loans terms or by transferring the collateral
to the lender (or its designee) in satisfaction of the debt. When
the collateral is transferred to the lender as part of a foreclosure or
deed in lieu of foreclosure or the lender elects to allow the property
to be sold to a competing bidder on the courthouse steps during a
foreclosure proceeding, the loan has been satisfied in accordance
with the loans terms and no COD income results. The foreclosure is treated as if the borrower sold the collateral to a third party
for the full amount of the debt (even if greater than the propertys
value) and used proceeds from this sale to pay the lender the
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full amount of the nonrecourse debt. In a foreclosure or deed in
lieu of foreclosure of a nonrecourse loan, the Special Servicer files
a 1099-A with the borrower and the IRS. Similarly, should the
lender elect to let the property go to a competing bidder on the
courthouse steps at foreclosure in satisfaction of the borrowers
nonrecourse debt, the special servicer should file a 1099-A despite
the fact that the lender technically never takes title to the collateral
property.
DPOs: The borrower may agree in a discounted pay off (or DPO)
to pay the lender cash or property other than the collateral and, in
return, the debt is canceled and the lien on the collateral is released.
The DPO generates COD income that the borrower must recognize unless an exception applies. For DPOs, the Special Servicer
files a 1099-C with the borrower and the IRS.
PSA Requirements: The Special Servicer must comply with the PSA when
reporting income from the settlement of a loan. A typical PSA provision
relating to this requirement reads as follows:
The Special Servicer shall report to the Internal Revenue
Service and the related Mortgagor, in the manner required
by applicable law, the information required to be reported
regarding any Mortgage Property which is abandoned or
foreclosed, information returns with respect to the receipt
of mortgage interests received in a trade or business and
the information returns relating to cancellation of indebtedness income with respect to any Mortgage Property
required by Sections 6050J, 6050H and 6050P, respectively,
of the Code. Such reports shall be in form and substance
sufficient to meet the reporting requirements imposed by
Sections 6050J, 6050H, and 6050P of the Code. The Special
Servicer shall deliver a copy of any such report upon
request to the Trustee.
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The form required by applicable law, either a Form 1099-A or 1099-C, will
differ depending on the circumstances of the settlement of the defaulted
loan.
The instructions for Form 1099-C provide that until the IRS issues further guidance, no penalty will apply to the Special Servicers failure to file
Form 1099-C for a canceled debt held by a REMIC. While the IRS may not
levy a penalty against a REMIC for failing to file a Form 1099-C, Special
Servicers must file these information returns for proper PSA compliance.
When to Report? If a borrower retains a right of redemption after a
foreclosure sale under state law, the noteholders Form 1099-A reporting obligation does not arise until this redemption right expires. If the
borrower wants to realize a gain or loss from the foreclosure prior to the
expiration of the right of redemption, the borrower may waive this right.
In contrast, a borrower realizes a discharge of indebtedness in the year
when the debt is legally forgiven or becomes unenforceable (for example,
as a result of the statute of limitations).
Borrower Concerns: Given the varying tax consequences to a borrower of
COD (1099-C) and gain on sale (1099-A) income, borrowers may attempt
to recharacterize the nature of a workout to accomplish their tax goals.
In general, gain on sale income cannot be excluded from the borrowers
income but may be taxed at reduced rates. COD income is taxed at the
borrowers regular tax rate but may, depending on the circumstances, be
excluded from the borrowers income. Borrowers must understand that the
economics of a workout will control the borrowers tax consequences, not
the form of the transaction or the label that the borrower and the Special
Servicer put on the transaction. For example:
Short Sales: When nonrecourse debt is canceled incident to a short
sale of the collateral to a third party, the borrower has gain on sale
(1099-A) rather than COD (1099-C) income despite the fact that
the lender does not ever acquire the collateral property before
this property passes to the purchaser. In a recent case, a borrower
owned property subject to a $25 million nonrecourse debt. The
borrowers tax basis in the property was $11 million, meaning that
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the borrower would have taxable gain on sale of $14 million (the
difference between the amount of the debt and the borrowers tax
basis in the collateral) if the lender foreclosed the collateral (as the
borrower is treated as having sold the property to a third party for
$25 million). This gain could not be excluded from the borrowers
gross income. The borrower sold the property to a third party in
a short sale and took the incorrect position that the short sale did
not generate $14 million of gain on sale income but rather generated COD income that could be excluded from the borrowers
income (based on the borrowers circumstances and an applicable
exception). As support for this position, the borrower argued that
the short sale was separate from the debt cancellation because the
sale involved a purchaser other than the borrower and the loan was
not assumed by the purchaser.
The court disagreed with the borrower and held that there was
only one transaction and the lenders cancellation of the debt in
exchange for the sales proceeds from the short sale was evidence
that the transaction was like a foreclosure with the borrower realizing gain on sale (1099-A) rather than COD (1099-C) income. The
court did not rule out the possibility of a borrower having COD
income where the collateral is subsequently transferred to a third
party and a prior write-down of the nonrecourse debt occurs. The
court did, however, indicate that a borrower seeking COD income
in these types of transactions must establish that a lenders prior
write-down of the debt was separate from the subsequent disposition of the collateral in the short sale.2
2 Some commentators have incorrectly suggested that Treas. Reg. Section 1.1274-5(b)(1) supports the notion
that in a short sale transaction if the buyer of the collateral property assumes even $1 of the original borrowers
debt as part of the short sale, the original borrower can treat any income realized on the write down of the debt
from its face amount in the hands of the original borrower to $1 in the hands of the buyer as COD (1099-C)
income rather than gain on sale (1099-A). Treas. Reg. Section 1.1274-5(b)(1) provides generally that if a debt
instrument is modified (reduced) in connection with a sale, the modification is treated as a separate transaction
that takes place before the sale of the property and is only between the original borrower and the lender. Treas.
Reg. Section 1.1274-5(b)(1) should be read as nothing more than a regulatory acknowledgement of the general
tax principle that the buyer of property subject to assumed debt does not experience the tax consequences of the
modification to the assumed debt done solely to facilitate the sale of the property to the buyer. Rather the tax
consequences of the write down of the debt remain with the seller/original borrower. To suggest that Treas. Reg.
Section 1.1274-5(b)(1) can be used by a defaulting borrower to convert gain on sale (1099-A) to COD (1099-C)
income in what is in effect the original borrowers surrender of the collateral property to the lenders designee in
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Write-down of Debt Prior to Sale: A borrower seeking COD
rather than gain on sale income may offer some form of consideration to the lender for a write-down of the debt prior to (but in
anticipation of) a foreclosure or deed in lieu of foreclosure. In this
situation, too, the economics of the transaction will control: the
write-down of the debt in anticipation of the borrowers transfer
of the collateral to the lender in complete satisfaction of the debt
will be disregarded and the borrower should recognize gain on sale
from the transaction despite the fact that the lender technically
wrote down the debt prior to the foreclosure.
Conversion of Debt to Recourse: A borrower may have the lender
convert the loan to recourse debt before foreclosure all the while
never intending for the lender to pursue the deficiency created by
this new recourse obligation. In a foreclosure of a recourse debt,
the defaulting borrower has gain on sale income (1099-A) equal to
the difference between the fair market value of the collateral and
the borrowers tax basis in the collateral and COD income (1099C) equal to the deficiency to the extent forgiven. The conversion
of the loan from nonrecourse to recourse is not respected for tax
purposes and the taxpayer has gain on sale for the entire amount
of gain on the transaction. Remember, no borrower would agree to
have a defaulted nonrecourse loan convert to a recourse obligation
before foreclosure absent a preexisting agreement from the lender
not to pursue the borrower on the deficiency.
DPOs by Loan Sale: Another common borrower request in the
current environment involves an effort to convert a negotiated
DPO (which would generate COD income for the borrower) to
a loan sale to a party friendly with the borrower. Unlike a DPO,
a loan sale in these circumstances would, if respected as a true
sale, generate no taxable consequences to the borrower, as the
full amount of the loan remains outstanding after the sale. In this
case too, the economics of the transaction should control and
the Special Servicer should examine this sale (arranged by the
satisfaction of the original borrowers debt is an overly broad reading of the regulation that is inconsistent with
general tax principles and not supported by the decisional law that has considered the issue.
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borrower often at the eleventh hour after a DPO has been thoroughly negotiated and only when the borrower realizes that it faces
a large tax bill related to COD income if the DPO goes forward)
very carefully before agreeing to issue the borrower something
other than a Form 1099-C in connection with the transaction.
Aside from the fact that the Special Servicer can only sell a loan
pursuant to the express terms of the PSA, the fact that the transaction was initially structured and negotiated as a DPO and the
fact that the sales price received was not a price established on the
open market as a fair value for the loan but rather represented the
previously negotiated DPO amount should be warning signs to the
Special Servicer.
Transfer to Lenders Designee/Receiver Sales: A REMIC cannot
provide financing to the purchaser of REO on which the REMIC
has foreclosed. As a result, a popular transaction in the current
environment is the use of a receiver to market and sell the collateral property subject to the modified terms (including a principal
write down) of the existing nonrecourse debt.
Despite the form of the transaction (i.e., a direct transfer from the
current borrower to the buyer where the REMIC never accepts
title of the collateral property) the transaction will be treated like
a short sale, for tax purposes, as if the borrower transferred the
collateral property to the REMIC (generating gain on sale for the
original borrower equal to the difference between the amount realized from the transaction and the borrowers basis in the property)
and the REMIC subsequently transferred the collateral property to
the buyer subject to the terms of the modified debt.
It has been suggested in the context of a receivership transfer and
loan assumption that because the original loan will be modified
and reduced as to the buyer of the property and because the collateral property was never transferred to the lender in satisfaction
of the original borrowers debt, the receivership transfer must
somehow create COD income for either the original borrower or
the assuming borrower depending on when the assumed loan is
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written down. This suggestion is incorrect. Rather than creating
COD income, the tax consequences of the receivership sale are
controlled by the economics of the sale and the transaction is classified as a transfer by the original borrower to the REMIC/lenders
designee in satisfaction of the original borrowers obligation (creating gain on sale for the original borrower) and an assumption of
the loan on modified terms by the buyer with no tax consequences
for the buyer at that time. No COD income is realized as a result of
the receiver sale and loan assumption.3
Basis and Amount Realized: The borrowers tax consequences of a loan
workout are affected by the borrowers tax basis in the collateral, the
amount realized by the borrower in connection the workout, and the
structure of the workout.
As noted above, a foreclosure or deed in lieu related to a nonrecourse loan
is classified for tax purposes as if the borrower sold the collateral to a third
party. This transaction creates gain on sale income for the borrower equal
to the difference between the amount realized on the transaction and the
borrowers tax basis in the collateral. For these purposes, the amount realized includes the amount of the nonrecourse debt to which the collateral
is subject at the time of the foreclosure.
Similarly, the borrowers tax basis in the collateral includes the amount of
the acquisition indebtedness (including the nonrecourse debt) to which
the collateral is subject.
Consider the following example: A borrower has a basis of $10 in the
collateral (comprising $2 of cash equity contributed by the borrower to
acquire the collateral and $8 of nonrecourse debt that encumbers the collateral). If the lender forgives $2 of the nonrecourse debt in connection
with a workout of the loan in year 1, the borrower has $2 of COD income
at that time (which may be excluded from the borrowers income in certain
circumstances). If the borrower then sells the collateral in year 2 for $9, the
borrower has a $1 loss on the sale transaction ($9 realized on the transaction less borrowers $10 basis in collateral). Combining this $1 loss on the
3 See footnote above regarding the proper application of Treas. Reg. Section 1.1274-5(b)(1) in the context of a
receiver sale.
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sales transaction with the $2 of prior gain related to the COD income from
year 1, the borrower has realized a net gain of $1. These tax results are consistent with the economics of the transaction - the borrower contributed
$2 of cash to acquire the collateral and received $3 on the sale of the collateral ($9 received on the sale less $6 used to payoff the outstanding debt
at the time of the sale) for a net plus $1.
If, instead, the lender forecloses on the collateral in year 2, the borrower
has a $4 loss on the sale (1099-A) equal to the difference between the $6
amount realized on the foreclosure (the amount of the nonrecourse debt
to which the property is subject) and the borrowers tax basis in the collateral ($10). Taking this $4 loss on the foreclosure transaction with the
$2 of COD income that the borrower realized when the lender wrote
down the loan by $2 in year 1, the foreclosure generates a net $2 loss for
the borrower. These tax results are consistent with the economics of the
foreclosure, as the borrower contributed $2 of cash to acquire the collateral and the borrower has lost this entire $2 investment as a result of the
foreclosure.
Guarantor Reporting: A guarantor of a loan is not a debtor or borrower
for purposes 1099-A and -C reporting. A Special Servicer will not, therefore, issue a 1099 to a guarantor when a loan is settled against the borrower
even if the Special Servicer establishes a deficiency but elects to abandon
any effort to recover that deficiency from the guarantor. Aside from the
fact that the Form 1099 Instructions are clear that a 1099 should not be
issued to a guarantor, as a fundamental tax matter a guarantor realizes
no income when a Special Servicer abandons any attempt to recover any
of the deficiency from a guarantor. As a general matter, a taxpayer does
not realize income from the forgiveness of an obligation the payment of
which would have entitled the taxpayer to an offsetting deduction in the
first instance. In the case of a guarantor making a payment on a borrowers
deficiency claim, the guarantor would be entitled to a bad debt or other
deduction for the amount paid in satisfaction of the borrowers deficiency
as the borrower is without any assets and otherwise insolvent at the time
the guarantor makes this payment. Under these facts, the Special Servicers
abandonment of the effort to pursue the guarantor for the deficiency does
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not result in any COD income to the guarantor as a matter of fundamental
tax principles.
Conclusion and Summary: The tax consequences of workouts and foreclosures are complicated and sometimes counter-intuitive. A foreclosure
or deed in lieu of foreclosure that satisfies a nonrecourse loan (whereby the
borrower returns the collateral to the lender) is treated, for tax purposes,
as if the borrower sold the collateral in a transaction for the full amount
of the debt. The borrower has gain on sale income equal to (i) the amount
of debt to which the collateral was subject, minus (ii) the borrowers tax
basis in that collateral. The fair market value of the collateral is irrelevant
in computing the tax gain. The borrower cannot exclude this gain on sale
from its income, and the Special Servicer must report the transaction to
the IRS and the borrower on a 1099-A.
A DPO or other settlement of a nonrecourse loan in which the borrower
retains ownership of the collateral and all or some portion of the related
debt is forgiven generates COD income for the borrower equal to the
excess of the existing debt over the amount the borrower pays to settle that
debt. COD income may be excluded from the borrowers income depending on the borrowers solvency, whether the borrower is in bankruptcy and
other circumstances specific to the borrower. The Special Servicer must
report a transaction that generates COD income to the IRS and the borrower on a 1099-C, without regard to whether an exclusion applies.
Special Servicers must understand these basic concepts if they are to negotiate effectively with borrowers and maximize recovery on defaulted loans.
Thomas J. Biafore
Suite 2800
t 404 8156250
f 404 5413129
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Property Protection Advancing in CMBS
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Property Protection Advancing in CMBS

