Updated IRS Reg Will Benefit Distressed Commercial Properties

Last September, the IRS updated Rev. Proc. 2009-45 which allows for a proactive approach to obtain a commercial loan modification.

The IRS realizes that owners of commercial real estate will have a harder time refinancing when their loan reaches maturity, due to present tax law regulating pools of commercial mortgages. Because of current market conditions and the tightening of credit, many commercial borrowers in the next few years won't be able to refinance. Even if owners have good cash flow, they still run the risk of default.

To really understand the significance of the IRS change, we need to briefly understand how commercial mortgages are packaged.

Once a loan is issued it becomes a CMBS or Commercial Mortgage-Backed Security which is pooled together with other loans and placed in a REMIC or Real Estate Mortgage Investment Conduits. The purpose of the REMIC is to sell it to Wall Street investors or other investor entities as a securitized asset. PSA's or Pooling and Servicing Agreements define what a Loan Servicer can or cannot do.

When is comes to modifications, the IRS imposed limits on when a modification can be started within a REMIC to avoid tax penalties, usually when a borrower was already in default or near default. Loan Servicers also were hesitant to perform major changes to loans to prevent possible tax penalties. Now the updated IRS procedure allows for a proactive role to prevent commercial loan defaults and still allow REMICs to enjoy their tax favored status.

Under the IRS procedure update, the Loan Servicer must reasonably believe that the borrower is at risk of default at maturity date or earlier. The Servicer must diligently determine from the borrower's "credible factural written representations" that indeed a default is at risk. The good part about this update is that there is no maximum period to determine a loan default risk. This means that if a loan is performing but a year or so down the line the maturity date is due, the Servicer can take reasonable action to head-off a default through a commercial loan modification or workout. Of course market conditions, property values and credit accessibility would play a part in determining default risk.

As more commercial mortgages reach maturity, a good number of properties will have problems refinancing. A good workout plan to extend terms, lower interest rates or defer payments will help many avoid foreclosure.

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