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Technical Objections to the CARES Act Bailout

Posted on Apr. 20, 2020

The Luv Guv.

Yes, readers, women’s online forums are gushing and calling New York Gov. Andrew Cuomo the Luv Guv. Ladies, please get a grip. We know it’s hard being confined at home, but Cuomo is the same guy he’s always been — the one you didn’t even bother to vote for.

Every day at about 11 a.m., Cuomo gives a press conference, with PowerPoint slides, about the previous day’s COVID-19 statistics. He laments the deaths, notes encouraging signs about hospital admissions, and reminds viewers that they are still in lockdown. He occasionally scolds young people. He often complains about medical equipment — conveniently forgetting his own administration’s decision not to spend $500 million stockpiling ventilators. He ends the talk with a personal anecdote about a family member. His brother, a CNN commentator, and the brother’s wife have the coronavirus.

Cuomo’s very professional pressers are convincing New Yorkers that he has risen to the occasion. He’s being talked about as a Democratic presidential nominee, and polls show Democratic voters prefer him to the stiff presumptive nominee. Some days he wears a polo shirt and other days a suit. We haven’t figured out the coded messaging in his wardrobe choices, but it seems that the polo shirt is supposed to look “hands on” while the suit is to convey seriousness of purpose. The governor is now seen as the new daddy who’s protecting us.

Cuomo probably can’t become the Democratic presidential nominee. Nonetheless, around here, we really want an E train election. Think of it — debates between two Queens natives who have never pronounced the letter R in their lives! New Yorkers would be fully hedged. One or the other candidate would have to get some federal money directed toward New York’s problems, like the Hudson tunnel that has not collapsed only because fewer people are coming into Manhattan from New Jersey.

Of course, with Cuomo as their nominee, Democrats would have to be willing to take a lot of Trump derangement syndrome issues off the table — corruption, authoritarian tendencies, bad manners, hotheadedness, vindictiveness, inherited privilege, and messy love lives. Speaking of the latter, an indication that Cuomo might be thinking about entering the race is the reappearance of his former girlfriend, television chef Sandra Lee, for whom first lady of the state of New York apparently wasn’t good enough. We’ll know he’s serious if he turns up in a suit that fits.

Cuomo promises that lockdowns won’t last forever. “I believe the worst is over if we continue to be smart, and I believe that we can start on the path to normalcy,” he told constituents recently, announcing a blame-absorbing task force of northeastern governors on reopening, called the Covid Corridor Council. As this article was being written, he ordered New Yorkers to wear face coverings in public.

After getting into a reopening row and Twitter feud with just about everyone, including and especially Cuomo, President Trump kicked the decision back to the states with an elaborate set of reopening criteria. The president had wanted to make a showy declaration that the country is back in business, claiming total authority to do so. States are different, but it’s inconsistent to declare Wyoming a disaster area and then admit they’re safe. “We don’t have a king,” Cuomo snarled, following up with a lecture on federalism. “The statement that he has total authority over the states in this matter cannot go uncorrected.”

Reopening across the board is just not feasible, as a practical or constitutional matter, although governors are making unconstitutional shutdown commands. Every entertainment, food, and lodging business that depends on charging people a lot of money to cram them into a small space breathing on each other for hours is out of business. That describes a lot of urban businesses.

Andrew Cuomo, Governor, New York
New York Gov. Andrew Cuomo is now seen as the new daddy who’s protecting us. (Michael Brochstein/Sipa USA/Newscom)

That means a lot of commercial landlords are stuck with buildings that don’t produce income. That means those landlords’ lenders are stuck with bad loans because the collateral is worth less than loan principal. Much of that debt has been packaged and sold to investors.

A lot of commercial mortgages are in REMICs, REITs, or investment vehicles organized as grantor trusts. A lot of commercial real estate is in REITs. In this article, we’re looking at these issues, because the IRS has just granted relief on a question we raised in a previous article. In Rev. Proc. 2020-26, 2020-18 IRB 1, the IRS said that a mortgage servicer agreeing to modifications of distressed mortgages would not cause a REIT to be treated as holding disqualified mortgages.

REMIC Relief

If underlying mortgages are altered by forbearance or other negotiations, the desired tax classification of the securitization vehicle could be jeopardized. The penalty in all cases is entity-level taxation as a corporation.

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), lenders are required or encouraged to provide relief to borrowers. Sections 4022 and 4023 of the CARES Act give borrowers of federally backed mortgages the right to request forbearance for 90 to 180 days, depending on the number of units in the building, with no fees or extra interest charged. Foreclosure is prohibited during that period.