Thomas J. Biafore
Rex R. Veal
No issue impacts the critical areas of CMBS servicing more than a servicers decision to advance for property protection items. In order to
undertake any action, a servicer must determine that the proposed action:
(1) does not have negative REMIC consequences; (2) does not violate the
terms of the PSA; and (3) makes sense from a credit perspective.
Common items for which a servicer may consider making property protection advances include:
Advancing funds to a borrower to pay tenant improvement and
leasing commissions (TILCs) necessary to retenant a collateral
property;
Purchasing the claims of unrelated creditors in a borrowers bankruptcy in order to control the reorganization effort; or
Paying a mezzanine lender that is threatening to derail the servicers workout strategy to cooperate.
In each case, the servicer must consider REMIC and PSA permissibility
and the credit advisability of the proposed advance.
REMIC Issues:
1. No New Loans. Under the asset test for REMIC qualification, a REMIC
can hold qualified mortgages and permitted investments. See Tom
Biafore, REMIC Qualification Why Do We Care? and Fear of the
Unknown: The Danger of Holding Unqualified Assets in this Guide for
a discussion of the significance of the asset test for REMIC qualification.
A qualified mortgage has both a quality component (i.e., the obligation
must be principally secured by real property (LTV no greater than 125%)
at the time the loan is contributed to the REMIC or otherwise modified)
and a timing component (i.e., the obligation generally must be held in the
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REMIC as of the end of the third month following the REMICs startup
day).
The timing requirement for a qualified mortgage may affect a servicers
ability to recover an advance against a borrower, because an advance that
is not specifically provided for in the borrowers loan documents may be
considered to be a new loan that was not held in the REMIC at the time
the REMIC was formed. Typical advances for taxes or insurance and other
property protection items are authorized in the borrowers loan documents and present no meaningful issues if the servicer advances for these
items and recovers the advanced amounts plus interest accruing at the note
rate from the borrower under the existing terms of the borrowers loan
documents.
Other advances (for example, for TILCs to retenant the property or for
working capital for the borrowers operations) may not be authorized in
the borrowers loan documents and may therefore more closely resemble
a new loan to the borrower rather than an advance under the borrowers existing financing. It might be suggested that, because the advanced
amount will be passed through the REMIC back to the servicer in its
individual capacity as the advancing party, any new loan that may have
arisen as a result of a property protection advance is to the borrower from
the servicer as the advancing party, not from the REMIC as the holder of
the borrowers loan.
As support for this position, it is the servicer as the advancing party that
benefits from the repayment of the advance plus interest at the advance
rate and bears the ultimate credit risk should the advance not be repaid
from the borrower, the collateral or the general assets of the trust. (See
the discussion below on Advancing Limitations in this article related to
advancing issues that arise when the REMICs assets as a source for recovering property protection advances are reduced over time.) Whats more,
it is the servicer that determines whether an advance will be recoverable
under the terms of the PSA. One counterargument to this characterization
of the loan as being between the borrower and the servicer, however, is that
the benefit of any positive interest rate spread between what is paid to the
servicer as the advancing party and what is recovered from the borrower
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inures to the benefit of the REMIC and its certificateholders (although
the REMIC also bears the detriment of any negative interest rate spread).
It could be possible to characterize this interest-rate spread as a form of
hedge that the REMIC entered into in connection with the formation of
the trust, but there are difficult REMIC issues that must be resolved before
the servicer makes any advances that are not authorized in the borrowers
loan documents but that the servicer intends to include in the balance due
from the borrower.
In addition to the REMIC tax issues associated with any recovery of an
advanced amount from the borrower, whether the advance can be recovered from the borrower will weigh in the servicers decision to make
the advance in the first instance. Having loan documents in place that
expressly contemplate the making of the advance and recovering the
advanced amount from the borrower can help the servicer make this
determination.
2. Advances as a Credit Enhancement. The REMIC provisions of the
Internal Revenue Code do not indicate how an advance is treated for
purposes of the asset test for REMIC qualification. Should an advance
be considered as part of one of the REMICs qualified mortgages, as a
separate permitted investment held by the REMIC or as some other asset
or contract right that is entirely outside of the REMIC and exclusively
between the servicer as the advancing party and the borrower?
The applicable regulations clarify this ambiguity and provide that a servicers advance for property protection items is treated for REMIC tax
qualification purposes as part of the qualified mortgage to which the
advance relates. Curiously, the regulations sanction as permitted advances
only those expenses incurred to protect the REMICs security interest
in the collateral property rather than the collateral property itself.
Without question, a servicers advance to perfect or otherwise correct a
faulty mortgage filing would fit the definition of a permissible advance,
but what about a servicers proposed advance to fix a hole in the roof of
the collateral property? Under a technical reading of the regulations, such
an advance is not necessary to protect the REMICs security interest
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in the collateral property, but rather is essential to protect the property
itself. Commentators and practitioners alike have noted that a strict reading of the regulations limiting permissible protective advances to those
outlays necessary to protect the REMICs security interest in the collateral property makes no sense. If such a limited reading of a permitted
advance were accepted, a REMIC could not, under the regulations, make
an advance for REO property (i.e., property that the REMIC owns outright
as a result of foreclosure or deed in lieu of foreclosure), as with such property the REMIC has no security interest to protect. As an alternative,
advances for the benefit of REO property could be characterized not as
a credit enhancement to a qualified mortgage (as the qualified mortgage
no longer exists following foreclosure or a deed in lieu) but rather as an
investment in the REMICs permitted investments (qualified foreclosure
property). In this regard, an advance for the benefit of the REMIC-owned
foreclosure property seems more properly characterized as a loan from the
servicer to the REMIC for the benefit of the REMIC-owned foreclosure
property. Whatever the rational, all PSAs sanction the use of the REMICs
advancing mechanism to protect and operate REO property despite the
fact that no qualified mortgage related to that REO property exists following foreclosure.
Another curiosity in the regulatory description of a permitted advance
relates to the fact that an advance includes expenses necessary to
preserve the REMICs security interest in the collateral property. Query
whether outlays in the nature of capital items, which if made by the borrower (or the REMIC in the case where the REMIC holds the property as
REO property) would not be expensed in the current year, can be treated
as a permitted advance? While the wording in the regulations is less than
precise, practitioners are generally comfortable treating an outlay necessary to protect the collateral securing a borrowers qualified mortgage as
a permissible advance whether such property has been converted to REO
property or whether such an outlay would ordinarily be expensed by a
taxpayer in the year incurred.
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PSA Concerns:
1. Advancing for the Mortgaged Property. PSAs distinguish between the
servicers advance for the benefit of REO property (i.e., property owned
by the REMIC) and an advance for the benefit of the mortgaged property (i.e., property owned by the borrower, but serving as collateral for the
REMICs qualified mortgage).
Typically, a PSA will authorize a servicer to advance for the benefit of the
Mortgaged Property only to maintain, preserve and protect the borrower-owned property. With REO, however, the PSA will provide that
the servicer can advance to maintain, preserve, protect and operate the
related REMIC-owned REO property. The PSA distinction between REO
property and mortgaged property which authorizes servicer advances
to operate REO property but does not authorize similar advances with
respect to the mortgaged property may represent a meaningful limitation
on the servicers ability to advance or could simply be an acknowledgment
that in the case of the mortgaged property the borrower, rather than the
REMIC, owns and operates the related property so that there would be
no expectation that the servicer would ever be advancing to operate the
borrower-owned property.
This distinction is best illustrated by examining a servicers proposed
advances for TILCs to retenant a property. In the case of TILCs, the servicers advances to retenant REO property (rather than the mortgaged
property) would present no PSA issues, as the PSA specifically authorizes advances to operate the REO property. But, compare an advance
for TILCs related to the borrower-owned mortgaged property. In this case,
the PSA does not specifically authorize the servicer to advance to operate
the mortgaged property; rather, advances for the benefit of the mortgaged
property are limited to those outlays necessary to manage, preserve or
protect the related borrower-owned mortgaged property. When faced with
a borrowers request for an advance to operate the mortgaged property,
the servicer might consider avoiding any potential PSA issues by allowing
the borrower to access other reserve funds for such purpose. In this way,
the servicer can avoid the potential issue that the advance for TILCs and
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similar operational items for the benefit of the mortgaged property was
not authorized under the PSA.
2. Recovering Advances. Generally, advances made by a servicer are recovered from the proceeds of the related qualified mortgage or, following a
foreclosure, the disposition of REO property. As discussed above, advances
made with respect to a loan should be recoverable from the borrower and
the advanced amounts can be added to the loan balance under the terms
of the borrowers loan documents.
As between the REMIC as noteholder and the borrower, the advances,
as additions to the loan balance, carry an interest rate equal to the contract rate on the loan. The interest rate payable to the servicer for making
an advance generally will be a lower rate normally the Prime Rate, as
defined in the PSA. Depending upon the circumstances, the advances may
be recovered from the borrower simply by billing the borrower for the
advanced amounts and collecting the advances in due course. More often,
however, repayment by the borrower (rather than from the liquidation of
the loan or REO property) will be delayed until the eventual refinancing
or satisfaction of the loan. If the delay is due to the terms of a workout,
the advances may be considered Workout Delayed Reimbursement
Amounts or WODRA (a concept that generally appears in PSAs for
transactions closed in 2001 or thereafter) with the result that the servicer
may be reimbursed from principal collections on the loan pool as a whole.
Assuming the advances are not the result of a workout and the servicer
otherwise elects not to pursue remedies against the borrower, the advances
may remain outstanding until the loan is paid off, at which point the borrower may be required to pay the advances along with all other amounts
due under the loan documents in order to have the REMICs lien on the
mortgaged property released.
Servicers should note that, notwithstanding the interest rate that a servicer
receives on advances, the borrower is liable for interest on the advances at
the loans contract rate or possibly at the default rate. Moreover, if the delay
in the collection of these amounts is extended, the servicer should send a
reservation of rights letter asserting the trusts right to collect the advanced
amount and any monthly billing statements should include those amounts.
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In terms of priority of repayment at the time a loan or REO property is
liquidated, the payment application provisions in most PSAs will provide
that the liquidation proceeds will be applied to repay advances and interest
on those advances before any application of proceeds to the interest and
principal due on the loan.
3. Advancing Limitations. Before making an advance, a servicer must
determine that the advance will be recoverable from the proceeds of the
loan (i.e., the total outstanding amount of all advances on the loan, P&I
advances and servicing advances will be less than the amount expected to
be received on the loan). For example, if REO property worth $5 million
has proven more difficult to dispose of and more expensive to operate than
expected, a servicer may face a situation where the total of all advances for
the asset is approaching the propertys value and the recovery of any future
advances is doubtful. Under these circumstances, a servicer may determine that a future advance would be nonrecoverable and will not make
additional advances. Many PSAs contain a mechanism for paying critical property protection expenses such as taxes and insurance even when
the likelihood of recovering these amounts from the loan or related REO
property is remote. In the example above, the servicer would not make
advances for P&I or for basic property expenses, but to avert a disaster for
the trust if the property were uninsured and burned down. The servicer
will be authorized by most PSAs to advance for such expenses, even if the
advances are nonrecoverable. In these situations, the PSA will require that
the critical expenses be paid from the collection account for the entire loan
pool as additional trust fund expenses.
Generally, master servicers make recoverability determinations, but with
respect to specially serviced loans and REO property, most PSAs permit the master servicer to rely on the special servicers determination of
recoverability. The master servicer is almost always free to make its own
determination that an advance would be nonrecoverable, even if the special servicer determines that the advance would be recoverable (i.e., the
special servicer does not have the right to force the master servicer to make
an advance the master servicer believes would be nonrecoverable). On
the other hand, the special servicer may determine that future advances
would be nonrecoverable and instruct the master servicer to cease making
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advances even if the master servicer believes such an advance would be
recoverable. In that case, other than critical expenses discussed above, the
master servicer would be precluded from making any additional advances.
Because a servicers advance is secured only by the assets of the trust,
before making an advance servicers must consider whether there will be
trust collections sufficient to pay any nonrecoverable advances that may
result. As the trusts assets dwindle over time and the potential sources
for repayment of additional advances become scarcer, this issue becomes
more critical. Many PSAs permit a servicer to take into consideration overall trust assets in making recoverability determinations, and this practice
among servicers is common whether or not the PSA addresses the issue.
Given that servicer advancing is intended to provide liquidity assistance
to the REMIC and does not serve as an overall credit enhancement, the
servicers consideration of the overall trust assets in the servicers nonrecoverability determination seems appropriate. Servicers should always
consult the applicable PSA to determine the specific mechanism and limitations with respect to nonrecoverability determinations.
Examples:
The concepts discussed above related to permissible advances, recoverability, REMIC qualification and PSA authorization apply in a straightforward
manner in most typical advancing situations (e.g., taxes and insurance,
direct property protection outlays). In the current environment, however,
many contemplated advances are far from typical. This section discusses
the issues a servicer must confront when considering whether to advance
to pay off a mezzanine lender that is threatening to scuttle the servicers
workout efforts or to acquire the claims of an unrelated creditor in order
to control a debtors bankruptcy proceeding. In each of these cases, the
desirability of the advance from a credit perspective may be apparent, but
the servicer must carefully consider any potential advance in light of the
REMIC requirements and the PSAs advancing limitations.
1. Paying Mezzanine Lenders. In transactions that closed in the years
immediately preceding the collapse of the real estate markets, where virtually every financing was highly structured, a servicer may be forced to deal
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in a restructuring effort with not just the borrower, but also a subordinate
noteholder or holder of mezzanine debt secured by a pledge of indirect
ownership interests of the borrower. It is not uncommon that the mezzanine lender will threaten to unravel a servicers proposed plan with respect
to a defaulted loan and the servicer may want to pay the mezzanine lender
some fraction of its debt to cooperate. Whether the servicers payment to
the mezzanine lender is permitted under the PSA and to what extent the
servicer can charge back and recover from the borrower any advanced
amounts are issues that the servicer must consider.
Under the PSA, the servicers advance to pay the mezzanine lender is
technically an advance for the benefit of the borrower-owned mortgaged
property rather than REMIC-owned REO property. As we have seen, most
PSAs authorize the servicer to advance for the benefit of the mortgaged
property to manage, preserve and protect that mortgaged property. It is
difficult to see how a payment to mezzanine lender would fall under this
standard.
While the servicer may argue that a payment to a mezzanine lender is
similar to a payment to a competing party that holds a lien on the mortgaged property (e.g., tax or materialmens lien) and thus necessary to
preserve the mortgaged property under the PSA, this argument is not
particularly compelling when one considers that the mezzanine lender
holds only an indirect interest in the mortgaged property through the
pledged interests of the borrowers owner. Whats more, the mezzanine
lenders interest can be foreclosed out should the servicer elect to take title
to the collateral property for the benefit of the REMIC. Alternatively, the
servicer may suggest that the payment to the mezzanine lender is not an
advance with respect to the mortgaged property, but instead is a necessary
step to restructure the loan or acquire title in the collateral property. In this
regard, the payment is arguably similar to paying recording fees or other
expenses necessary to realize on the collateral property. Neither argument
is beyond challenge, and a servicer should review the PSA carefully and
consult with REMIC counsel when making a decision to advance sums to
pay a mezzanine lender to cooperate.
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2. Buying Claims in Bankruptcy. A servicer may be tempted to acquire
the claims of an unrelated trade creditor in a borrowers bankruptcy proceeding in order to control the proceeding and avoid the undesirable
consequences of a potential cram-down. While this strategy is common
outside of the CMBS world, the acquisition of another creditors bankruptcy claim by a REMIC raises potential issues.
The acquired claims may be viewed as a new trust asset that is neither a
qualified mortgage nor a permitted investment. As noted above, when
advanced amounts can be added to the balance due from the borrower
under the existing borrowers loan documents, no material REMIC tax
issues should result. In the case of a claim acquired in the borrowers bankruptcy, however, any such claim cannot, as a result of the bankruptcy, be
added to the balance due from the borrower and is necessarily treated in
the bankruptcy proceeding as an asset that is separate and distinct from
the REMICs primary claim.
Depending on the nature of the claim, practitioners believe that the
REMICs acquisition of a bankruptcy claim may be permissible, despite
the fact that the acquired claim cannot be added to the noteholders primary claim against the borrower and would represent a separate claim
against the borrower for bankruptcy purposes. If a servicers advance for
the amounts represented by the claims would be permissible were the borrower not in bankruptcy, there should be no REMIC problems associated
with the acquisition of the bankruptcy claims as the means by which these
claims are satisfied. There should be no REMIC tax distinction between a
direct advance to pay the creditor if the borrower were not in bankruptcy
and the indirect acquisition of these claims in borrowers bankruptcy. A
servicer should exercise caution, however, when considering purchasing
the claims of any other creditor in a borrowers bankruptcy proceeding.
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Conclusion:
The concepts related to a servicers advancing funds for property protection items are straightforward. In practice, however, technical issues
related to the nature of the advance and the means by which the advance
will be recovered make advancing issues difficult for the servicer. Servicers
must take care to determine the REMIC and PSA permissibility and the
consequences of any contemplated advances.
Thomas J. Biafore
Suite 2800
404 815 6250
Rex R. Veal
Suite 2800
404 815 6240
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134
Financing REO in CMBS:

Some Answers and Some Questions
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136
Financing REO in CMBS: Some Answers and Some

