The credit crunch is severely reducing the availability of financing and refinancing for commercial real estate. Many borrowers with loans maturing in the next few years, who originally expected to refinance their commercial mortgage loans before maturity, are now concerned that they will not be able to do so and will default when the mortgage becomes due.

This concern extends to all commercial real estate loans, even those secured with properties that have good cash flow. Anticipating the many challenges facing the commercial real estate industry, the U.S. Department of Treasury and the Internal Revenue Service have provided helpful tax guidance to remove some impediments for commercial mortgage loan refinancings. As a result, many commercial real estate borrowers may soon find it easier to renegotiate their commercial mortgage loans.

According to some estimates, roughly one-third of all commercial loans are held by investor pools known as Real Estate Mortgage Investment Conduits (REMICs). REMICs administer their day-to-day operations of the mortgage loan pools through servicers. These servicers also handle the modification and restructuring of defaulted loans, as well as foreclosure or similar conversion of defaulted mortgage loan property.

The Treasury and the IRS believe the loan pool administrators have developed and implemented procedures for monitoring both the status of the commercial properties securing the mortgage loans and the likelihood of borrowers being able to refinance their mortgage loans or sell the mortgaged property as the loans mature. They believe these administrators are able to foresee impending difficulties for a mortgage loan well in advance of any actual payment default.

Until now, despite being able to anticipate loan defaults, REMICs have been reluctant to renegotiate and restructure these mortgages for fear of losing certain favorable tax benefits that apply to them. Existing rules severely hamper the ability of a REMIC to modify any mortgages that it holds. These rules were drafted at a time when the government did not anticipate the challenges faced today by the mortgage industry.

The Treasury and the IRS have now issued some clarifying rules in anticipation of a rise in defaults of commercial real estate loans to give REMICs comfort that they will not face dire tax consequences when they modify commercial mortgages. The regulations say that “(t)hese changes will affect lenders, borrowers, servicers and sponsors of securitizations of mortgages.”

The relief is generally limited to commercial real estate loans and multifamily housing loans, and does not apply to single-family residential mortgages. The new rules will not affect commercial mortgages held by banks because the same tax rules do not apply to banks.

Specifically, the revised rules allow changes in collateral, guarantees, credit enhancements and changes to the nature of an obligation from nonrecourse to recourse without adverse tax consequences to the REMIC. One caveat is that the mortgage must continue to be principally secured by real property after giving effect to any releases, substitutions, additions or other alterations to the collateral. Under the old rules, the fair market value of the real property securing the mortgage would have had to have been at least 80 percent of the face amount of the mortgage at the time it was originated.

The new rules allow for retesting of the fair market value taking into account any reductions in the amount of the mortgage at the time of the modification. Another favorable new rule permits a more relaxed method for satisfying the principally secured test. As long as the fair market value of the real property that secures the loan immediately after the modification equals or exceeds the fair market value of the real property that secured the loan immediately before the modification, the test is satisfied.

According to the Treasury, all these changes are intended to “accommodate evolving commercial mortgage industry practices” and to allow for more loan modifications.

There are numerous other areas of uncertainty in tax law as they apply to loan modifications, which impede loan modifications in other circumstances. For now, it appears that the Treasury and the IRS are working hard to provide clarifying rules in many of these other areas, as well. For example, the Treasury has also asked for comments from tax practitioners and the industry about extending tax flexibility to loan revisions for properties held by other types of investment trusts.

Of course, loan modifications do not only affect lenders from a tax perspective. In many cases, the tax consequences of a loan modification also severely limit the borrower’s options and willingness to enter into a workout. Many borrowers modify their loans only to learn of the negative tax consequences and tax-efficient alternatives after the fact. Although tax consequences may be the tail wagging the dog, they are important considerations for both the lender and the borrower in any debt-workout situation.