On Monday, April 13, 2020 the Internal Revenue Service (the “IRS”) published Revenue Procedure 2020-26 (“Rev. Proc. 2020-26”), providing safe harbors to existing securitization vehicles that currently hold mortgage loans in which the borrower has asked to participate in a COVID-19 forbearance program, as well as safe harbors relating to future securitization vehicles that securitize mortgage loans in which the borrower has previously participated in a COVID-19 forbearance program prior to securitization.

On March 27, 2020, Congress passed and President Trump signed into law the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”). Under the CARES Act, borrowers under federally backed residential mortgage loans,¹ or multifamily borrowers under federally backed multifamily mortgage loans,² are able to request and entitled to obtain forbearance on such mortgage loans if the borrower is experiencing a financial hardship directly or indirectly due to COVID-19. For borrowers under a federally backed residential mortgage loan, if a forbearance is requested and granted then the borrower is entitled to forbearance for up to 180 days (which may be extended an additional 180 days at the borrower’s request). During this forbearance period, the CARES Act prohibits the charging of fees, penalties or interest beyond the amounts scheduled or calculated as though the borrower made all required payments on time and in full under the loan agreement. For multifamily borrowers that are current (as of February 1, 2020) under a federally backed multifamily mortgage loan, if a forbearance is requested and granted then the multifamily borrower is entitled to forbearance for up to 30 days (plus an additional two 30-day extensions, if certain conditions are satisfied, for a total of 90 days).

Notably, the mandates under the CARES Act which require forbearances do not apply to residential mortgage loans or multifamily mortgage loans that are not federally backed mortgage loans. However, many servicers of non-federally backed mortgage loans have nonetheless started entering into (or intend to enter into) forbearance agreements with borrowers that are experiencing COVID-19-related financial hardships. These forbearance agreement programs generally provide for forbearance periods of up to six months (though timelines may vary), and are either voluntarily implemented programs or are mandated by a particular state. The terms of these forbearance agreement programs vary from program to program and may include various resolutions at the end of the forbearance terms such as (i) deferring the forbearance amounts to the end of the mortgage loan as a non-interest bearing account due at the end of the loan or payoff, (ii) entering into repayment plans for some duration at the end of the forbearance term such that the borrower repays the amount over a period of months, (iii) requiring the forbearance amount to be paid in full prior to the end of the forbearance term or (iv) entering into modifications to adjust the remaining terms of the loan.

The safe harbors provided in Rev. Proc. 2020-26 provide clarity with respect to residential mortgage loans securitized in either a real estate mortgage investment conduit (“REMIC”) or a grantor trust. This guidance will minimize the potential market disruption of COVID-19-related forbearance agreements and modifications that could result from loss of a coveted tax classification. Unfortunately, however, Rev. Proc. 2020-26 does not address non-mortgage asset classes that are frequently securitized in grantor trusts such as student loans, auto loans or credit card receivables. Further as discussed in more detail below, there is some uncertainty as to the safe harbor applications to non-federally backed multifamily mortgage loans or other commercials loans secured by real estate.

Forbearances to Which Rev. Proc. 2020-26 Applies (the “Applicable Forbearances”)

Subject to the caveats discussed below, the safe harbors of Rev. Proc, 2020-26 apply to mortgage loans currently held by a REMIC or an investment trust, as well as to mortgage loans acquired by a REMIC (“future REMICs”) regardless of whether or not such loans fall under the auspices of the CARES Act (i.e. federally backed mortgage loans and federally backed multifamily loans) as well as forbearances occurring between March 27, 2020 and December 31, 2020 for mortgage loans that are not federal backed mortgage loans and federally backed multifamily mortgage loans, provided that with respect to loans outside the CARES Act (a) the forbearance is provided by a holder or servicer and is made pursuant to a forbearance program for borrowers experiencing a financial hardship due, directly or indirectly, to COVID-19 and (b) such program is either voluntarily or through a state-mandated loan forbearance program to provide forbearances for three to six months or is similar to such program.