Questions
Robert L. Brown
The deterioration of the real estate and credit markets resulted in a marked
increase in the number of defaulted CMBS mortgage loans. As of the first
quarter of 2012, the cumulative default rate of loans in CMBS pools stood
at approximately 12.9%. Projections indicate that this number will only
increase. The increased default rate has caused a corresponding increase
in the number of mortgage loans being transferred from master to special servicers, and a corresponding rise in foreclosures and deed-in-lieu
transactions. After a foreclosure or consensual take-back, the mortgaged
property becomes REO (real estate owned) and the REMIC holding the
REO must sell the property for cash as its exit strategy.
The increase in the number of defaulted mortgage loans and inventories
of REO has resulted in creative efforts by special servicers to seek relief
from restrictions imposed by the Internal Revenue Code (the Code)
and Treasury Regulations that prohibit a REMIC from financing or otherwise originating a new loan in connection with the sale of REO. See
Tom Biafore, Workouts, Cancellation of Indebtedness and IRS Reporting
Requirements: What Borrowers and Special Servicers Need to Know in
this Guide for a discussion of techniques used by special servicers (e.g.,
receiver sales and loan assumptions) to comply with the REMIC provisions. Against this backdrop, a number of initiatives, including one by the
American Special Servicers Association (ASSA), have proposed changes
to the REMIC provisions to permit a purchaser of REO to buy the property subject to a continuing qualified mortgage for REMIC tax purposes
even if the REMIC foreclosed on the related collateral property and, as a
result, the original qualified mortgage no longer exists.
What follows is an examination of the problems currently facing REMIC
trusts and servicers when dealing with dispositions of REO, together with
a summary of initiatives to address these concerns.
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Issues under the REMIC Rules
Code Sections 860A through 860G provide that an entity satisfying
specific requirements can qualify as a REMIC and be treated as a passthrough entity for tax purposes (i.e., income passes through the REMIC
to certificateholders without paying tax at the REMIC trust level). In order
to maintain its tax-free status, substantially all of the REMICs assets must
be qualified mortgages or permitted investments. This test is referred
to as the asset test for REMIC qualification. A qualified mortgage is an
obligation that is principally secured by an interest in real property and
that is transferred to the REMIC by the end of the third month following
the REMICs startup day.
In the event of a foreclosure, a qualified mortgage ceases to exist for purposes of the asset test for REMIC qualification. Following a foreclosure,
the collateral property subject to the lien of the qualified mortgage is converted to foreclosure property, which is a permitted investment for
purposes of applying the asset test. A REMIC is allowed to hold foreclosure property until the end of the third tax year following the year the
REMIC acquires the foreclosure property, which period can be extended
for an additional three years upon written request to the IRS. See Tom
Biafore, Foreclosure Property Extensions When and Where to File?
in the Guide for a discussion of the extension process. During this holding
period, the REMIC (through the special servicer) will typically seek to sell
the foreclosure property to a cash purchaser for the highest possible price
in order to minimize any losses to the REMICs certificateholders.
A purchaser of foreclosure property may face difficulty in securing acceptable financing for its purchase. The REMIC rules prohibit the REMIC from
originating new loans to assist in the purchasers acquisition of the foreclosure property and the Pooling and Servicing Agreement (the PSA),
which governs the formation and operation of the REMIC, requires that
the special servicer sell REO for cash.
Summary of ASSAs Proposal
ASSAs proposal was one of many that sought to allow a purchaser of REO
to buy foreclosure property subject to a continuing qualified mortgage
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for REMIC tax purposes even though the original qualified mortgage was
extinguished at the time of foreclosure. Under this proposal, the REMIC
would treat the date of the purchase (and the related date of the seller
financing by the REMIC) as relating back to the date of the REMICs initial acquisition of the original qualified mortgage on the REMICs startup
day. By treating the original qualified mortgage, the foreclosure, and the
subsequent purchase of REO as a single transaction, the new loan would
be treated as a qualified mortgage, in much the way the REMIC provisions treat an assumption of a qualified mortgage incident to a purchasers
acquisition of the collateral property.
Potential Problems
Although these initiatives to provide financing for REO property, address
certain concerns under the REMIC provisions, they leave unanswered a
number of other questions. For example:
How would the REO be treated while a purchaser is being
sought and how would thenew mortgage loan be treated after
the sale? We believe thatthe REOwill be treated as foreclosure
property and that, when a purchaser is found, the new mortgage
loan would be treated as a qualified mortgage for purposes of the
asset test.
If the new mortgage loan subsequently becomes a defaulted
loan itself, would the holding period for REO start over following a second foreclosure? This is an issue not addressed in existing
PSAs. It is anyones guess how the IRS would count the holding
period for foreclosure property in a situation like this.
How much flexibility should the special servicer have to renegotiate the terms of the defaulted mortgage loan? Must the
new mortgage loan be made on the same terms as the existing
defaulted mortgage loan? While the greatest possible flexibility
may be desirable,it seems unlikely thatinvestment-grade certificateholders (especially the most senior certificateholders)
would accept a new ten-year mortgage loan on the sale of REO.
Investment-grade certificateholders have expressed concern about
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the leeway given in PSAs for maturity date extensions, where special servicers can grant extensions up to a date no later thantwo
or three years before the final rated distribution date. Not surprisingly, these same investment-grade investors have objected to any
proposal allowing for the financing of REO. It is less disruptive to
this investor groups expectations to provide the REO financing
with a maturity date matching the original mortgage loan maturity date (or perhaps a year or two beyond that date if the default
that led to foreclosure was a maturity default). From an investment-grade certificateholders perspective, it may be logical that
the maturity date should not extend beyond what would have been
themaximum period for holding the REO.
Even if the REMIC rules were changed to allow for the financing of REO,
the PSAs governing the operation of REMICs were not drafted to permit
such transactions:
PSA Amendments: Many PSAs would need to be amended to
permit seller financing. It may be difficult to argue that such an
amendment would not be material and adverse to some classes of
certificateholders. If the Trustee cannot reach that conclusion, the
amendment process would likely require certificateholder consent
a daunting task, particularly where the certificates are widely
held.
P&I Advances: If the new mortgage loan subsequently goes into
default, what is the correct principal and interest advance amount?
Is it the amount that would have applied to the original mortgage
loan, or is it the principal and interest amount for the new mortgage loan?
Workout or Liquidation Fees: Should the special servicer be entitled to a workout fee or a liquidation fee? Because the mortgage
loan would for all practical purposes remain in place (albeit on at
least slightly different economic terms), we believe that the special
servicer should collect a workout fee rather than a liquidation fee
at the time the new mortgage loan is granted.
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Conclusion
By providing a method by which a REMIC could effectively maintain
its pool of loans rather than having to liquidate REO at fire-sale prices,
these proposals could make rising default rates in CMBS less of a concern.
A number of the proposals that have been put forward to allow for the
financing of REO do not, however, address theissues that would naturally be raised by a REMIC providing seller financing of REO. In order to
address the turmoil in the current market, all parties in the CMBS industry need to work together to develop more comprehensive solutions.
Robert L. Brown
Eighth Floor
Two Embarcadero Center
San Francisco, CA 94111
t 415 273 7589
f 415 520 9459
RoBrown@KilpatrickTownsend.com
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Deeds in Lieu and Keeping Qualified Mortgages

AliveFact from Fiction
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144
Deeds in Lieu and Keeping Qualified Mortgages

AliveFact from Fiction
Thomas J. Biafore
James R. Pulliam
In the current economic environment, special servicers are occasionally

told by their counsel of the great and novel idea that their counsel has
come up with that will solve all of the special servicers problems. Rather
than foreclosing on the related collateral that secures a defaulted qualified mortgage and in effect convert a qualified mortgage to foreclosure
property, counsel suggests that the special servicer can keep the qualified
mortgages alive through a deed in lieu transaction.
The Solution? If the REMIC can continue to hold a qualified mortgage
rather than foreclosure property, the argument goes, this qualified mortgage (which counsel incorrectly believes can be kept alive through a deed
in lieu to a single purpose entity created by the REMIC) can be assumed
by the eventual purchaser of foreclosure property despite the fact that a
REMIC is prohibited from originating new loans. Whats more, counsel
informs the special servicer that their novel idea of using this deed in lieu
arrangement has the added benefit of allowing the special servicer to avoid
all of those pesky REMIC rules related to the operation, holding period
and disposition of foreclosure property.
Despite the obvious economic benefit of these arrangements, keeping a
qualified mortgage alive through a deed in lieu transaction will not work
from a technical REMIC tax perspective. As is so often the case, when a
proposed solution to a problem (in this case, the prohibition on a REMIC
originating new loans to provide financing to a buyer of foreclosure
property and the REMIC limitations dealing with foreclosure property)
is so apparent and obvious, a special servicer should be leery about that
solution.
To be sure, there may be many benefits to taking a deed in lieu on collateral
property through an SPE created by the related REMIC. Depending on the
jurisdiction, a deed in lieu can be a much quicker way for the REMIC to
obtain title to and control of the collateral property. Whats more by taking
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the deed in lieu through an SPE that is owned by the REMIC, the REMIC
may be able to avoid any merger considerations as a matter of local real
estate finance law such that the REMIC can, if necessary, subsequently
and formally foreclose out any competing creditor interests that impact
the REO. Taking a deed in lieu through an SPE will not, however, provide
a basis for the REMIC to offer assumable financing to the eventual purchaser of REO and will not allow the special servicer to treat foreclosure
property as a qualified mortgage and avoid the restrictions the REMIC
rules place on the special servicer when dealing with foreclosure property.
From a technical REMIC tax perspective, following a deed in lieu transaction the related collateral will be treated for all REMIC tax purposes as
foreclosure property at the time of the deed in lieu (whether or not the
loan is kept alive or the title to the REO is held in an SPE rather than the
REMIC itself). Following the deed in lieu, the REMIC must apply for a
foreclosure property extension at the end of the third year following the
deed in lieu, must dispose of the property at the expiration of the grace
period for foreclosure property, may not engage in impermissible new
construction activity on the property and may be subject to tax on net
income from foreclosure property to the extent that the property does
not generate rents from real property. To suggest otherwise and to avoid
the limitations in the REMIC provisions related to the operation and disposition of foreclosure property simply because the REMIC owns the
foreclosure property derivatively through an SPE that the REMIC created
and owns and continues to hold the related note and mortgage directly
is just a veiled attempt to do an end run around the foreclosure property rules and one that every special servicer would be advised to make
if such an arrangement would be respected for REMIC tax purposes. See
Tom Biafore, Foreclosure Property Extensions When and Where to
File; Steve Edwards, Foreclosure Property Qualification Restrictions
on Construction of REO; and Eric Berardi, Multiple Sales of REO:
Preserving Qualified Foreclosure Property in this Guide for a discussion
of the issues and limitations that a special servicer faces when dealing with
foreclosure property.
What counsel is failing to realize is that REO held derivatively by the
REMIC through the SPE must be treated as foreclosure property at the
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time of the deed in lieu as the REMIC has all the benefits and burdens of
ownership of the REO. There is no third party borrower for the loan at the
time of the deed in lieu and there is no legitimate argument the special
servicer can make to suggest that the REMIC holds a qualified mortgage
rather than foreclosure property other than perhaps the unpersuasive
notion that the loan remains outstanding and alive as a result of the deed
in lieu transaction and the avoidance of any merger considerations by taking the deed in lieu in an SPE formed by the REMIC.
Conclusion: The REMIC cannot orchestrate a deed in lieu transaction
to keep notes alive and in effect convert REO (foreclosure property for
REMIC qualification purposes) to a qualified mortgage. The concept of
keeping a note alive can be a useful tool to allow the REMIC to quickly go
to title on collateral property and to preserve the REMICs ability to foreclose out competing creditors should the situation arise. The orchestrated
deed in lieu technique cannot, however, let the REMIC avoid the REMIC
rules related to foreclosure property or the prohibition against a REMIC
originating new loans. If a special servicer believes a buyer for collateral
may more easily be found if the REMIC provides financing for a property,
the special servicer should not foreclose on the related collateral property
or take a deed in lieu of that property but rather should have a receiver
appointed to operate the collateral, find a buyer, sell the property and have
the loan assumed. Unlike with the deed in lieu transaction, with a receiver
in place the REMIC will never hold the collateral property as foreclosure
property but rather will hold a qualified mortgage that can be assumed by
the eventual buyer of that property.
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Thomas J. Biafore
Suite 2800
t 404 815 6250
f 404 541 3129
James R. Pulliam
214 North Tryon Street
Suite 2500
Charlotte, NC 28202-2381
t 704 338 5288
f 704 807 7488
JPulliam@KilpatrickTownsend.com
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Qualified Foreclosure Property
149
150

Qualified Foreclosure Property
Eric J. Berardi
Background: The REMIC rules generally restrict a REMIC from actively

engaging in business with the loans and REO that the REMIC holds.
In general, a REMIC may only hold qualified mortgages and permitted
investments (one of which is foreclosure property as defined in Code
Section 860G(a)(8)). See Tom Biafore, REMIC Qualification Why
Do We Care? and Fear Of The Unknown The Danger Of Holding
Unqualified Assets in this Guide for a discussion of the significance of
the asset test for REMIC qualification. This summary relates to issues confronted by a special servicer when a REMIC acquires REO as a result of a
foreclosure (or deed-in-lieu of foreclosure) of a defaulted loan and subsequently disposes of that property in more than one sale.
Using REO in a Trade or Business: As a general rule, REO ceases to be
REMIC qualified foreclosure property for purposes of the prohibited
transaction rules if a REMIC uses the property in a trade or business
other than through an independent contractor.
One way that a REMIC will be deemed to be engaged in a trade or business
with REO is if the REMIC actively develops and otherwise holds any REO
on which the REMIC has foreclosed for sale to customers in the ordinary
course of a developers business. For example, a REMIC that forecloses
on an apartment building and offers that building for sale as part of the
REMICs liquidation strategy will not be engaged in a trade or business
with the apartment building. If, however, the REMIC elects to convert
that same apartment building to condominiums, markets individual condominium units for sale to the units eventual inhabitants and holds itself
out as the developer of the condominium project, the REMIC will be holding the REO for sale to customers in the ordinary course of its business
of developing the condominium project. In this later case, the apartment
building will cease to be REMIC qualified foreclosure property for purposes of the prohibited transaction rules.
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The test for determining whether a REMIC is engaged in a trade or business with respect to multiple sales of REO is a facts and circumstances test
for which there are no bright-line rules. There is no requirement in the
Code or applicable regulations that a REMIC sell all of its REO in a single
transaction to a single purchaser. This is often the case where the REMIC
foreclosed on a portfolio of properties located in a number of different
areas as it would be unlikely that one party would be willing or able to buy
all of the properties. Other factors to consider in making a determination
of whether a REMIC is engaged in a trade or business with REO as a result
of multiple sales of REO include:
Location: If REO is comprised of multiple parcels located in different locations, multiple sales of the different parcels should not,
in and of itself, result in the REMIC being deemed to be in a trade
or business with respect to the REO. In this case, the property is
geographically distinct and the REMIC will not engage in material
preparatory work (tax parcel, subdivision, signage, access, etc.) for
the multiple sales.
Reason for Multiple Sales: If the REMIC is proposing to subdivide
REO for multiple sales, the servicer must address whether there is a
logical reason why different buyers would be interested in different
aspects of the property? For example, if the property is half retail
and half office, the fact that one purchaser may be interested only
in the retail portion while a different purchaser may be interested
only in the office portion should not result in the REMIC being
deemed to engage in a trade or business as a result of conducting
two separate sales of the REO to accommodate the fact that the
REO serves two specific needs (i.e., retail and office).
Purchasing Party: To the extent that the purchasing party is
uniquely suited to acquire some but not all of the REO, the more
likely it will be that the REMIC will not be deemed to be engaged
in a trade or business with respect to the REO as a result of multiple sales of the REO. This would be the case where an existing
(non-borrower) tenant at the property (movie theatre, bowling
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alley, etc.) desires to purchase the space that it currently occupies
but not the entire collateral property.
Number of Sales and Preparatory Work: The more sales a REMIC
has with respect to a single parcel of REO, the more likely the
REMIC will be considered to be engaged in a trade or business
with respect to such REO. Similarly, the more preparatory work
in which the REMIC must engage to accommodate the multiple
sales (signage, tax parcel, site plan, access, utilities, etc.), the more
likely the REMIC will be deemed to be in the trade or business of
developing the REO.
Marketing and Appearance. In order to be deemed to be engaged
in a trade or business, the REMIC must be engaged in an activity on a regular basis rather than intermittently or sporadically.
To the extent that the REMIC: (a) holds itself out as a developer
of the REO, (b) is willing and able to subdivide existing REO to
accommodate multiple potential buyers and (c) otherwise gives
the outward appearance as a party that is actively developing REO
rather than simply trying to realize on the security for a defaulted
mortgage loan, the more likely the REMIC will be deemed to be in
a trade or business with respect to the disposition of the REO.
Conclusion: While no one factor controls the analysis of whether the
REMIC will be deemed to be engaged in a trade or business as a result of
multiple sales of REO, the factors outlined above serve as a starting point
when conducting an analysis of whether a REMIC can subdivide or otherwise have multiple sales of REO without running afoul of the REMIC
provisions.
153

Eric J. Berardi*
The Grace Building
1114 Avenue of the Americas
21st Floor
New York NY 10036-7703
t 212 775 8714
f 212 775 8804
EBerardi@KilpatrickTownsend.com
*Admitted in Georgia and New York
154
Is There Hope for A/B Notes?
155
156
Is There Hope for A/B Notes?

