Co-authored by Brandon D. Hadley

On January 6, the Internal Revenue Service issued final regulations (T.D. 9513) under U.S. Treasury Department Regulation Section 1.1001-3 clarifying that a change in the issuer’s credit quality between the issue date and the modification date of a debt instrument is not considered in determining the nature of the instrument or property that results from modification of the debt instrument. For example, a decrease in the fair market value of a debt instrument between the issue date and modification date is not taken into account if it is attributable to the deterioration of the obligor’s financial condition and not to a modification of the instrument’s terms. This rule does not apply if the modification includes the substitution of a new obligor or the addition or deletion of a co-obligor.

On January 5, the IRS released Revenue Procedure 2011-16 with respect to modifications of mortgage loans held by a real estate investment trust (REIT). If a mortgage loan modification qualifies for the safe harbor described below, then (1) the REIT is not required to treat it as a new commitment to make or purchase a loan for purposes of ascertaining the loan value of the real property; (2) the modification is not a prohibited transaction; and (3) the IRS will not challenge the REIT’s treatment of a loan as a real estate asset if the REIT computes the loan value using one of the acceptable methods provided by Revenue Procedure 2011-16.

The new safe harbor applies to a mortgage loan modification which (or an interest in which) is held by a REIT if either (1) the modification was occasioned by default, or (2) the modification satisfies both of the following conditions based on all of the facts and circumstances: (A) the REIT or servicer of the pre-modified loan, after a diligent contemporaneous determination of the risk, reasonably believes that there is a significant risk of default of the pre-modified loan upon maturity of the loan or at an earlier date; and (B) the REIT or servicer reasonably believes that the modified loan presents a substantially reduced risk of default, as compared with the pre-modified loan.

Click here for a copy of the final regulations, and here for a copy of the REIT guidance.