Of note, Rev. Proc. 2020-26 provides similar, but slightly different language with respect to which mortgage loans that qualify for existing REMICs or investment trusts as compared to mortgage loans acquired by a future REMIC. For example, Section 5.01(1) provides that for current a REMIC or investment trust, Rev. Proc. 2020-26 applies to forbearances under the CARES Act “and all related modifications.” The “and all related modifications” language is absent from Section 5.02(1), which describes the applicable mortgage loans acquired by a future REMIC. In addition, Section 5.01(2) provides that for a current REMIC or investment trust, Rev. Proc. 2020-26 applies to forbearance programs for borrowers experiencing a financial hardship due “directly or indirectly” to the COVID-19 emergency. The “directly or indirectly” language is absent from Section 5.02(2)(b), which describes the applicable mortgage loans acquired by a future REMIC. It is unclear whether or not the slightly different language in Section 5.01 and Section 5.02 is intentional, and what are the purposes of these distinctions.

REMICs

A REMIC is a statutorily created securitization vehicle which has many favorable tax attributes including no entity level taxation with the additional benefit that all of its interests are characterized as indebtedness for tax purposes even if the interests do not have traditional debt-like characteristics. Debt instruments are extremely tax beneficial to non-US investors and a very efficient way for such investors to invest in US real estate. In order to be classified as a REMIC with this preferential tax classification, the assets of a REMIC are generally required to be static and REMICs are severely limited in their ability to dispose of mortgage loans or add new mortgage loans. Certain modifications of mortgage loans are treated as a deemed exchange of mortgage loans and an impermissible addition of a new loan to the REMIC. Consequently, the REMIC rules prohibit the “significant modification” of any mortgage loans unless such mortgage loan is in default or default is reasonably foreseeable. Thus, if a mortgage loan held by a REMIC is subject to certain forbearances or otherwise modified, such modification must be tested to determine if such modification is “significant.” If the modification is significant, then there may be a deemed exchange of the “old” mortgage loan for the modified “new” mortgage loan. Since a REMIC is limited in its ability to dispose of mortgage loans or acquire new mortgage loans, a deemed exchange of mortgage loans may result in significant adverse tax consequences to the REMIC, including endangering REMIC classification status or the imposition of a 100% “prohibited transactions” tax.

Mortgage Loans Subject to Forbearance Currently Held by Existing REMIC

In Rev. Proc. 2020-26, the IRS addressed three scenarios applicable to REMICs that currently hold mortgage loans that are subject to COVID-19 forbearance agreements.

A significant modification of a mortgage loan held by a REMIC results in a deemed exchange of such mortgage loan unless an exception exists. The most significant exception is the exception for mortgage loans that are in default or for which default is reasonably foreseeable. Prior to the release of Rev. Proc. 2020-26, it was unclear as to whether a COVID-19 forbearance agreement would constitute a modification for which default is reasonably foreseeable as it is quite likely that up until April 2020 the borrower was current in all payments of principal and interest and thus the determination of reasonably foreseeable was not clear. While the IRS declined to specifically address this point, Rev. Proc. 2020-26 creates an additional exception for COVID-19 forbearances without any analysis of whether such forbearance is in fact a significant modification. Instead, Rev. Proc. 2020-26 provides that if one or more mortgage loans held by a REMIC is modified in accordance with the Applicable Forbearances, the forbearance will not result in a newly issued mortgage loan for purposes of determining if there is a deemed exchange of such mortgage loan. As such, it is not necessary to determine if default on a mortgage loan was reasonably foreseeable so long as the COVID-19 forbearance agreement otherwise complies with Rev. Proc. 2020-26.

The REMIC rules prohibit sales or dispositions of mortgage loans unless a specific exception applies and failure to meet one of these exceptions results in a 100% prohibited transaction tax on any income received from an impermissible disposition. The primary exceptions relate to either a disposition of loans pursuant to a qualified liquidation or a disposition incident to foreclosure, default or imminent default. Prior to the release of Rev. Proc. 2020-26, it was unclear as to whether a COVID-19 forbearance agreement would result in a deemed disposition of a mortgage loan that would be subject to the 100% prohibited transactions tax. Again declining to specifically address whether such deemed disposition would be the result of an “imminent default,” Rev. Proc. 2020-26 effectively creates an additional exception for COVID-19 forbearance agreements by stating that if one or more mortgage loans held by a REMIC are modified in accordance with the Applicable Forbearances, the forbearance will not result in disposition that is subject to the prohibited transactions tax.