Stephen A. Edwards
Background: Consider one of the most common situations in the current

stressed real estate market: A property that was once worth more than the
amount of the loan that financed it is now worth only a little more than 60
to 70 percent of the unpaid balance of that loan. The borrower is trying to
make the project work, but the cash flow from the property after paying
operating expenses isnt enough to pay for debt service, required reserves,
and necessary maintenance and improvements. The borrowers sponsors
are reluctant to invest new funds. The servicer, on the other hand, wants to
avoid the expense and delay of foreclosing on the property, operating the
property prior to sale, and attempting to sell the property in a depressed
market.
A structure that both the servicer and the borrower often turn to in this
situation is one in which the trust forgives or defers a portion of the interest or principal on the loan in exchange for an agreement by the borrower
to make an additional investment in the project. This is often documented
by bifurcating the existing note into two notes: an A Note that has a fixed
interest rate and maturity date and a principal amount approximately
equal to the current fair market value of the collateral and a B Note that
may not bear interest and is payable, if at all, at the maturity of the loan
or upon an intervening capital event, such as a sale or refinancing. The B
Note is payable only from hoped-for increases in value of the collateral
and so is sometimes referred to as a hope note. It is often subordinated
to the obligation to repay the new capital contribution made by the borrower in connection with the modification of the loan. This solution can
be appealing to the trust not only because it avoids the costs of acquiring
and operating foreclosure property, but because the borrower will have
made an investment that gives it an additional incentive to improve the
value of the property.
REMIC Issues: Although these structures as well as other structures
involving contingent payments have potential advantages for both the
trust and the borrower, they also raise concerns about whether the modification of the loan will cause the trust to no longer qualify as a REMIC
157

under Section 860D of the Internal Revenue Code of 1986 (the Code).
To understand why, we must first review some basic rules. Code Section
860D(a)(4) provides that substantially all of a REMICs assets must consist of qualified mortgages and permitted investments. Code Section
860G(a)(3)(A) defines qualified mortgage to mean any obligation . . .
which is principally secured by an interest in real property and which . . . is
transferred to the REMIC on the startup day (or, in certain circumstances,
within three months of the startup day). For the current discussion, the
important components of this definition are, first, the mortgage must be
an obligation, second, the mortgage must be principally secured by an
interest in real property, and, third, the mortgage must be transferred to
the REMIC on the startup day.
1. Does the trust continue to hold an obligation ? The question of whether the trust continues to hold an obligation following a
modification that provides the trust with a contingent return is related to
an issue that has long vexed tax lawyers: whether an investment is debt
or equity for general tax purposes. The reason that this question is so
difficult is that, while it is easy to characterize instruments at each end
of the spectrum a traditional promissory note is debt and a share of
stock is equity instruments in the middle often have aspects of both
debt and equity and are therefore difficult to place squarely in either category. Obligations that are designated as notes but include a contingent
component may be particularly difficult to classify. In the current context,
for example, it could be argued that the REMIC (by virtue of holding the
contingent component of the modified debt) is holding a partnership or
joint venture interest with the borrower.
The term obligation is not defined in the REMIC rules and is not
explicitly limited to obligations that come within the definition of a debt
instrument for purposes of other Sections of the Code (for example,
Section 1275(a)(1)).1 The REMIC provisions defining a qualified mortgage only require that the value of the real property collateral be 80% of
the principal amount of the obligation secured by the mortgage. This supports the conclusion that an obligation for REMIC purposes need not
The U.S. Supreme Court has observed, [A]lthough an indebtedness is an obligation, an obligation is not
necessarily an indebtedness within the meaning of [that term]. Deputy v. DuPont, 308 U.S. 488 (1940).
1
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be indebtedness for all tax purposes. For certain other tax provisions
nonrecourse loans secured by property with a fair market value less than
the amount of the loan are arguably not entirely debt.
Moreover, other provisions of the REMIC rules permit structures that
might not be considered debt for purposes of other Sections of the Code.
For example, Treasury Regulation Section 1.860G-2(a)(7) specifically permits instruments that provide for contingent principal payments, provided
the non-contingent payments at least equal the instruments issue price. 2
Still, this provision has its own ambiguities, including the questions of
how issue price is calculated when a mortgage note is modified and how
far beyond the specific provisions one may go before an instrument is no
longer an obligation.
In determining whether an A/B Note structure produces something other
than an obligation that can be held by a REMIC, the participants must
consider many tax issues on both sides of the argument, most of which
are far too technical to discuss here. It would be very odd, though, if those
issues led to the conclusion that this structure changes the loan into something other than a qualified mortgage, when a less desirable (and arguably
more contingent) result could be obtained merely by having the trust forebear in enforcing its rights or foreclose on the collateral property. By its
very nature, a nonrecourse loan is fully contingent to the extent the value
of the collateral has declined below the outstanding balance of the loan,
which is the position the trust was in before bifurcating the loan into an A
Note and a B Note. The servicer would not bifurcate the loan unless it concluded that, by doing so, it was increasing the trusts likelihood of recovery
and effectively reducing the contingency.
2. Is the obligation principally secured by an interest in real property?
The second component of the definition of a qualified mortgage that
it be principally secured by an interest in real property raises a similar
issue. If a separate instrument is created that is paid solely from an interest
in the net revenues of the business conducted on the real property securing
The presence of contingent interest can under circumstances result in an obligation being treated as an equity
interest in a joint venture. See Farley Realty Corp. v. Commr, 279 F.2d 701 (2d Cir. 1960).
2
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the primary obligation, it is possible that the instrument will no longer be
considered to be principally secured by an interest in real property.
3. Was the obligation transferred to the REMIC on the startup day?
The final component of the definition of a qualified mortgage that it
be transferred to the REMIC on the startup day raises an issue familiar to most asset managers: Will the modification of the loan result in a
disposition of the original obligation and a replacement of the obligation
with the modified loan? Treasury Regulations interpreting the REMIC
rules provide that if an obligation is significantly modified . . . then the
modified obligation is treated as one that was newly issued in exchange
for the unmodified obligation that it replaced.3 If the modification of the
existing loan constitutes a significant modification of the loan, the loan
may be deemed to have been acquired after the REMICs startup day and
may therefore not be a qualified mortgage. See Steve Edwards et al., The
Loans (and the Rules) They Are a Changin Modifying Loans Held by
REMICS in this Guide for a detailed discussion of what forms of modification of mortgage loans will result in a significant modification.
In most transactions in which the servicer is agreeing to the sort of modifications being discussed here, it will have done so because it believes
that there has been a default or a default is reasonably foreseeable (as
that phrase was expanded in Rev. Proc. 2009-45). In these circumstances,
Section 1.860G-2(b)(3) of the Treasury Regulations provides an exception
for loans held by REMICs to the general rule in Code Section 1001:
[C]hanges in the terms of an obligation are not significant modifications regardless of whether they would be
significant modifications [under Code Section 1001] if the
changes in the terms of the obligations [are] occasioned by
default or a reasonably foreseeable default.
This exception is obviously very helpful, but it applies only for purposes
of Code Section 860G, not Code Section 1001, so there will presumably
have been a deemed exchange for general tax purposes. This leaves a
3 Treas. Reg. 1.860G-2(b)(1).
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number of important questions unanswered. For example, the exception
in Treasury Regulation Section 1.860G-2(b)(3) does not tell us whether
the modified qualified mortgage must still be an obligation. It also
does not tell us what the issue price of the modified obligation will be,
which makes it difficult to determine how to apply the provision of the
Treasury Regulations quoted above that permits obligations with contingent payments.
****
Because there are few clear answers in this area, servicers must be very
cautious in modifying loans in a manner that results in contingent payments to the trust. Fact patterns that raise difficult issues include,
notes that are transferable separately or assumable separately,
where payments on one note are certain and easily determinable
and payments on the other are contingent and uncertain,
a sale of the collateral, subject to a written-down A Note, followed
by negotiation of a bifurcation,
creation of a new obligation in which the aggregate potential principal or debt service payments exceed those due on the original
mortgage note,
a B Note that matures after the A Note, and
modified obligations in which the contingent note is larger than
the fixed note.
Pooling and Servicing Agreement Issues: Apart from the REMIC tax issues
associated with an A/B Note restructuring, servicers should be aware of
potential issues under pooling and servicing agreements related to principal and interest advances associated with the B Note. Provided the A/B
Note is structured properly, there should be no scheduled payment on
the B Note during the time that the B Note is outstanding and under the
applicable pooling and servicing agreement no obligation for the servicer
to make any advance on the B Note.
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Certificateholder Issues: A servicer may consider an A/B Note structure
in the current environment because a valuation of the collateral property may prove difficult and the servicer believes that there is a need to
resize the defaulted loan so that the loan can be supported by the collateral,
but the servicer does not want to provide the borrower with the potential
windfall associated with a write down of a portion of the defaulted loan.
In deciding on an A/B Note structure, servicers should consider whether
the B Note has at least some potential for recovery. A failure to do so may
impact certificateholders. Senior certificateholders might suggest that the
B Note is just a mechanism to avoid a write down of certificates to keep the
controlling class of the trust in place. As in an appraisal reduction event or
foreclosure on collateral property, at the time of the A/B Note restructuring there is no final forgiveness or other liquidation event with respect to
the amount due and owing on the B Note and there should be no requirement to write down the balance of any certificates at that time.
The A/B Note structure can be a legitimate tool to avoid foreclosure, obtain
a better recovery and avoid any windfall to the borrower. Servicers must,
however, review the applicable pooling and servicing agreement in making
a determination of the impact, if any, that the A/B Note restructuring may
have on certificateholders, including the potential effect on the controlling
class or directing certificateholder.
Conclusion: The lesson for servicers in this analysis is to be creative but
careful when considering an A/B Note structure. This is an area in which
there are many traps for the unwary.
Stephen A. Edwards
Suite 2800
t 404 815 6278
f 404 541 3191
162
Federal ReceivershipsWhat You Should Know
163
164
Federal ReceivershipsWhat You Should Know

Eric J. Berardi
Burleigh L. Singleton
Background: The recent economic downturn sent special servicers scrambling to come up with novel approaches to maximize recovery of the
defaulted loans and REO that they service. Unfortunately, owing to restrictions under the REMIC rules, typical techniques that may be available to
lenders outside of the CMBS world are not, in some cases, viable options
for special servicers. See Tom Biafore, REMIC QualificationWhy
do We Care?; and Steve Edwards Foreclosure Property Qualification:
Restrictions on Construction of REO in this Guide for a discussion of
issues and limitations that a special servicer faces as a result of the REMIC
provisions.
No New Loans: The REMIC rule that prohibits a REMIC from originating new loans following the REMICs startup day has resulted in special
servicers increasingly turning to receiverships (rather than taking title to
the related collateral property that secures a defaulted loan) in those situations where the special servicer anticipates that a buyer of the collateral
property will need financing to acquire that property. See Robert Brown,
Financing REO in CMBSSome Answers and Some Questions?; Tom
Biafore, Workouts, Cancellation of Indebtedness and IRS Reporting
Requirements in this Guide for a discussion related to the REMIC issues
related to financing of REO and the techniques used by special servicers
(e.g., receiver sales and loan assumptions) to comply with the REMIC
provisions.
Factors Supporting the Appointment of a Federal Receiver: When the
borrowers obligation under the terms of a defaulted mortgage loan is
secured by multiple properties in different states, the special servicer may
consider seeking the appointment of a receiver for the properties in federal
rather than state court. Federal courts consider several factors when determining whether to appoint a receiver, including:
(1) whether the party seeking the receiver has a valid claim;
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(2) whether there is imminent danger that the property at issue
will diminish in value;
(3) the inadequacy of the legal remedies available to the moving
party;
(4) the availability of a less drastic equitable remedy; and
(5) the likelihood that appointing a receiver will do more harm
than good.
While a provision in the loan documents authorizing the appointment
of a receiver upon the occurrence of an event of default can be sufficient
grounds for the appointment of a federal receiver, not all federal jurisdictions will enforce a contractual provision authorizing the receiver unless
one or more of the factors noted above also support the appointment of a
receiver.
Advantages and Disadvantages of Federal Receiverships: When considering whether to seek the appointment of a federal receiver, a special servicer
should consider factors such as:
-The type of collateral: is the collateral a collection of franchised
hotels under the same flag/franchise that are operated as a collective going concern? Or is the collateral a group of unrelated
property types that have little to no common operational relationship to one another (e.g., mini-storage in state X, multi-family in
state Y and a retail center in state Z)?
-The states where the properties are located: is the collateral located
in states with lender-friendly state receivership laws that give the
receiver broad powers? Or jurisdictions where state courts will
hear emergency receivership applications on an ex parte basis? Or
is the collateral located in jurisdictions where state court receiverships can be a time consuming, restrictive and costly process?
-The exit strategy: is the special servicer looking for a short-term
interim remedy while it completes its foreclosure upon the properties? Or does the special servicer want the receivership action to
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continue for enough time to allow the receiver an opportunity to
market and sell the collateral?
The advantages of a federal receivership include the economic efficiency
of having to file only one action that gives the receiver control over all
property securing the loan regardless of where the properties are located
(Note: certain statutory procedures must be followed in order to vest the
receiver with power over property located in states outside of the state
where the receivership action was filed). Comparatively, seeking a receiver
in state court would entail filing a state court action in each state where the
collateral is located, resulting in higher litigation costs for the REMIC and
the receiver having to monitor compliance with multiple, potentially conflicting state court receivership orders. In addition, federal law can give the
receiver broader powers than what might be available to a receiver under
state law, such as the ability to market and sell the properties.
Disadvantages of federal receiverships include the requirement that
diversity of citizenship exist between the plaintiff and the defendant(s)
depending on its organizational structure (i.e., a partnership or limited liability company), the plaintiff may need to disclose the names and
states of citizenship of its investment partners or members which might
be a sensitive issue for the party bringing the action. See Keith Brandofino,
Proceeding in Federal Court - Borrower Challenges to Diversity
Jurisdiction in this Guide for a discussion of standing issues in federal
receivership actions involving REMIC trusts and special servicers. In addition, it can take longer to schedule an emergency hearing in federal court
and once scheduled, the burden to show the existence of an emergency
that warrants the appointment of a receiver can be greater in federal court
than in state court. Finally, a federal judge is more likely to monitor the
timing and progress of the receivership case, resulting in numerous status
and pre-trial conferences and a fast trial date. State courts, on the other
hand, might allow the receivership action to continue for months without
setting the case down for trial, thereby giving the receiver ample time to
stabilize, market and sell the property.
The special servicer should also be aware that filing in federal court
may require additional considerations regarding venue, local practices
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regarding the appointment and powers of receivers, and choice of law rules
used in the forum state. For example, if venue is proper in districts located
in different states, the special servicer must consider whether and the
extent to which federal courts follow the customs (e.g. bond, qualifications,
and reporting requirements) for appointing receivers utilized by state
courts in each district, whether and the extent to which the substantive
law of the states differ (e.g. whether one state may apply the one-action
rule or allows non-judicial foreclosure), and whether the substantive law
of the state, including factors affecting the choice-of-law analysis, may be
more creditor-friendly, borrower-friendly, or neutral.
Conclusion: Federal receivership is not a one-size-fits-all type of remedy,
even on loans secured by multiple properties in various states. Careful
consideration must be given to the facts supporting the appointment of a
receiver, jurisdiction and venue issues, the type and number of properties
involved and the ultimate objective of the special servicer. In the right scenario, a federal receivership can be a valuable remedy for a special servicer
seeking to efficiency liquidate its collateral in multiple jurisdictions and
otherwise maximize recovery on a defaulted mortgage loan.
Eric J. Berardi*
The Grace Building
New York, NY 10036-7703
t 212 775 8714
c 917 239 9732
f 212 775 8804
EBerardi@KilpatrickTownsend.com
*Admitted in Georgia & New York
168

Burleigh L. Singleton
Suite 2800
t 404 815 6201
c 404 376 4442
f 404 541 3391
BSingleton@KilpatrickTownsend.com
169
170

to Diversity Jurisdiction
171
172

to Diversity Jurisdiction
Keith M. Brandofino
The delays inherent to judicial foreclosure jurisdictions have caused many

special servicers to consider whether to bring future foreclosure actions in
federal rather than state court. While there is no one size fits all answer
to this inquiry, two threshold questions must be answered to determine
whether proceeding in federal court is an option that is available to the
special servicer: (i) who has standing to maintain the action on behalf
of the mortgagee (i.e., who is the real party in interest?); and (ii) is there
complete diversity of jurisdiction between plaintiff and defendants (i.e., is
plaintiff and each defendant citizens of different states?).
Intuitively, the party that has standing to commence an action on a
defaulted CMBS loan is a trustee acting on behalf of a REMIC trust that
acquired its interest in the loan documents by way of an assignment of
note and mortgage. Although attacking assignments of loan documents
was the favored defense of the defaulted borrowers during the last cycle,
most servicers and their legal counsel have put in place best-practices to
avoid falling prey to a borrowers attack on the chain of title of the loan
documents. In the face of such documentation, borrowers are unlikely to
be successful in challenging a trustees entitlement to recover the debt.
The production of the assignment documents, however, may not be determinative of the identity of the true party in interest and whether or not
diversity jurisdiction exists to support the special servicers decision to
bring action in federal court. As highlighted by an action commenced in
the United States District Court for the Southern District of New York,
U.S. Bank National Association, as Trustee, etc. v. Nesbitt Bellevue Property
LLC, et al. (the Nesbitt Case), borrowers focused on these issues as a way
to delay recovery by the trustee.
In the Nesbitt Case, the borrowers did not attack the assignment documents. Instead, the borrowers took the position that the delegation of
duties to the special servicer under the subject Pooling and Servicing
Agreement to prosecute actions on the loan documents required a
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determination that the special servicer was the true party in interest. As
a result, the borrowers argued that the court must rely upon the special
servicers citizenship to determine diversity. This was significant in the
Nesbitt Case because: (i) the trustee is a national banking association with
its main offices in the State of Ohio; (ii) the special servicer is a Delaware
entity; and (iii) the borrowers are all Delaware limited liability companies.
If the borrowers were correct, the action could not proceed in federal court
because the special servicer and the borrowers were all Delaware entities
and therefore not diverse.1
In support of their position, the borrowers referenced general enabling
provisions of the PSA that provided that:
T he Special Servicer shall, for the benefit of the
Certificateholders, direct, manage, prosecute and/or
defend any and all claims and litigation relating to (a) the
enforcement of the obligations of each Mortgagor under
the Loan Documents and
The Southern District of New York2 rejected borrowers position by finding that the PSA does not convey to the special servicer any interest in a
claim under the loan documents. Indeed, it is the trustee on behalf of the
trust that maintains the claim under the loan documents. The designation
of a special servicer or the conveyance of certain powers does not vest the
servicer with an ownership interest in the loan documents, but instead the
servicer is an agent for the trustee. In that regard, the court in the Nesbitt
Case noted that the PSA expressly stated:3
The Master Servicer and the Special Servicer, each as an
independent contractor, shall service and administer the
Mortgage Loans on behalf of the Trust Fund and the
Trustee
1 It is important to note that Federal diversity jurisdiction requires complete diversity (i.e., all planitiffs and
defendants must be citizens of different states.
2 U.S. Bank Natl Assn v. Nesbitt Bellevue Prop. LLC, No. 12 Civ. 423 (JGK), 2012 WL 1590518 (S.D.N.Y. May 7,
2012).
3 This, or similar language can be found at Section 3.01(a) (Master Servicer to Act as Master Servicer;
Administration of Mortgage Loans) of a PSA.
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Even more supportive of the notion that the special servicer was not the
true party in interest in any enforcement action under the terms of the any
loan documents, the PSA in the Nesbitt Case required that if the special
servicer filed suit to enforce the trustees rights in connection with a loan,
the special servicer must indicate its representative capacity:
Notwithstanding anything contained herein to the contrary, neither the Master Servicer nor the Special Servicer
shall, without the Trustees written consent initiate
any action, suit or proceeding solely under the Trustees
name without indicating the Master Servicers or Special
Servicers, as applicable, representative capacity
Consistent with this requirement, the caption of the action in the Nesbitt
Case identified the special servicer in its representative capacity only and
not as an interested party.
In support of their claim that the special servicer is the real party in interest and therefore no diversity of jurisdiction existed in the Nesbitt Case,
borrowers also relied heavily on a 7th Circuit decision4 in which the servicer commenced an action in place of the trustee. In Chicago Properties,
however, the PSA contained language whereby the court determined that
the trust transferred equitable ownership of the claim to the servicer.
No such language exists in the PSA at issue in the Nesbitt Case. To the
contrary, the Southern District of New York noted that the PSA in the
Nesbitt Case contained language whereby the trust preserved the right to
bring an action in its own name. As such, under the PSA in the Nesbitt
Case, the special servicer was given no interest in the claim but instead
only assigned the special servicer with the task of prosecuting an action to
recover the debt on behalf of the trust.
In that same vein, the Southern District of New York determined that the
special servicers interest in the action was due solely to its designation as
special servicer under the PSA. With no interest in the action beyond its
representative duties under the PSA, the Southern District held that the
special servicers citizenship was irrelevant for purposes of determining
4 CWCapital Asset Management, LLC v. Chicago Properties, LLC, 610 F.3d 497, 500 (7th Cir. 2010) (Chicago
Properties).
175

