April 17, 2020
On April 13, 2020, the Internal Revenue Service (IRS) released Revenue Procedure 2020-26 (the Revenue Procedure) that provides guidance with respect to certain forbearances and related modifications of mortgages as a result of the COVID-19 pandemic. As discussed further below, the guidance generally clarifies that the U.S. federal income tax status of a real estate mortgage investment conduit (REMIC) and an investment trust, will not be affected as a result of forbearances and related modifications resulting from the COVID-19 pandemic.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Stability Act (CARES Act) was enacted into law. The CARES Act was intended to provide various forms of relief to individuals and companies as a result of the COVID-19 pandemic. Under the CARES Act, borrowers with federally backed mortgage loans and multifamily borrowers with federally backed multifamily mortgage loans that experience a financial hardship due to the “COVID-19 Emergency,” may obtain a forbearance on their loan. The COVID-19 Emergency is defined under the CARES Act as the national emergency resulting from the COVID-19 outbreak declared by the President on March 13, 2020.
For federally backed single—family mortgage loans, the CARES Act provides that if a borrower is experiencing a financial hardship due, directly or indirectly, to the COVID-19 Emergency, the borrower’s mortgage servicer shall provide a forbearance for up to 180 days, which may be extended for an additional 180 days at the request of the borrower if the borrower’s extension request is made while the COVID-19 Emergency is ongoing. During the forbearance period, no fees, penalties, or interest beyond the amounts that would normally accrue had the borrower made all contractual payments on time and in full, shall accrue to the borrower’s account. For federally backed single—family mortgage loans, the CARES Act did not define the period in which a borrower may request a forbearance. Notably, the CARES Act does not require servicers to obtain documentation of financial hardship of borrowers for single—family mortgage loans (but such documentation is required with respect to multifamily mortgage loans as discussed below).
For federally backed multifamily mortgage loans, a borrower may request a forbearance if the borrower was current on its payments as of February 1, 2020, and is experiencing financial hardship, subject to documentation requirements during the COVID-19 Emergency. Unlike the provisions applicable to forbearances on federally backed single—family mortgage loans, the CARES Act does not provide specific guidance with respect to the accrual of fees, penalties, and interest for federally backed multifamily mortgage loans. The forbearance is for up to 30 days with two additional 30 day forbearances available subject to certain conditions. For federally backed multifamily mortgage loans, a borrower may request a forbearance from March 27, 2020 until the earlier of the end of the COVID-19 Emergency or December 31, 2020.
In general, federally backed single—family mortgages and multifamily mortgages are mortgage loans made pursuant to certain government programs or are mortgages purchased or securitized by Freddie Mac or Fannie Mae. While not required under the CARES Act, many holders and servicers of mortgage loans that are not federally backed have voluntarily or through state—mandated forbearance programs offered to provide forbearances for three to six months to borrowers experiencing financial hardship as a result of the COVID-19 Emergency. Many mortgage loans are held in securitization vehicles that are treated as a REMIC or an investment trust (often referred to as a grantor trust) for U.S. federal income tax purposes. As a result of the number of forbearances, guidance has been requested as to whether such forbearances will cause a REMIC or a grantor trust to lose its relevant tax status.
Under the rules related to REMICs, for an entity to be considered a REMIC, all of the interests in the REMIC must consist of one or more classes of regular interests and a single class of residual interests, issued on the startup day of the REMIC. An interest issued after the startup day of the REMIC does not qualify as a regular interest. In addition, a regular interest must not be contingent. Subject to the REMIC regulations, contingencies affecting the payment of principal and interest, including defaults on qualified mortgages, generally are not considered contingencies.
An entity generally qualifies as a REMIC only if, among other things, substantially all of its assets consist of qualified mortgages as of the close of the third month beginning after the startup date of the REMIC and all times thereafter. A qualified mortgage is generally a mortgage that is transferred to the REMIC on the startup day in exchange for a regular or residual interest in the REMIC. Under applicable regulations, however, a forbearance with respect to a mortgage, may constitute a modification of the mortgage. In the event that such a modification is treated as a “significant modification,” the mortgage is treated as one that was newly issued for the unmodified mortgage. Therefore, in the event one or more forbearances are considered significant modifications of a qualified mortgage, a REMIC may lose its status as a REMIC.
In addition to qualified mortgages, a REMIC may hold foreclosure property. However, a REMIC may not treat property as foreclosure property to the extent that the REMIC knew or had reason to know that default would occur. The REMIC rules also provide an additional tax with respect to income derived from prohibited transactions. In certain instances, a disposition of a qualified mortgage may be a prohibited transaction.
Mortgage loans are also securitized through investment trusts, generally referred to as grantor trust structures. A grantor trust is not a taxable entity. However, for an entity to be classified as a trust and not a business entity, which could be taxable as a corporation, the trustee must not have the power to vary the investment of the trust’s certificate holders.
The IRS issued the Revenue Procedure to provide guidance with respect to forbearances and the related modifications related to a financial hardship occurring as a result of the COVID-19 Emergency. The provisions of the Revenue Procedure apply to single—family mortgages and multifamily mortgages, regardless of whether such mortgage is federally backed.
With respect to REMICs, the Revenue Procedure provides that the forbearance and any related modification, will not result in: (i) the deemed reissuance of a REMIC regular interest; (ii) a mortgage being treated as newly issued; and (iii) a prohibited transaction. In addition, in the event that a REMIC acquires a mortgage that has had a forbearance, such forbearance and any related modification, will not be treated as evidence that the REMIC had improper knowledge of an anticipated default for purposes of determining whether the mortgage is foreclosure property. The prior forbearance and any related modification, is not taken into account for determining the origination date of the mortgage loan, and delays and shortfalls in payments due to such forbearance or related modifications, will not be taken into account for determining whether the mortgage is subject to contingencies. In short, forbearance programs designed to mitigate financial hardships experienced due to the COVID-19 Emergency, will not affect the characterization of a REMIC for U.S. federal income tax purposes.
The Revenue Procedure also provides that a grantor trust will not be considered to have the power to vary its investments as a result of its participation in a forbearance program. Thus, forbearance programs will not impact the characterization of a grantor trust for U.S. federal tax purposes.
The Revenue Procedure provides helpful guidance for holders of mortgage—backed securities issued by REMICs and grantor trusts such that a forbearance and related modification, either pursuant to the CARES Act, voluntarily, or through a state—mandated program, will not affect the U.S. federal income tax characterization of the REMIC or trust. Notably, the Revenue Procedure only applies to trusts that hold mortgages and no other types of assets. In addition, the Revenue Procedure does not provide that a forbearance and its related modification will not be treated as a significant modification, only that such modification will not affect the tax status of the entity holding the mortgage.
Please contact any member of the Shearman & Sterling LLP tax team for further information.