Finally, Rev. Proc. 2020-26 provides that if one or more mortgage loans held by a REMIC are modified in accordance with the Applicable Forbearances, then such forbearance or modification will not result in a deemed reissuance of the REMIC regular interests. This holding is curious because a modification of underlying mortgage loans should never result in a deemed reissuance of a REMIC regular interest. Further clarification from the IRS would be helpful to understand the concern here.

Mortgage Loans Subject to Forbearance Prior to Acquisition by a REMIC

Substantially all of the assets of a REMIC must consist of qualified mortgages and permitted investments. In order for a mortgage loan to be a “qualified mortgage” eligible for inclusion in a REMIC, the mortgage loan must satisfy certain loan-to-value tests at either origination or contribution to the REMIC. If a mortgage loan is significantly modified in a non-default situation, then the date of origination becomes the modification date and not the initial origination date. Furthermore, even if a mortgage loan meets the loan-to-value test, if the REMIC acquired the loan with “improper knowledge” such mortgage loan would not qualify as a permitted investment upon foreclosure. In order for foreclosure property to qualify as a permitted investment, a REMIC could not have known or had reason to know that default would occur at the time it was contributed to the REMIC. As such, there were concerns among market participants prior to Rev. Proc. 2020-26 that if a mortgage loan were subject to a COVID-19 forbearance agreement, any resulting foreclosure property would not constitute permissible foreclosure property. Rev. Proc. 2020-26 resolves this issue by providing that if a REMIC acquires one or more mortgage loans on or after March 27, 2020, in which the borrower has requested and agreed to a COVID-19-related forbearance agreement and modification in accordance with the Applicable Forbearances, then such prior forbearance (and all related modifications) will (i) not result in the REMIC having had improper knowledge of an anticipated default and (ii) not be taken into account in determining the date of origination of such mortgage loan. Accordingly, the date of modification should be ignored for purposes of determining whether such mortgage loan is a qualified mortgage and any resulting foreclosure property acquired by the REMIC should be treated as permissible foreclosure property should the REMIC foreclose on such mortgage loan.

An additional concern related to the inclusion of loans in a REMIC that were previously granted a COVID-19 forbearance involved the tax consequences of a later default of such loans. One of the guiding rules of a REMIC is that the principal amount of a regular interest may not be contingent absent an exception. Regulations promulgated by the US Department of the Treasury list certain contingencies that may affect the payment of principal and interest and not jeopardize REMIC status. Prior to the release of Rev. Proc. 2020-26, there was concern that a COVID-19 forbearance agreement entered into prior to such loan’s contribution to a REMIC could result in impermissible contingencies if that loan were to later default causing a REMIC regular interest to fail to qualify as such. Rev. Proc. 2020-26 provides that if one or more mortgage loans held by a REMIC is modified in accordance with the Applicable Forbearances, then the IRS will treat resulting delays in payments or shortfalls in payments of interest and principal from such forbearance as a contingency that can be disregarded in determining whether an interest in such REMIC fails to so qualify as a regular interest. Contingencies that the IRS will disregard include delays or shortfalls resulting from (i) excess fees paid for servicing such mortgage loans; (ii) the inability of a servicer to advance funds associated with such mortgage loans; and (iii) payments that are subject to forbearance not accruing compound interest. It is unclear as to whether other delays or shortfalls in payments associated with or caused by COVID-19-related forbearance agreements and modifications, if not specifically enumerated in Rev. Proc. 2020-26, will similarly be disregarded by the IRS.

Investment Trusts

Trusts (in particular grantor trusts referred to as investment trusts) are securitization vehicles commonly used to hold a pool of mortgage loans. In order for a trust to be classified as an investment trust, there cannot be a power to vary the trust’s investments. As discussed above, if a mortgage loan is significantly modified, then there may be a deemed exchange of the “old” mortgage loan for the modified “new” mortgage loan. The addition of the “new” mortgage loan to the trust may be treated as an impermissible power to vary which would jeopardize the “investment trust” status of the trust. As a result, there was a similar concern that if a mortgage loan held by an investment trust is subject to a COVID-19 forbearance agreement and related modifications, such forbearance agreements could result in the failure of a trust to qualify as an investment trust.