diversity of jurisdiction. As such, the Southern District of New York found
that there existed complete diversity of jurisdiction between the trustee
and the borrowers.
The Southern District of New Yorks analysis of the PSA and prior case
law analyzing PSAs are instructive regardless of whether the caption of
the case is fashioned similar to the Nesbitt Case, or whether the special
servicer creates a single purpose entity to take title to the loan documents
prior to commencement of an action on the loan documents. In either
event, it is necessary for the special servicer and its counsel to review the
PSA (in addition to the assignment documents) to determine whether
proceeding in federal court is a viable option and whether and to what
extent a borrower will be in a position to raise a challenge to proceeding in
federal court based on a lack of diversity of jurisdiction challenge.
Keith M. Brandofino
The Grace Building
t 212 775 8713
KBrandofino@KilpatrickTownsend.com
176
A Primer on Net Income from

Foreclosure Property
177
178
A Primer on Net Income from Foreclosure Property

Thomas J. Biafore
Stephen A. Edwards
A. Introduction
One of the fundamental rules for servicing loans and real estate owned
(REO) held by a REMIC is that the REMIC must remain passive. For
this reason, REMICs are structured and operated as entities that are not
authorized to engage in an active trade or business. Provided the REMIC
maintains its status as a passive entity, the REMIC should never be subject
to tax. One exception to this rule is that a REMIC may need to take title to
the property securing a defaulted loan and then operate that property. It is
possible for the REMIC to directly operate property that secured the borrowers obligation following foreclosure, but the REMICs activities may
result in tax to the REMIC.
Pending disposition of the REO, the special servicer for the REMIC may
need to decide whether to lease REO or to operate REO through a management contract. It is critical that, prior to making this decision, the special
servicer analyze the possible effects of any tax on foreclosure property. A
lease, if properly structured, generates passive rents from real property
that are not subject to the tax on net income from foreclosure property,
whereas a management contract can result in the REMIC generating active
business income from the REO. Whether or not a particular method of
operation for REO (i.e., lease versus management contract) will result in
tax may not be determinative in the decision about which course to take,
but it should be taken into consideration.
B. Background: Foreclosure Property
Section 860D(a)(4) of the Internal Revenue Code of 1986 (the Code)
provides that substantially all of a REMICs assets must consist of qualified mortgages and permitted investments. Foreclosure property (as
defined in Code Section 860G(a)(8)) acquired by a REMIC is a permitted
investment.1 Code Section 860G(a)(8) defines foreclosure property as
See footnote 3.
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property (A) which would be foreclosure property under Section 856(e)
. . . if acquired by a real estate investment trust, and (B) which is acquired
in connection with the default or imminent default of a qualified mortgage
held by the REMIC. Foreclosure property within the meaning of Code
Section 856(e) includes only real property and any personal property
incident to such real property. For personal property to be considered
incident to real property, the personal property must be used in a trade
or business conducted on the property or the use of the personal property
must be an ordinary and necessary corollary of the use to which the real
property is put. Treasury Regulation Section 1.856-6(b)(2). With respect
to a hotel property, furniture, appliances, linens, china and food are considered examples of incidental personal property.
Moreover, for a property to be foreclosure property within the meaning of Code Section 856(e), the related loan must not have been acquired
by the REMIC at a time when the REMIC intended to foreclose or when
the REMIC had reason to know default would occur (such knowledge
being referred to herein as Improper Knowledge). The Internal Revenue
Service (the IRS) has provided no definitive guidance as to what constitutes Improper Knowledge and has provided no safe harbors on which a
REMIC can rely in determining that it had no Improper Knowledge with
respect to a loan. Nevertheless, where a loan was current as of the date it
was contributed to the REMIC and the REMIC had no indication at that
time that the borrower would not remain current under the terms of the
loan, we believe that the REMIC will not be deemed to have Improper
Knowledge with respect to the loan. See PLR 9720014 (where the IRS concluded that default resulting in Improper Knowledge is the type that would
cause a reasonable lender to institute foreclosure proceedings against the
borrower).
C. Prohibited Transactions Tax; Net Income from Foreclosure
Property vs. Rents from Real Property
The general rule is that a REMIC is not subject to tax. Code Section
860A(a). A REMIC may, however, be subject to one of two distinct taxes
arising from the REMICs activities with respect to property on which the
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REMIC has foreclosed. The first is the 100% tax on prohibited transactions; the second is the tax on net income from foreclosure property.
Prohibited Transactions Tax. A REMIC is subject to a tax equal to 100%
of the REMICs net income attributable to a prohibited transaction. Code
Section 860F(a)(1). It is therefore essential that the REMIC not operate the
REO in a manner that would result in the imposition of this tax.
The term prohibited transaction includes the receipt of income attributable to an asset that is neither a qualified mortgage nor a permitted
investment.2 Code Section 860G(a)(5)(C). A permitted investment for
these purposes includes foreclosure property within the meaning of
Code Section 860G(a)(5) (as described above in section B).
Even if REO otherwise qualifies as foreclosure property for purposes of
the definition of permitted investments, however, income generated by
the REO will be subject to the prohibited transactions tax3 if the REMIC
generates active income from the REO as a result of: (i) the REMICs use of
the REO in a trade or business (except through an independent contractor4), or (ii) the REMICs construction activities on the REO unless (a) the
construction consists of the completion of a building where more than
10% of the construction of such building was completed before the related
loan default became imminent, and (b) any construction more than 90
days after such property was acquired by the REMIC is performed by an
See footnote 3.
It is important to note that the following actions, which would disqualify the property as foreclosure property for a REIT, will not disqualify the property as foreclosure property for a REMIC for purposes of determining whether the REMIC holds only qualified mortgages or permitted investments.
4
No amount received or accrued, directly or indirectly, with respect to any real property (or any personal
property leased under, or in connection with, the real property) qualifies as rents from real property if the
real estate investment trust furnishes or renders services to the tenants of the property or manages or operates the property, other than through an independent contractor from whom the trust itself does not derive or
receive any income. ... Compensation to an independent contractor determined by reference to an unadjusted
percentage of gross rents will generally be considered to be adequate where the percentage is reasonable taking
into account the going rate of compensation for managing similar property in the same locality, the services
rendered, and other relevant factors. Treasury Regulation Section 1.856-4(b)(5)(i). The trustees or directors
of the [REMIC] are not required to delegate or contract out their fiduciary duty to manage the trust itself, as
distinguished from rendering or furnishing services to the tenants of its property or managing or operating the
property. . . . The trustees or directors may also make capital expenditures with respect to the trusts property (as
defined in section 263) and may make decisions as to repairs of the trusts property (of the type which would be
deductible under section 162), the cost of which may be borne by the trust. Treasury Regulation Section 1.8564(b)(5)(ii).
2
3
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independent contractor from whom the REMIC does not derive or receive
any income. Treasury Regulation Section 1.856-6(c).5
Net Income from Foreclosure Property. To the extent the REO qualifies
as foreclosure property and does not fall into either of the categories
described in the preceding section that give rise to the 100% prohibited
transactions tax, the tax treatment to the REMIC of amounts it receives
with respect to the REO will be determined by whether the revenue generated by the REO is rents from real property (described in greater detail
below in Section E) or net income from foreclosure property (as defined
in the rules applicable to real estate investment trusts and provided for in
Code Section 857(b)(4)(B)). Net income generated from the REO that are
not rents from real property will be considered net income from foreclosure property.
A REMIC will be taxed at the highest marginal corporate income tax rate
on its net income from foreclosure property. Code Section 860G(c). The
income that is subject to tax is the income that would be taxable under
Code Section 857(b)(4) if the REMIC were a real estate investment trust.
Code Section 857(b)(4)(B) states that the term net income from foreclosure property means . . . the gross income for the taxable year derived
from foreclosure property, but only to the extent such gross income is not
described in subparagraph (A) . . . of Section 856(c)(3). Subparagraph
(A), in relevant part, excludes from net income from foreclosure property income that constitutes rents from real property as defined in Code
Section 856(d)(2)(C). A REMICs operation of hotels and other active
business properties (e.g., healthcare facilities, nursing homes, etc.) does
not generate rents from real property. Accordingly, the active income that
the REMIC realizes from these types of properties may be subject to tax.
D. PSA Issues
Most pooling and servicing agreements (PSAs) emphasize that the
REMIC should not be subject to tax as a result of the REMICs handling
The term building for these purposes generally refers to the building as planned by the borrower at the time
of default. Renovation of a building, including remodeling to reconfigure the layout, is considered construction. Health and safety improvements (fences, sidewalks, etc.) should not constitute construction. Treasury
Regulation Section 856-6(e)(5).
5
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of REO. The following language is typical of the PSA limitations that are
placed on the special servicer when operating REO on which the REMIC
has foreclosed that could generate active business income:
3.17 Title and Operation of REO Property:
(a)
prior to the acquisition of title to a Mortgaged
Property, the Special Servicer shall review the operation of
such Mortgaged Property and determine the nature of the
income that would be derived from such property if it were
acquired by the Trust Fund. If the Special Servicer determines from such review that:
(i) None of the income from Directly Operating such
Mortgaged Property would be subject to tax as net income
from foreclosure property (such tax referred to herein
as an REO Tax), such Mortgaged Property may be
Directly Operated by the Special Servicer as REO Property;
(ii) Directly Operating such Mortgaged Property as
REO Property could result in income from such property that would be subject to an REO Tax, but that a
lease of such property to another party to operate such
property . . . or another method of operating such property would not result in income subject to an REO Tax,
then the Special Servicer may (provided, that in the good
faith and reasonable judgment of the Special Servicer,
it is commercially reasonable) acquire such Mortgaged
Property as REO Property and so lease or operate such
REO Property; or
(iii)
It is reasonable to believe that Directly
Operating such property as REO Property could result
in income subject to an REO Tax and that no commercially reasonable6 means exists to operate such property
without the Trust Fund possibly incurring an REO Tax
Some PSAs use a commercially feasible standard in place of the commercially reasonable standard quoted
above. Query whether there is a meaningful distinction between these two standards.
6
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on income from such property, the Special Servicer shall
deliver to the REMIC Administrator, in writing, a proposed
plan (the Proposed Plan) to manage such property as
REO Property.
An open issue exists with respect to the standard of commercially reasonable (or feasible) in the context of the typical PSA. Assuming the special
servicer can directly operate (pursuant to a management contract) an
active business property more profitably (even after potential taxes) compared to a lease arrangement, the special servicer still needs to determine
whether the standard of commercially reasonable or feasible provided
for in the typical PSA will be satisfied.
More recent PSAs address this potential dilemma by abandoning the
three-tier operating structure noted above in favor of a net after tax benefit test. Under this test, the special servicer is free to operate the related
property in any manner that is designed to provide the greatest after-tax
benefit to certificateholders, irrespective of whether the servicer has independently determined that there was no commercially reasonable (or
feasible) way to operate the related property in a manner that would
not generate net income from foreclosure property that may be subject to
tax (i.e., through a lease agreement that generates passive rents from real
property for the REMIC).
Whether the PSA requires that the special servicer demonstrate the
absence of commercial reasonability or feasibility or simply demonstrate that the certificateholders would benefit if the related REO were
operated directly through a management contract, special servicers must
determine the amount of net income from foreclosure property, if any, that
could potentially be generated. Without undertaking this computation, the
special servicer cannot assess the effect on the REMIC of using a management contract rather than a lease to operate REO.
E. Rents from Real Property
If a REMIC forecloses on REO and then leases the entire property to a
third party (the Lessee) from whom the REMIC would receive a set payment under the lease agreement with the Lessee (the Lease), the income
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the REMIC receives should qualify as rents from real property. There are,
however, a number of important qualifications to this general statement.
Personal Property. Rents attributable to personal property leased under
or in connection with the lease of the foreclosed property must not exceed
15 percent of the total rents received. Code Section 856(d)(1)(C).
Services Customarily Furnished. Even where the REO is subject to a
Lease, the REMIC must take care that services rendered by it to the Lessee
must be customarily furnished in order for rent received from the Lease
to qualify as rents from real property under Code Section 856(d)(1). The
Treasury Regulations define services customarily furnished and provide that services are considered customary if in the geographic market
in which the building is located, tenants (e.g., hotel operators) in similar
class buildings are customarily provided with similar services. Treasury
Regulation Section 1.856-4(b)(1). Examples of customary services may
include the furnishing of utilities, the performance of cleaning services,
parking facilities, guard services, and other services. For services to be considered customary, they must be provided by an independent contractor.
When non-customary services are performed by the REMIC, any revenue related to those services is not considered rents from real property.
Moreover, the related property will not be considered foreclosure property for purposes of the prohibited transactions tax unless the services are
performed by an independent contractor. In order to qualify as an independent contractor, the following conditions must be met:
The relationship between the trust and the independent contractor
must be an arms-length relationship.
The independent contractor must not be an employee of the trust
(that is, the independent contractor must not be controlled by the
trust).
All services must be furnished or rendered through the independent contractor and the facilities through which the services are
furnished must be maintained and operated by the independent
contractor.
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The cost of the services must be borne by the independent contractor, a separate charge must be made for the services, the amount
of the separate charge must be received and retained by the independent contractor, and the independent contractor must be
adequately compensated for the services.
Treasury Regulation Section 1.856-4(b)(5).
Contingent Rent. In addition, in order for income to be considered rents
from real property, the income must not be generated based in whole or
in part on the net income or profits (as opposed to a percentage of gross
receipts or sales) of any person. Code Section 856(d)(2)(A).7 The REMIC
would typically receive rent from the Lessee based on a fixed monthly payment; however, the REMIC might in some circumstances wish to receive
payments based on a fixed percentage of the revenues from the REO (a
Contingent Rent provision). Code Section 856(d)(2)(A) and Treas. Reg.
Section 1.856-4(b)(3) specifically allow Contingent Rent, provided the
amount received or accrued as rent for the taxable year is based on a fixed
percentage of the lessees receipts. Thus, provided the Contingent Rent is
based on a gross receipts factor (as opposed to a factor based on the net
income of the REO), Code Section 856(d)(2)(A) will not bar amounts
received from the Lessee under the Lease from being characterized as rents
from real property.
Other factors must also be considered, however, that could prevent the
rent received from the Lessee from qualifying as rents from real property,
even where the Contingent Rent payments are based on a fixed percentage of the gross receipts generated by the REO. The Treasury Regulations
include rules for determining whether a rental payment that is otherwise
based on a gross receipts factor (such as a Contingent Rent payment) will
nonetheless be deemed to be based on a net income factor in violation of
the provisions of Code Section 856(b)(2)(A). These rules require that the
Contingent Rent (i) must be fixed at the time the Lease is entered, (ii) must
See also Treasury Regulation Section 1.512(b)-1(c)(4), which provides, payments for the use or occupancy
of rooms and other space where services are also rendered to the occupant, such as for the use or occupancy of
rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist
camps or tourist homes, motor courts, or motels, or for the use of occupancy of space in parking lots, warehouses, or storage garages, does not constitute rent from real property.
7
186

not be renegotiated during the term of the Lease in a manner that has the
effect of basing the Contingent Rent on income or profits of the REO, and
(iii) must conform with normal business practice. Treasury Regulation
Section 1.856-4(b)(3).
True Lease. Finally, and in addition to the foregoing, the Lease must be
respected as a true lease for federal income tax purposes and not treated
as a service contract, joint venture or similar arrangement in order for
the rent (including any Contingent Rent) received from the Lessee to be
considered rents from real property. Whether the Lease is a true lease
depends on an analysis of the surrounding facts and circumstances. In
making such a determination, courts have considered a variety of factors,
including the following: (i) the intent of the parties, (ii) the form of the
agreement, (iii) the degree of control over the property that is retained by
the property owner (that is, whether the lessee has substantial control over
the operation of the property), and (iv) the extent to which the property
owner retains the risk of loss with respect to the property (e.g., whether
the lessee bears the risk of increases in operating expenses or the risk of
damage to the property). Freese v. Commissioner, 84 T.C. 920, 940 (1985).
In structuring the Lease, the following elements would support a conclusion that the Lease is a true lease for federal tax purposes;
the Lessee has the right to exclusive possession and use of the REO
during the term of the Lease;
the Lessee bears the cost of, and is responsible for, day-to-day
maintenance and repair of the REO;
the Lessee bears all costs and expenses of operating the REO;
the Lessee benefits from any savings in the costs of operating the
REO during the term of the Lease;
the Lessee is obligated to pay substantial fixed rent for the period
of use of the REO; and
the Lessee stands to incur losses (or achieve gains) depending on
how successfully it operates the REO.
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F. Net Income from Foreclosure Property
Where the REMIC operates the REO through an independent contractor
rather than leasing it to a third party, the REMIC must determine whether
doing so will subject the REMIC to a tax on net income from foreclosure property. This requires a determination of whether there will be net
income from the property.
A fundamental tax accounting principle is that income is determined
based on the annual accounting period. Furthermore, REMICs are generally required to use the accrual method of accounting.8 For tax purposes,
net income includes all revenue received or accrued during the tax year
less permitted offsetting deductions incurred over that same period. When
forecasting the potential tax consequences of a REMICs operation of REO,
it does not matter that foreclosure property generated positive cash flow
for a number of months. Rather, the numbers that the special servicer
must review relate to the propertys net income for the entire accounting
period.
Code Section 860G(2) defines income from foreclosure property as the
amount which would be the REMICs net income from foreclosure property under Code Section 857(b)(4)(B) if the REMIC were a real estate
investment trust (a REIT). Treasury Regulation Section 1.857-3(b) provides, in turn,
a deduction which is otherwise allowed by Chapter 1 of the
Code is allowable against the gross income from foreclosure property if it has a proximate and primary relationship
to the earnings or the income therefrom. Thus, in the case
of gross income from real property that is foreclosure
property, directly connected deductions would include
depreciation on the property, interest paid or accrued on
the indebtedness of the trust (whether or not secured by
the property) to the extent attributable to the carrying of
the property, real estate taxes, and fees paid to an independent contractor hired to manage the property. On the other
Code Section 860C(b).
188

hand, general overhead and administrative expenses of the
trust are not directly connected deductions.
(Emphasis added.) Accordingly, the REMICs losses in prior periods and
in the current period cannot be carried forward to determine any net
income from foreclosure property in subsequent periods for a particular property on which the REMIC has foreclosed. This is true even if the
operating losses are directly attributable to the REMICs operation of foreclosure property in prior years. Rather than carrying these losses forward
to offset income in subsequent periods, any such losses are instead used
currently to offset other REMIC income in the year the REMIC incurs
these losses.
Under the REIT regulations, the defaulted loan itself is not classified as
foreclosure property such that the loss that the REMIC realizes from
foreclosing on the related REO cannot be used to offset post-foreclosure
income from the REO when calculating net income from foreclosure
property. In light of the types of deductions that are contemplated in the
regulations, there is no authority or persuasive argument for extending
this statutory definition beyond the real property and related improvements acquired by the REMIC as a result of foreclosure. Furthermore,
because the REMIC will realize the loss from the foreclosure transaction
(i.e., the difference between the REMICs basis in the defaulted loan and
the fair market value of the collateral the REMIC takes back) before any
income is derived by the REMIC from the foreclosure property, such a loss
would likely not be proximate in time to the earnings and income from
the foreclosure property. In summary, such losses, like the REMICs other
general losses, are not attributable to the carrying of foreclosure property because losses realized on the foreclosure transaction arise before the
related collateral is acquired by the REMIC.
Losses From the Foreclosure Property. The REMICs overall losses are
also not considered to have a proximate and primary relationship to any
income generated from foreclosure property such that these losses can
be used to offset the income from REO when computing net income
from foreclosure property. But what about losses in prior periods that are
directly related to a particular foreclosure property? With respect to prior
189

losses associated directly with foreclosure property, the REMIC is also not
entitled to future deductions when computing the REMICs net income
from foreclosure property in subsequent periods. Prior losses from foreclosure property would certainly seem to pass the threshold requirement
that these losses be proximate and primary to the generation of earnings
from the foreclosure property. The regulations, however, make it clear
that these prior losses flow through the REMIC in the year these losses
are realized and cannot be used by the REMIC to offset future net income
from foreclosure property. Treas. Reg. 1.857-3(c) states that the tax on net
income from foreclosure property applies only if there is net income. If
there is a net loss from foreclosure property, the loss is taken into account
immediately for purposes of computing income in the current period only
and is not carried forward to subsequent periods.
Deducting Interest. Treasury Regulation Section 1.857-3(d) also prescribes
the rules governing how much of a REMICs interest expense attributable to the interest that the REMIC pays on regular interest certificates
may be deducted from the gross income from foreclosure property when
computing the net income from foreclosure property. Because the REMIC
has foreclosed on the REO, any interest that would have accrued on the
original loan is disregarded for purposes of computing interest deductions post-foreclosure.9 Interest that is not specifically allocated to REO is
apportioned between foreclosure property and the other property under
the principles of Treasury Regulation Section 1.861-8(e)(2)(v).10 These
regulations were promulgated under Section 861 the section that provides the basic statutory framework for determining US source income.
Part of that framework is the allocation of deductions (including interest).
Treasury Regulation Sections 1.861-9T through 13T provide guidance
concerning the allocation of interest expense.11 Treasury Regulation
In the case of the allocation and apportionment of interest expense to the related REO when computing net
income from foreclosure property, the regulations state,
interest that is specifically allocated to an item of property is attributable only to the carrying of that property.
Interest is treated as specifically allocated to an item of property if (i) the indebtedness on which the interest is
paid is secured only by that property, (ii) such indebtedness was specifically incurred for the purpose of purchasing, constructing, maintaining or improving that property, and (iii) the proceeds of the borrowing were
applied for that purpose.
10
Treas. Reg. 1.857-3(e)(3).
11
Treas. Reg. 1.861-8T(e)(2).
9
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Section 1.861-9T(c) adopts a principal of uniformity for allocating interest expense and provides that the aggregate of deductions for interest in
all cases is considered related to all income producing activities and assets
of the taxpayer and, thus, interest allocable to all the gross income which
the taxpayers assets generate, have generated or could reasonably have
been expected to generate. Treasury Regulation Section 1.861-9T(a).
Foreclosure property need not generate income, (e.g., in excess of direct
expenses) in order to be allocated (general) interest expense attributable to
the REMICs regular interests.
Two points regarding the allocation of interest merit emphasis. First, the
interest allocation rule noted above does not override the specific interest allocation provision. That is, if interest is specifically allocated to a
particular asset, any interest deduction is the amount of interest that is
specifically allocated when computing the net income from foreclosure
property from a particular asset.12 Second, not just income-producing
assets are part of the allocation equation; the ambit of this rule encompasses assets that historically generated income or that were acquired
with a view to generating income, whether or not that has happened.
Foreclosure property need not generate income (e.g., in excess of direct
expenses) in order to be allocated (general) interest expense attributable to
the REMICs regular interests.
In general, apportionments of interest deductions may be made either
on the basis of the REMICs tax book value of its assets or on the assets
fair market value.13 Adoption of a fair market valuation method must
be established to the satisfaction of the Commissioner. Otherwise, the
Commissioner can compel the taxpayer to revert to the tax book value
method.14 Once the taxpayer uses fair market value as the means to allocate interest, the taxpayer and all related persons must continue to use
such method unless expressly authorized by the Commissioner to change
To the extent that the special servicer is required to make principal and interest as well as property protection
advances with respect to a particular property, an argument could be made that the interest advanced by the
special servicer as well as the interest reimbursed by the REMIC to the special servicer would be specifically
allocated to the related foreclosure property.
13
See Treas. Reg. 1.861-9T(g).
14
Treas. Reg. 1.861-9T(g)(1)(iii).
12
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methods.15 Accordingly, a REMIC has the option to use book value or the
REMIC may elect to use fair market value in determining the value of its
respective assets for the purpose of allocating its general interest expense
between the mortgages, the foreclosure property and any other REMIC
assets (e.g., a reserve fund or collections fund).
Loss From the Foreclosure Transaction. Treas. Reg. Section 1.860C-2(b)(3)
provides that for purposes of determining a REMICs bad debt deduction
under Section 166, debt owed to the REMIC [(the defaulted loan that the
REMIC holds)] is not treated as non-business debt under Code Section
166(d). Although stated in the negative, this provision means that the
defaulted loan will be treated as business debt and can be deducted by
the REMIC as an ordinary loss. Consequently, the REMIC is allowed a
deduction in determining the REMICs taxable income in the year the
debt becomes worthless under the rules of the Code Section 166(a).16 As
discussed above, however, the REMIC may not use this deduction or loss
to offset revenue generated from the related REO when computing any net
income from foreclosure property.
Amount of Loss and Tax Basis. The general rule under Code Section 166
for measuring the mortgagees loss in the event mortgaged property is sold
for less than the amount of a debt and the debt is determined to be wholly
or partially uncollectible, is that,
where the creditor buys in the mortgaged property, loss
or gain is realized and measured by the difference between
the amount of those obligations of the debtor which are
applied to the purchase or bid price of the property (to the
extent that such obligations constitute capital or represent
an item the income from which has been returned by the
creditor) and the fair market value of the property. The
fair market value of the property for this purpose shall, in
the absence of clear and convincing proof to the contrary,
be presumed to be the amount for which it is bid by the
taxpayer. Treas. Reg. Section 1.166-6(b).
Treas. Reg. 1.861-8T(c)(2).
In contrast, a non-business bad debt is treated as resulting from the sale or exchange of a capital asset held for
not more than one year and triggers short-term capital loss. Section 166(d).
15
16
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This rule has been extended to other situations when a creditor repossesses property that secures a borrowers obligations under the terms of a
defaulted loan.17 In such situations, the amount of the loss is the excess of
the creditors (the REMICs) basis in the defaulted loan over the fair market
value of the property that the creditor repossesses. When there is no bid
price (as in the typical deed-in-lieu transaction), the amount of any loss
would be equal to the excess of the REMICs basis in the defaulted loan
over the fair market value of the mortgaged property at the time the property is acquired in satisfaction of the defaulted loan.
The fair market value of the property will also be the REMICs initial basis
in the foreclosure property for purposes of determining the REMICs
depreciation deduction when computing the REMICs net income from
foreclosure property in subsequent years.
Gain on Disposition of REO. At the time the foreclosure property is disposed of, the REMIC realizes gain equal to the difference between the
amount the REMIC receives for the foreclosure property and the REMICs
basis in such property. For purposes of the computing the REMICs net
income from foreclosure property, however, any gain realized on the sale
of qualified foreclosure property is not included as net income from foreclosure property unless the foreclosure property constitutes stock in trade
or other property that would be included as inventory for the REMIC if
on hand at the end of the REMICs taxable year. Accordingly, in all but the
rarest of cases, a REMIC will not generate net income from foreclosure
property when the REMIC realizes a gain on the disposition of foreclosure
property.
Loss on Disposition of REO. Similarly, if the REMIC receives an amount
less than the REMICs basis in foreclosure property at the time the REMIC
disposes of such property, the REMIC realizes a loss. This loss, like any
gain on the disposition of REO, is typically not included in the REMICs
computation of net income from foreclosure property.
See Rev. Rul. 68-523, 1968-2 C.B. 82.
17
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Summary. The following chart summarizes the tax consequences of the
typical foreclosure scenario and the computation of net income from foreclosure property post-foreclosure:
Type of
Income or
Loss
Loss on
Foreclosure
Depreciation
Interest
Deduction
REMIC
Losses PreForeclosure
Income or
Loss from
Operating
REO
Loss
Carryovers
from REO
PostForeclosure
Computation
Included in Computation of
Net Income from Foreclosure
Property
No
Difference between
REMICs basis in
defaulted loan and
FMV of REO
Based on FMV
Yes
of REO following
foreclosure
Based on allocation
Yes
(FMV, book value or
specific allocation)
of interest paid
by REMIC on
regular interests or
reimbursed to the
special servicer
Based on standard tax No
accounting rules
Based on standard tax Yes
accounting rules
The excess of directly No
connected deductions
associated with the
production of income
from the REO over
gross income from
the REO
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Gain on
REMICs Sale
or Disposition
of REO
Loss on
REMICs Sale
or Disposition
of REO
Difference between
amount received in
exchange for REO
and REMICs basis in
REO
Difference between
REMICs basis in
REO and amount
REMIC receives in
exchange for REO
No, provided REO is not

held by REMIC in trade or
business capacity.
No
Special servicers should always estimate the potential tax consequences

related to the operation of REO before taking title. Without undertaking this computation, the special servicer will not be able to determine
whether operating REO through a management contract rather than a
lease of REO is appropriate and in the best interest of certificateholders.
195

Thomas J. Biafore
Suite 2800
t 404 815 6250
f 404 541 3129
Stephen A. Edwards
Suite 2800
t 404 815 6278
f 404 541 3191
196