Rev. Proc. 2020-26 provides that if one or more mortgage loans held by an investment trust is subject to a COVID-19 forbearance agreement and related modification in accordance with the Applicable Forbearances, the IRS will not treat such power to forbear by the trust as a power to vary the investments of the certificateholders of such trust. Accordingly, a mortgage loan held by an investment trust which is subject to a COVID-19 forbearance agreement and related modification should not result in such trust failing to qualify as an investment trust.

It is unclear if the forbearance of mortgage loans held by investment trusts are subject to requirements that are in addition to the requirements of Applicable Forbearances. For example, Rev. Proc. 2020-26 notes that the safe harbors apply to investment trusts if the forbearances are described in “section 5.01(1) of this revenue procedure, or are described in section 2.07 of this revenue procedure,” subject to certain qualifications. This reference notes that the forbearance must be granted as a result of a borrower experiencing a financial hardship due to a COVID-19 emergency. It is unclear if this is an additional requirement and therefore it is similarly unclear whether a forbearance of a mortgage loan held by a REMIC does not contain such a requirement (i.e., does it merely require that that program by which the forbearance is offered is for borrowers experiencing a financial hardship due to COVID-19 without having to actually confirm that the borrower was in fact experiencing financial hardship due to COVID-19). As such, additional guidance would be helpful to clarify what requirements must be met for the forbearance of a loan held in an investment trust and if they differ from the requirements for a loan held in a REMIC.

Effect on Other Asset Class Securitizations

While Rev. Proc. 2020-26 provides much needed safe harbors for residential mortgage loans modified in connection with a COVID-19 forbearance agreement and related modification, it is unclear whether this relief extends to holders and acquirers of commercial mortgage loans (other than federally backed multifamily mortgage loans). As currently drafted, the IRS appears to define a non-federally-backed mortgage loan as any mortgage loan that is not a federally backed mortgage loan or a federally backed multifamily mortgage loan. However, no explicit mention is made to commercial mortgage loans. Additional clarification from the IRS would be helpful to address whether Rev. Proc. 2020-26 would apply to commercial mortgage loans. Finally, as noted above, Rev. Proc. 2020-26 does not apply to other asset classes such as student loans, auto loans or credit card receivables. Additional clarifications and guidance from the IRS would help address some of these uncertainties and help contribute to settling an otherwise turbulent market.

Finally, we would note that in the aggregate the safe harbors as they apply to REMICs have the effect of a COVID-19 forbearance not resulting in a taxable event to the REMIC that would cause a REMIC to fail to qualify as such or be subject to the prohibited transactions tax.  With respect to investment trusts, the safe harbors have the effect of preventing an investment trust from failing to qualify because of a power to vary the investments.  However, if a COVID-19 forbearance otherwise would result in a taxable exchange mortgage loans, the safe harbor does not prevent such result.  As such, both a REMIC and certificateholders in an investment trust still may be required to recognize gain or loss with respect to the deemed disposition of a mortgage loan held by a REMIC or an investment trust, even if the COVID-19 forbearance otherwise is an Applicable Forbearance.

^{1 Section 4022(a)(2) of the CARES Act defines the term “Federally backed mortgage loan” to include any loan that is secured by a first or subordinate lien on residential real property (including individual units of condominiums and cooperatives) designed principally for the occupancy of from 1-4 families and that is (i) insured by the Federal Housing Administration under title II of the National Housing Act; (ii) insured under section 255 of the National Housing Act; (iii) guaranteed under section 184 or 184A of the Housing and Community Development Act of 1992; (iv) guaranteed or insured by the Department of Veteran Affairs; (v) guaranteed or insured by the Department of Agriculture; (vi) made by the Department of Agriculture; or (vii) purchased or securitized by the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or the Federal National Mortgage Association (“Fannie Mae”).}

^{2 Section 4023(f)(2) of the CARES Act defines the term “Federally backed multifamily mortgage loan” to include any loan (other than temporary financing such as a construction loan) that is (i) secured by a first or subordinate lien on residential multifamily real property designed principally for the occupancy of 5 or more families, including any such secured loan the proceeds of which are used to prepay or pay off an existing loan secured by the same property and (ii) is made in whole or in part, or insured, guaranteed, supplemented, or assisted in any way, by any officer or agency of the Federal Government or under or in connection with a housing or urban development program administered by the Secretary of Housing and urban Development or a housing or related program administered by any other such officer or agency, or is purchased or securitized by Freddie Mac or Fannie Mae.}