The Purchase Option and Beyond
197
198

The Purchase Option and Beyond
A Special Servicer has a number of resolution options when dealing with
a specially serviced mortgage loan. Common strategies include: loan
modifications, seeking the appointment of a receiver, foreclosing on collateral property or taking a deed-in-lieu, or accepting a discounted payoff
from the borrower. Another arrow in the Special Servicers quiver seeing
more use in the current environment is the sale of the defaulted mortgage
loan1 to a third-party purchaser. This article addresses such transactions,
primarily through the purchase option mechanism under pooling and
servicing agreements for securitizations issued between 2001 and 2009.
PSA Compliance: Even when a sale of a defaulted mortgage loan is the
Special Servicers preferred strategy, the required mechanics of the loan
sale can be a trap for the unwary. Frequently, the Special Servicer unwittingly enters into a loan sale agreement directly on behalf of the REMIC
trust that holds the loan without considering whether the Special Servicer
has the authority to do so under the pooling and servicing agreement.
The Special Servicer must be aware of the restrictions in the pooling and
servicing agreement related to the sale of a defaulted mortgage loan. In
particular, the Special Servicer must consider the following:
What triggers the option to purchase a defaulted mortgage loan
(the Purchase Option)?
Who holds the Purchase Option?
At what price can a defaulted mortgage loan be sold?
When does the Purchase Option expire?
How and to whom can the Purchase Option be assigned?
1 From a REMIC compliance perspective, the mortgage loan must be a defaulted mortgage loan (or one on
which an imminent default is likely) before any party under the pooling and servicing agreement can sell
the loan. Under the REMIC provisions, the sale of a performing loan results in a prohibited transaction that
is subject to a 100% tax. Pooling and servicing agreement requirements are generally more restrictive (i.e.,
Defaulted Loan is generally defined as a mortgage loan with a monetary default or a default that has resulted
in acceleration).
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The answers to these questions are typically contained in Section 3.182 of
the related pooling and servicing agreement. Note that in addition to the
issues mentioned above, when a loan is subject to a co-lender, intercreditor, or participation agreement the Special Servicer must also address the
option rights of other holders, including holders of subordinate interests
in the loan.
Notice Provisions: The Special Servicers first step in the loan sale process is to notify the parties specified in Section 3.18 of the pooling and
servicing agreement (and, if applicable, the co-lender, intercreditor or
participation agreement) that the loan is a defaulted mortgage loan. The
parties receiving this notice are usually the parties that hold the Purchase
Option (the Option Holders) and the trustee. Once sent, the notice triggers the Purchase Option for the Option Holders (the notice is referred to
herein as the Trigger Notice). The Option Holders are typically, but not
always, the directing certificateholder (or equivalent, such as the majority
subordinate holder of the controlling class or the controlling class representative) or the Special Servicer. If applicable, the junior or subordinate
loan holder may also have similar rights.
Fair Value: After determining to whom the Trigger Notice must be given,
the Special Servicers next step is to determine the fair value of the defaulted
mortgage loan (the Fair Value Determination). Until the Special Servicer
makes the Fair Value Determination, the Special Servicer will only be
permitted to sell the defaulted mortgage loan at par (generally the thencurrent balance of the loan plus all accrued interest, expenses and special
servicing fees). The Special Servicer generally will make the Fair Value
Determination by taking into account all relevant factors, including by
way of example the appraised value of the property, the period and amount
of the delinquency, the occupancy and physical condition of the related
property, the state of the local economy in the area where the property is
located, and the expected net recovery on the loan if the Special Servicer
pursues workout or foreclosure strategies. To this end, the Special Servicer
must review the related pooling and servicing agreement to make certain
the Special Servicers Fair Value Determination is in accordance with the
For convenience, Section 3.18 is referred to throughout this article; however, in some instances the purchase
option may be set forth in a different section of the pooling and servicing agreement.
2
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pooling and servicing agreement and the applicable servicing standard.
It is important to keep in mind that the determination will be of the fair
value of the defaulted mortgage loan and not of the mortgaged property.
Once the Special Servicer makes Fair Value Determination, the Special
Servicer must notify the Option Holders of the Fair Value Determination.
The Special Servicer is required to update the Fair Value Determination
from time to time based on changed circumstances or when the Fair Value
Determination expires based on the passage of time (e.g., 90 days).
If the party ultimately exercising the Purchase Option is an affiliate of the
Special Servicer, the fair value will generally have to be certified by a neutral party such as the master servicer or trustee. This may also be true if the
Controlling Class is exercising the option, even if it is not an affiliate of the
Special Servicer. Careful review of these provisions is important to avoid
delays or unauthorized sales.
Assigning the Option: An Option Holder may assign the Purchase Option
to a third-party purchaser in accordance with the terms of the pooling
and servicing agreement. If under the applicable pooling and servicing agreement there is only one Option Holder, the assignment of the
Purchase Option to the ultimate third party purchaser is a simple step.
In other instances, however, there may be two or more Option Holders
that have exclusive time periods within which to exercise their respective Purchase Option. In these instances, absent a waiver of the Purchase
Option, each Option Holder must wait a specified period of time for the
immediately preceding Option Holder to exercise its Purchase Option.
If an Option Holder does not exercise its Purchase Option, then the next
Option Holder in line has the right to exercise its Purchase Option. It is
common that once the last Option Holders Purchase Option expires, the
Purchase Option reverts back to the first Option Holder (usually the controlling class option holder) exclusively. The process may repeat itself if
the value determined in the Fair Value Determination (the Fair Value)
changes as a result of the Special Servicers updating its determination. In
some pooling and servicing agreements, the process is essentially an auction among the Option Holders and the Option Holder willing to pay the
highest purchase price greater than the Fair Value is the party who can
exercise or assign the Purchase Option. If the exercising Option Holder
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is not the Special Servicer, then it is important for the Special Servicer to
be proactive and coordinate closely with the Option Holder to avoid any
delays in the loan sale closing. In most instances the Option Holder will
be the Controlling Class Representative, or equivalent, who not only will
be the Option Holder but most likely will have consent rights over the sale
of the loan pursuant to the terms of the pooling and servicing agreement
(i.e., even if the Special Servicer is the Option Holder the Controlling Class
Representative may still have to consent to the sale). Remember that under
pooling and servicing agreements for securitizations issued from 2001
to 2009, a direct sale of the loan from the trust to a third party purchaser
is not permitted and the Purchase Option assignment process must be
followed.
If the Purchase Option is assigned to a third party, the Special Servicer
should make certain that the assignment is clearly extinguished if the
loan sale does not close within any required time period. The best way
to accomplish this is by including language in the assignment of the purchase option that terminates the assignment if the loan sale does not close
within the time period specified. The pooling and servicing agreement
will usually require the sale to close within a relatively short time after
the Purchase Option is exercised. Until the Purchase Option is exercised
and the defaulted loan is sold, the Special Servicer should (and is often
required to by the terms of the pooling and servicing agreement) pursue
other resolution strategies for the defaulted loan.
As a word of caution, the pooling and servicing agreement may prohibit
an Option Holder from assigning its Purchase Option to the borrower or
an affiliate of borrower. If such a restriction exists the agreement pursuant
to which the loan will be sold should contain a representation from the
purchaser that is not related to the borrower. If a loan broker is being used,
the Special Servicer should alert the broker to do proper and thorough
diligence on all potential purchasers to determine whether the borrower is
an investor in a potential purchaser.
Sales Fees and Commissions: Frequently, the Special Servicer uses a
broker to assist in determining the value of the defaulted loan (i.e., essentially determining fair value by exposing the loan to the market) and to
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solicit potential buyers to the table. For its services, the broker will usually
request that a commission be paid at closing. The Special Servicer should
not agree to this arrangement without considering the intent of the applicable Purchase Option provisions of the pooling and servicing agreement.
Typically, the Option Holder would, under the pooling and servicing
agreement, buy the defaulted mortgage loan itself, so there should be no
fees incurred by the trust for a third-party broker to market the defaulted
mortgage loan to the general public. For this reason, the Special Servicer
should in most cases require the brokers commission to be paid by the
buyer directly to the broker at closing, separate from the payment of the
purchase price paid for the defaulted mortgage loan. Similarly, payment to
a broker of any break-up fee or similar fee should not exceed the value of
services provided in assisting in the the Fair Value Determination.
Servicing Fees: In some instances the Special Servicer is entitled to a
Principal Recovery Fee or, Liquidation Fee, in the event the assignment
of the Purchase Option is to a third party for no material consideration
and the Purchase Option is exercised by an unaffiliated third-party
purchaser (i.e., the Option Holder or the Special Servicer assigned the
Purchase Option to a third party as a liquidation strategy and did not purchase the loan for their own account or collect a brokerage or finders fee).
Escrows & Reserves: In connection with the sale of a mortgage loan,
Special Servicers may consider retaining all escrows and reserves or netting them from the purchase price. However because these funds belong
to the borrower (i.e., they are collateral until actually applied), the retention of the escrows may be subject to attack by a bankruptcy trustee. The
Special Servicer can protect itself from claims by the bankruptcy trustee by
transferring the escrows to the purchaser of the mortgage loan as part of
the sale with the purchaser paying a dollar-for-dollar price for the reserves.
Pre-2001/Post-2009: Generally prior to 2001 Special Servicers were permitted to sell defaulted mortgage loans to third parties without resorting to
the machinations of Fair Value Determinations and the Purchase Option
process. The sale of a defaulted mortgage loan was just another liquidation strategy to be considered. During 2001, the Purchase Option process
was added to address accounting issues related to the consolidation of
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the trust and its loans. After 2009, those accounting issues are no longer
relevant and the process for selling defaulted mortgage loans in CMBS
2.0/3.0 is evolving. In some 2010 and 2011 transactions there may be a
right of first refusal or right of last offer held by the Controlling Class. In
other transactions there may not be. As in any sale of a defaulted mortgage
loan, the provisions of the specific pooling and servicing agreement must
be reviewed and followed.
Freddie Mac K Transactions: The Federal Home Loan Mortgage
Corporation, Freddie Mac, multifamily securitizations known commonly
as the Freddie Mac K Transactions have their own unique provisions for
the sale of defaulted mortgage loans. In the Freddie Mac K Transactions,
even post-2009, the Purchase Option still exists. The Option Holder is the
directing certificateholder but, if Fair Value is less than 99% of par (plus
accrued interest, expenses, etc.), Freddie Mac as the guarantor of certain
of the senior certificates has the right to buy the defaulted mortgage loan
for a price at least 2.5% greater than the price at which the Option Holder
exercises the Purchase Option (i.e., Fair Value or such greater price as the
Option Holder offered). If Freddie Mac exercises its option, the Option
Holder has the right to purchase the loan at a price equal to the lesser of
99% of par or 2.5 % more than what Freddie Mac offered. Holders of second mortgages originated in Freddie Macs Supplemental Debt Program
have similar rights under the program intercreditor agreement.
Conclusion: Only defaulted mortgage loans may be sold by a REMIC
trust. The pooling and servicing agreement will generally define defaulted
mortgage loans to include only monetary defaults as material defaults
resulting in acceleration of the loan. For pooling and servicing agreements
dated between 2001 and 2009, the Special Servicer should not enter into
a loan sale agreement without considering the Special Servicers authority
to enter such an agreement on the trusts behalf. A review of Section 3.18
of the pooling and servicing agreement is required to determine whether
there is a Purchase Option and if so, how the Purchase Option is triggered,
assigned and exercised prior to selling a defaulted mortgage loan. For pooling and servicing agreements either before or after such time period, there
likely will be no Fair Value Determination process or Purchase Option but
the specific pooling and servicing agreement must still be consulted to
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determine what process requirements or limitations there may be for the
sale of a defaulted mortgage loan. When escrows and reserves are being
combined care must be taken to ensure the loan elements provide such a
right. For Freddie Mac K Transactions and their unique provisions, a careful reading of the pooling and servicing agreements and any intercreditor
agreement is critical.
Eugene P. Caiola
The Grace Building
t 212 775 8732
GCaiola@KilpatrickTownsend.com
205
206

Restrictions on Construction of REO
207
208

Restrictions on Construction of REO
Stephen A. Edwards
When a loan secured by real estate goes into default, the lender can try
to modify or work out the loan, but the lenders final recourse is to take
back the property, often very reluctantly. That reluctance comes from the
fact that, in many cases, the asset that the loan originator once valued so
highly has become run down as the cash-strapped borrower has scrimped
on maintenance and repairs. In other cases, even if the borrower has been
conscientious in keeping up the property, the rental market in which the
property is located has changed, making aspects of the property obsolete.
The servicer for this now less-desirable asset acquired in foreclosure by the
REMIC trust may feel that it would be prudent to invest funds in improving the property in hopes of increasing the propertys value. Unfortunately,
that is when REMIC counsel may have to step in and halt the servicers
plans. The Treasury Regulations governing REMICs impose cumbersome
restrictions on the ability of REMICs to engage in construction on property they own (usually referred to as real estate owned or REO). This
article addresses those restrictions.
Background: Foreclosure Property. REMICs are required to be passive
investors in mortgages principally secured by interests in real property.
The tax rules acknowledge, though, that a loan may go into default and
that a REMIC can end up taking title to the real property subject to the
mortgage securing the loan. Section 860D(a)(4) of the Internal Revenue
Code of 1986 (the Code) provides that substantially all of a REMICs
assets must consist of qualified mortgages and permitted investments.
Foreclosure property (as defined in Code Section 860G(a)(8)) acquired
by a REMIC is a permitted investment. Code Section 860G(a)(8) defines
foreclosure property as property (A) which would be foreclosure property under Section 856(e) if acquired by a real estate investment trust,
and (B) which is acquired in connection with the default or imminent
default of a qualified mortgage held by the REMIC.
Most REO would seem to fit within this definition, but it is the restrictions in Section 856(e) that create the problems for REMICs. Even if REO
209

otherwise qualifies as foreclosure property for purposes of the definition
of permitted investments, income generated by the REO will be subject
to the 100% tax on prohibited transactions1 if the REMIC generates active
income from the REO as a result of:
(i) the REMICs use of the REO in a trade or business (except
through an independent contractor), or
(ii) the REMICs construction activities on the REO unless,
(a) the construction consists of the completion of a building2 where more than 10 percent of the construction of such
building was completed before the related loan default became
imminent, and
(b) any construction more than 90 days after such property
was acquired by the REMIC is performed by an independent
contractor from whom the REMIC does not derive or receive
any income.3
Put more simply, a REMIC cannot use REO in a trade or business (except
through an independent contractor) and a REMIC cannot permit any
construction on the REO unless the construction is merely completing
construction that was underway at the time of default (and, here too, the
construction must be done by an independent contractor). Unfortunately,
renovation of a building, including remodeling to reconfigure the layout,
is considered construction. On the other hand, construction does not
include:
(i) the repair or maintenance of a building or other improvement (such as the replacement of worn or obsolete furniture and
appliances) to offset normal wear and tear or obsolescence, and
the restoration of property required because of damage from fire,
storm, vandalism or other casualty,
Code Section 860F(a)(2)(B).
The term building for these purposes generally refers to the building as planned by the borrower at the
time of default. Treas. Reg. 856-6(e)(5).
3
Treas. Reg. 1.856-6(c).
1
2
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(ii) t he preparation of leased space for a new tenant that does
not substantially extend the useful life of the building or other
improvement or significantly increase its value, even though, in
the case of commercial space, this preparation includes adapting
the property to the conduct of a different business, or
(iii) certain deferred maintenance that the defaulting party
failed to perform.4
Also, the REMIC may make subsequent modifications to a building or
improvement that increase the direct cost of construction of the building
or improvement if
(i) The modifications are required by a Federal, State, or local
agency, or
(ii) Where the building or improvement, as modified, was more
than 10 percent complete when default became imminent, the
modifications are alterations that are either required by a prospective lessee or purchaser as a condition of leasing or buying the
property or are necessary for the property to be used for the purpose planned at the time default became imminent.5
Applying the Rules. Aside from the provisions of the Treasury Regulations
outlined above, there has been virtually no guidance to taxpayers on
the question of what constitutes construction, leaving many difficult
questions of interpretation. For example, how far can the concept of obsolescence be pushed? The relevant provision of the Treasury Regulations
refers to repair or maintenance to offset obsolescence. Does this also
mean that components of a building can be replaced? It would be difficult
to imagine that only repairs would be permitted, since something that is
obsolete usually cannot be made current merely by repairing or maintaining it.
Another question is whether obsolescence extends to economic obsolescence (e.g., can a component be replaced merely because it is less
Treas. Reg. 1.856-6(e)(5).
Treas. Reg. 1.856-6(e)(3).
4
5
211

economical than what a reasonable owner would install today). Again, it
seems likely that replacement of a component that is economically obsolete should be permitted, since most items that become obsolete do so
primarily because of changes in technology or practices that are intended
to make operations more economically efficient. Still, would this extend to
a situation in which, although a component is still perfectly operational, it
is not what a prudent operator would install in a new facility?
The exception for the preparation of leased space for a new tenant also
raises difficulties. Does leased space refer only to the existing building or can the REMIC make structural alterations, including alterations
that change the footprint of the building? The prohibition against extending the useful life of the building or other improvement or significantly
[increasing] its value suggests that non-structural alterations can be
made, because non-structural alterations are much less likely to extend the
useful life or increase the value of the building or improvement.
The prohibition against substantially [extending] the useful life of the
building or other improvement or significantly [increasing] its value also
raises the issue of which useful life or which value must we use in making
that determination. A building that was constructed for a single retail tenant has very little value to any other tenant and will typically need to be
substantially renovated (or, in some cases, demolished and reconstructed)
in order to make it usable by another tenant. If the original tenant has
departed (because of a bankruptcy or other default or simply because the
original lease expired and the tenant moved to another property), the
building arguably has no value or useful life whatsoever. Does that mean
that the REMIC is prohibited from making any modifications to the building in order to attract a new tenant? The foreclosure property definition
was added to Section 856 of the Code in 1974 (another period of distress
in the real estate industry) and the accompanying legislative history indicated that Congress was adding the exception for foreclosure property
because, without it, the lender that had acquired REO may have to take
action which is not economically sensible to remain qualified.6 This suggests that the rules for foreclosure property should not force a REMIC to
take (or fail to take) actions that would not be economically sensible.
Senate Report 93-1357 at 12.
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It certainly would not seem to be economically sensible for a servicer to
allow a single-tenant building to remain vacant merely because of a concern that modifying the building in anticipation of a new tenant would
significantly increase the buildings value and violate this rule.
Similarly, it will sometimes be difficult to determine whether an expenditure is really for a new tenant. Hotel properties that become foreclosure
property are often subject to property improvement plans (PIPs) in order
to retain the flag of a hotel chain or to obtain a new flag. The PIP technically represents the requirements of the franchisor, not the tenant.
Moreover, a PIP may include improvements that are difficult to fit within
the distinction between preparing space for a new tenant and a complete
renovation of an existing facility.
The provisions of the Treasury Regulations permitting modifications that
are required by a Federal, State, or local agency or required by a prospective purchaser or lessee are also ambiguous, because they are placed in the
portion of the Treasury Regulations dealing with how to calculate whether
10 percent of the construction of the building was completed before the
related loan default became imminent, rather than as part of the exception
to the definition of construction (along with the exceptions for repair
or maintenance, preparation of leased space, and deferred maintenance).
This ambiguity is compounded by the fact that both sections have provisions that deal with the preparation of a building or improvement for a
prospective tenant. We think the best reading of these provisions is that
modifications required by a Federal, State, or local agency will not be
treated as construction and that preparation of a building or improvement for an identified tenant or purchaser should also not be treated as
construction unless the preparation is essentially a renovation of the
building or improvement to improve its marketability.
Finally, the Treasury Regulations impose the prohibited transactions tax
if any construction takes place on the property. Nevertheless, we believe
that they should not prohibit the REMIC from permitting a tenant to
engage in construction on the foreclosure property, although care must be
taken to ensure that the REMIC is not indirectly paying for the construction and essentially using the tenant as its agent.
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Conclusion. We are not aware of any authorities addressing the difficult
interpretive questions raised in this article, so it is impossible in many
cases to make an unqualified determination of whether something is
construction for purposes of the restrictions on foreclosure property.
Servicers will therefore often be forced to analyze closely proposed expenditures with respect to foreclosure property and to make fine judgments
about the strength of the argument that such expenditures do not constitute construction.
Stephen A. Edwards
Suite 2800
t 404 815 6278
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What does it really mean to me?
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216

What does it really mean to me?
Rex R. Veal
What is CMBS 2.0?: CMBS 2.0 is the common nickname given to commercial mortgage-backed securities transactions closed after the financial
crisis that began in 2008. Some have now taken to using CMBS 3.0 to
refer to the most recent transactions based on some perceived continuity
within these transactions. In reality, while some concepts have become
uniform, there is still considerable variation among CMBS transactions
and the market continues to evolve. The label CMBS 2.0 also describes
overall trends in the CMBS market in underwriting standards, credit
guidelines, and loan documents, as well as the evolution of CMBS transactional documents such as the pooling and servicing agreement and the
mortgage loan purchase agreement. The post-crisis political environment
and legislative and regulatory responses to the financial crisis drive some
of these changes. Other changes are driven by investor demand. A number
of these changes do not have a significant impact on servicers and are not
addressed in this article. This article alerts servicers to changes that have
occurred in recent CMBS transactions that will affect their day-to-day
operations and servicing activities.
Pooling and Servicing Agreement Forms: For a number of years, there
have been two primary forms of pooling and servicing agreements. The
most common form generally placed the primary servicing provisions
in Article III. The other form generally divided servicing for performing loans and specially serviced loans into two articles, usually Article
VIII and Article IX respectively. There are efforts underway through the
Commercial Real Estate Finance Council (CREFC) to standardize the
servicing provisions of pooling and servicing agreements. Considerable
progress has been made with respect to the task force set up by CREFC in
producing proposed standardized language for Article III. The current version of this standardized language can be found on CREFCs website. These
efforts to date have been primarily driven by servicers and their counsel.
Only time will tell whether issuers and their counsel will adopt these proposals. In the meantime, participants in the market may find unexpected
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changes in pooling and servicing agreements. Servicers and their attorneys
have grown comfortable with the standard forms, with typical variations
from issuer to issuer generally remaining fairly constant from a servicers
perspective. There is always the temptation to assume what the pooling
and servicing agreement for a given issuer says with respect to a particular
issue without consulting the document. While making such assumptions
is never a good practice and is always subject to risk, this is particularly the
case with recent pooling and servicing agreements, which can vary from
the established norms.
Rating Agency Contact/ Rating Agency Confirmations: Part of the fallout
from the financial crisis was a distrust of the rating agencies and their perceived lack of independence. Revisions to Rule 17g-5 promulgated by the
Securities and Exchange Commission (SEC) under the Credit Agency
Reform Act of 2006 are one of the results of that fallout. Under the new
requirements, direct contact by servicers with rating agencies is severely
limited. All communications generally must go through a password-protected internet website maintained by a party designated in the pooling
and servicing agreement. Recent pooling and servicing agreements now
contain express provisions addressing this process, which is still evolving.
All rating agencies will have access to the website, whether or not they rate
the specific transaction. This is thought to encourage unsolicited ratings
by agencies not originally involved in the transaction and to provide some
protection against pressure from arrangers with respect to rating agency
actions. While there are various other aspects of Rule 17g-5, the restriction
on rating agency contact and the protocol for processing requests to rating agencies have the primary impact on servicers. Servicers will need to
create procedures to assure compliance with the restrictions in the pooling
and servicing agreements. Generally, even if some oral contact might be
permitted, the safest course of action will be to require servicing personnel
to communicate with the rating agencies only in writing and to provide
those writings simultaneously to the party designated in the pooling and
servicing agreement for 17g-5 compliance.
Another perceived problem with the rating agencies was a reluctance to
address loan-specific issues, even though a pooling and servicing agreement might require the servicer to obtain a rating agency confirmation
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before approving a borrower request (e.g., the assumption of a large loan).
In response, pooling and servicing agreements in most recent transactions
provide a mechanism for dealing with the lack of a rating agency response
to such a request. These mechanisms vary but generally they require the
servicer to ask for the confirmation twice and, if there is no response, for
many types of requests, the servicer can deem the request for confirmation
granted or the requirement waived. Each pooling and servicing agreement will have its own specific language, and servicers should follow the
requirements closely.
Repurchase Claims: One of the requirements under the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank) was that
the SEC prescribe regulations that would require a securitizer to disclose
fulfilled and unfulfilled repurchase requests. As a result, Rule 15Ga-1 was
promulgated and pooling and servicing agreements were revised to provide a protocol for tracking repurchase requests and whether such requests
were denied, fulfilled or withdrawn. Servicers making a repurchase claim
on behalf of the trust or having knowledge of such a request by another
party are required to provide notice and details regarding the repurchase
request to the party, and in the manner, designated in the pooling and servicing agreement.
Risk Retention: Regulatory proposals are currently still under consideration to address the risk retention requirements of Dodd-Frank. Risk
retention essentially addresses the manner in which an issuer or mortgage
loan seller may be required to retain certain risks with regard to securitized loans. Requiring this risk retention is perceived as a way to improve
the quality of loans going into securitizations. While it may not be readily
apparent how risk retention is implicated by such requirements, proposals include requiring the existence of an operating advisor independent of
the controlling class and special servicer to review certain transactions or
to monitor servicer performance. The duties of such an operating advisor
may vary depending upon whether the special servicer is related to the
controlling class holder, the specific approval rights given to the controlling class, and whether the subordinate certificates have lost control rights.
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The operating advisor role varies considerably in CMBS 2.0 transactions
but, in more recent transactions, the pooling and servicing agreements
generally provide that the role is very limited until the original B-piece
holder has lost its control rights. A typical protocol would have the operating advisors role initially limited to reviewing the standard CREFC reports
issued by the trust along with the final Asset Status Report the initial
report produced by the special servicer setting the asset status and initial
strategy. This would continue until the designated control eligible certificates, usually the certificates acquired by the B-piece buyer, no longer have
control rights. Once the B-piece buyer loses the control, the operating
advisors role becomes much more active. (See discussion below regarding control rights.) Regardless of the specific terms of the pooling and
servicing agreement, the operating advisor is another party with whom
the servicer will interact and provide information and, depending on the
specific transaction, from whom the servicer will need to seek consent for
various transactions. Additionally, in CMBS 2.0, operating advisors will
generally conduct annual reviews of special servicer performance at some
point.
Control Rights: In CMBS 1.0, the controlling class was generally the most
subordinate class of certificates that had an outstanding certificate balance of at least 25% of that class initial certificate balance. Certificate
balance was only reduced by realized losses and, theoretically, if losses
were significant enough the control eventually could shift all the way up
to the most senior class. As losses mounted during the financial crisis,
in some instances control passed to classes of certificates that were more
widely held and responsiveness from these new controlling classes was
spotty. Additionally senior certificateholders raised concerns about perceived delays in liquidations and the use of more complex workouts that in
their opinion delayed recognition of inevitable losses. As a result, CMBS
2.0 transactions generally use different control rights protocol. In most
post-crisis transactions, only control eligible classes (usually the original
B-piece) have control rights and control now shifts based upon appraisal
reductions (i.e., a class loses its control rights once its certificate balance
is reduced, not only by realized losses but also by appraisal reductions,
to less than 25% of its initial certificate balance). In a typical transaction,
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once a class loses control, it will retain consultation rights until actual realized losses reduce its certificate balance below 25% of its initial amount.
During this consultation period, the operating advisor typically must
also be consulted on any matter which would have required controlling
class consent and begins active monitoring of the special servicers performance, including producing an annual report on that performance. After
all control eligible classes have lost their consultation rights, the operating
advisor generally assumes the role of the controlling class in approving
various transactions as well as continuing to report on the special servicers performance.
Conclusion: CMBS 2.0/3.0 is still evolving. There are new requirements
or protocols that change the way servicers interact with rating agencies
and report repurchase claims and their status. Pooling and servicing
agreements are changing to address these and other issues. In this new
environment, it remains as important as ever for the servicer to review
carefully the provisions of the specific pooling and servicing agreement
governing the issue at hand. As CMBS 2.0 continues to evolve and the once
familiar terms of pooling and servicing agreements change, even among
transactions from the same issuer closed in the same year, a careful read
of the pooling and servicing agreement has become even more critical lest
the unwary be caught by new requirements or protocols.
Rex R. Veal
Suite 2800
Atlanta GA 30309-4528
T 404-815-6240
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Special Servicers
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224

Special Servicers
Meena Dev-Sidhu
Background: In the current environment, where every loan seems to be

highly structured and participated, special servicers often find themselves
dealing not only with their defaulted borrower but also with an additional
creditor that holds some form of subordinated debt related to the primary
qualified mortgage that the special servicer services. This subordinated
debt may take various forms, but the most common are mezzanine loans
and B-notes, and while both have many similarities, they also have several
material differences.
A mezzanine loan is a loan made to an entity that owns an interest in the
property owner, and is secured by a pledge of that entitys ownership interests in the property owner. As such, the mezzanine lender is not a creditor
of the property owner and has no lien against the real property. An A/B
loan, on the other hand, arises when two notes, an A-note and a B-note,
held by two different lenders, are secured by the same mortgage (with the
borrower being the owner of the property). As the A-note in an A/B loan
would typically be securitized, and the B-note would be held by a third
party, servicers of the A-note will be responsible for servicing the loan
on behalf of both the A-note holder and the B-note holder, as a collective
whole.
With multiple lenders in the picture, each one with the ultimate goal of
having its debt repaid in full, it is not surprising that conflicts may arise in
the event a borrower defaults. For this reason, it is important for the parties to have a framework in place to govern the relationship between the
different lenders, explain how the loans relate to one another, and set forth
the rights and obligations of each lender.
This framework often takes the form of an intercreditor agreement (sometimes referred to as a co-lender agreement with respect to A/B loans). This
article will examine the key provisions special servicers should pay close
attention to when working with defaulted loans that either have a mezzanine piece or a B-note associated with them.
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Subordination: With respect to a mezzanine loan, an intercreditor agreement will contain customary subordination provisions whereby the
mezzanine lender will subordinate the mezzanine loan and the mezzanine
loan documents, and all rights and remedies contained therein, to the
senior (securitized real estate) loan. As part of this subordination, the
mezzanine lender will not be permitted to accept any payments from the
senior borrower, or the property, prior to the date that all obligations of the
senior borrower under the senior loan documents are paid. The subordination provisions will not, however, prohibit the mezzanine lender from
accepting payments of any amounts due from time to time under the mezzanine loan documents, while no event of default exists under the senior
loan. This position changes drastically if an event of default occurs under
the senior loan, and special servicers should note that, in such instance,
most intercreditor agreements will prohibit the mezzanine lender from
accepting any payment on account of the mezzanine loan until the senior
lender receives payment and performance in full of all amounts due, and
to become due, under the senior loan. For this reason, it is important for
special servicers to comply with any notice requirements in the intercreditor agreement that put the mezzanine lender on notice of a default under
the senior loan.
Similar to the subordination provisions relating to a mezzanine loan, an
intercreditor agreement for an A/B note structure will usually provide that
the right of the B-note holder to receive payments of interest, principal
and other amounts under the B-note are junior, subject to, and subordinate to the A-note and the right of the A-note holder to receive payments
of interest, principal and other amounts under the A-note. The precise
order in which payments are to be applied to each of the notes will be
described in detail in the intercreditor agreement, and will vary according
to whether or not an event of default has occurred. Upon the occurrence
of an event of default, special servicers should note that all collections or
recoveries on the A/B loan will be sequentially paid first to the holder of
the A-note, until the holder of the A-note (generally the securitization
trust) has received accrued interest and payment in full of the entire outstanding principal amount of the A-note, before any payments are made
to the holder of the B-note. Coupled with this, any losses incurred with
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respect to the A/B loan, will usually be allocated first to the B-note and
will be allocated to the A-note only when the losses have extinguished the
B-note in its entirety. The special servicer should pay close attention to the
post-default waterfall provisions of any intercreditor agreement to ensure
that the correct payment waterfall is being implemented, and that any
losses are being allocated in the manner set forth in and as agreed to by the
parties to the intercreditor agreement.
Cure Rights of Subordinate Lender: Most intercreditor agreements relating to mezzanine loans will provide the mezzanine lender with a right to
cure a senior loan default. The senior lender will be required to give the
mezzanine lender written notice of the default under the senior loan and
permit the mezzanine lender an opportunity to cure the default. Often the
cure periods are the same as those provided in the senior loan documents,
and will depend on whether the default is monetary or non-monetary. If
the default is a monetary default, the mezzanine lender will usually have
a cure period beginning after the later of (i) the date the senior lender
provides a senior loan default notice, and (ii) the expiration of the senior
borrowers cure period, if any. If the default is non-monetary, the mezzanine lender will usually have the same period of time as the senior
borrower to cure the default, although most intercreditor agreements will
allow for the cure period to be extended depending on the circumstances.
Similar cure rights can be found in intercreditor agreements relating to
A/B loans.
Purchase Rights of Subordinate Lender: Typically, intercreditor agreements relating to mezzanine loans will provide the mezzanine lender
with an option to purchase the senior loan, in whole and not in part, if
the senior loan is in default. This option will be exercisable upon prior
written notice to the senior lender, and the option price will usually be an
amount equal to the sum of the outstanding principal balance of the senior
loan, all accrued and unpaid interest thereon, all principal and interest
advances and servicing advances made by the servicer together with interest thereon, and all other costs outstanding and attributable to the senior
loan. The intercreditor agreement will also provide for automatic termination of the purchase option upon foreclosure of the senior loan (or
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acceptance of a deed-in-lieu of foreclosure), or upon the event or circumstances giving rise to the option ceasing to exist.
An intercreditor agreement relating to an A/B loan will provide for a similar purchase right with respect to the A-note in favor of the B-note holder.
In view of the length of time a purchase option may remain open, special
servicers should try to ascertain the intention of the subordinate lender as
soon as possible after the event or circumstance giving rise to the option
occurs. Otherwise, a special servicer may embark on lengthy and often
costly, workout negotiations, only to find later that the subordinate lender
intended all along to purchase the senior loan.
Modifications and Amendments of Senior Loan: In intercreditor agreements relating to mezzanine loans, the senior lender will have the right
to modify non-material terms of the senior loan without the consent of
the mezzanine lender. The senior lender will also be permitted to modify
material terms of the senior loan, without the consent of the mezzanine
lender, in the case of a workout of the senior loan. Such material modifications may include, increasing the interest rate of the senior loan, changing
the scheduled maturity date, amending the transfer provisions, or even
modifying cash management provisions. Despite the often long list of permitted modifications, certain amendments to the senior loan documents,
such as an increase in loan amount, or an extension of a prepayment
lockout period, may require the prior consent of the mezzanine lender
even during a workout of the senior loan. With mezzanine lenders now
more cautious, newer intercreditor agreements either eliminate altogether
the list of modifications permitted during a workout, or expand the list
of terms that may not be modified without the mezzanine lenders consent. In any event, the list of permitted modifications may differ from one
intercreditor agreement to another, and special servicers should carefully
review the intercreditor agreement prior to approving any modification of
the senior loan to ensure that any required consents are obtained.
With the exception of B-note holders with major decision rights (see
below), intercreditor agreements for A/B loans will usually give the A-note
holder the right, after the occurrence of an event of default, and without
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the consent of the B-note holder, to (a) modify or waive any of the terms
of the A/B loan documents, including any terms of the B-note; (b) consent
to any act or failure to act by the borrower or any other party to the A/B
loan documents; (c) encumber additional collateral; (d) cross-default the
mortgage with any other documents; (e) enter into a workout of the A/B
loan; and (f) take action to enforce or protect the interests of the A-note
holder and/or the B-note holder, including, without limitation, accelerating the A/B loan and foreclosing and/or selling the property. Provisions
in the intercreditor agreement will also provide that in the event of any
waiver or forgiveness of amounts due under the A/B loan, or any modifications resulting in a reduction in the principal amount or interest rate of the
A/B loan, all payments to the A-note holder should continue to be made
as though a workout did not occur, with the B-note holder bearing the full
economic effect of all such waivers, reductions or deferrals of amounts due
on the A/B loan attributable to the workout.
Major Decision Rights: For large A/B loans with substantial B-note interests, the B-note holder will usually be given significant approval rights
under the intercreditor agreement with respect to the A/B loan. These
rights are effective as long as no Control Appraisal Period exists, and
include the right to approve any modification or waiver of any monetary or
material non-monetary term of the A/B loan, the right to appoint an operating advisor, and the right to replace the special servicer for the A/B loan.
A Control Appraisal Period will exist when appraisal reduction amounts
and realized losses with respect to the entire A/B loan exceed a certain
percentage (usually 75%) of the then outstanding principal amount of the
B interest, and upon such occurrence, the B-note holder will relinquish its
approval rights, and control will shift back to the A-note holder.
Conclusion: In light of the fact that delinquency rates for CMBS loans
continue to rise, and the impact of the recent decision in the Stuyvesant
Town case,1 it is not surprising that subordinate lenders have become more
aggressive in their approach to negotiating intercreditor agreements. With
the evolution of CMBS 2.0 (See Rex Veal, CMBS 2.0 What does it really
1 See Bank of America, N.A. v PSW NYC LLC, 2010 WL 4243437 (Sup. Ct. N.Y. County 2010), which involved
a senior loan secured by an apartment complex in Manhattan known as Stuyvesant Town, where the judge
held that the intercreditor agreement required the mezzanine lender to cure all senior loan defaults as a precondition to mezzanine lender exercising its right to foreclose on its separate collateral.
229

mean to me? in this Guide), the pendulum is now swinging the other way,
with newer versions of the intercreditor agreement limiting the rights the
senior lender has with respect to a defaulted loan, while expanding the
rights of the subordinate lender. Despite these changes, the importance of
the intercreditor agreement remains unchallenged, and regardless of the
vintage, intercreditor agreements should always be reviewed carefully to
ascertain what rights each of the lenders has upon a default of the senior
loan, and how those rights are exercised.
Meena Dev-Sidhu
Kilpatrick Stockton & Townsend LLP
Suite 2800
t 404 815 6076
f 404 541 4757
MDev-Sidhu@KilpatrickTownsend.com
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Is There Hope for A/B Notes?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

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