Substantially all of a REMIC’s assets must be qualified mortgages. Congress intended the REMIC provisions to apply only to an entity that holds a substantially fixed pool of mortgages and that “has no powers to vary the composition of its mortgage assets” (S. Rep. No. 99-313, 99th Cong., 2d Sess. at 91-92). So lobbyists asked for IRS assurance that mortgages that were the subject of (perhaps undocumented) forbearance are not treated as being in technical default, or as deemed new loans, threatening the qualification of the REMIC holding them (section 860G; reg. section 1.860G-2(b)(3)(i)).

The IRS noted that lenders and credit investors complained that non-federally backed mortgages were being subject to forbearance or renegotiated, either voluntarily or through state-mandated relief programs. But under the REMIC regulations, if a significantly modified loan is treated as reissued under section 1001, the REMIC would be treated as newly acquiring a nonperforming loan that was not a qualified mortgage (reg. sections 1.860G-2(b), 1.1001-3). So even if the REMIC initially qualified, the signification modification of some mortgages could cause less than substantially all of its mortgages to be qualified (section 860D(a)(4)).

In the revenue procedure, the IRS stated that mortgages subject to forbearances will not be treated as disqualified REMIC investments if the forbearance was pursuant to the CARES Act or occasioned by the shutdown under some other relief program. Thus loan modifications occasioned by forbearance will not be treated as resulting in a newly issued obligation for purposes of the REMIC rules regardless of whether the loan is deemed reissued under the rules inspired by Cottage Savings v. Commissioner, 90 T.C. 372 (1988) (reg. sections 1.860G-2(b)(1) and (3)(i), 1.1001-3).

So there could be a recognition event or even COD income to a commercial borrower, but no REMIC disqualification. The revenue procedure does not take a position whether forbearance is a significant modification under section 1001. Under the regulations, a holder’s temporary forbearance, in the form of non-exercise of default rights, is not a modification, as long as it is no longer than two years (reg. section 1.1001-3(c)(4)(ii)). But there is a potentially long period of deferral of payments. The administrative forbearance safe harbor doesn’t shelter past due payments subsequently made. (Prior analysis: Tax Notes Federal, Apr. 6, 2020, p. 9.)

In Rev. Proc. 2020-26, the IRS went beyond requests that a REMIC stay qualified if the performing mortgages it acquired were later subject to forbearance. Planners have been using REMICs to acquire bad mortgages for quite a while, and it has been a sore spot for the IRS. Loans are not supposed to be in bad condition when acquired by a REMIC, even though there is a continuing debate about the use of REMICs as workout factories. (Prior analysis: Tax Notes Federal, Jan. 20, 2020, p. 359.)

But now a REMIC can buy loans that are in forbearance. The revenue procedure states that the IRS will permit a REMIC to acquire a loan that has already been subject to CARES Act forbearance or forbearance under some other similar program. Technically, loans for which servicers have provided forbearances to borrowers due to the COVID-19 emergency may be acquired by a REMIC without it being treated as having improper knowledge of an anticipated default. That’s a big deal.

Now, REMICs can have mortgages foreclosed, but they can’t have foreknowledge. They must pay tax on the income from foreclosure property, which is defined as property acquired upon a default or imminent default of a qualified mortgage (sections 856(e), 860G(a)(5) and (8)). But a REMIC cannot treat property as foreclosure property if the underlying loan was acquired with an intent to evict or foreclose, or the REMIC knew or had reason to know that default would occur (reg. section 1.856-6(b)(3)). That’d be a prohibited transaction subject to a 100 percent excise tax (section 860F(a)(1)).

Putting this all together, a REMIC can have a loan go into forbearance and not be disqualified under the asset test. A REMIC can buy a loan that has been subject to forbearance and not get hit with an excise tax.

How bad are loans subject to forbearance? Well, the CARES Act gives banks special permission not to book losses on them. Section 4013 of the CARES Act tells regulated lenders that they won’t have to take charge-offs or nonaccrual classifications for what would otherwise be impaired loans or troubled debt restructurings. That’s telling us how bad these loans are. They’re the kind of loans Congress didn’t want REMICs to knowingly hold.

At this moment, every REMIC has reason to know that its mortgages are going to be subject to mandatory or voluntary forbearance, or even greater modifications. That’s improper knowledge in the parlance of the regulations. A REMIC can buy in the secondary market, where price would be the only indicator of how bad the loan is. All residential mortgages and large swaths of commercial mortgages are forbearance candidates.

Bottom line, can you run a vulture fund from a REMIC? No, but the new guidance does not clarify the workout factory question. “The basic legal questions here haven’t changed,” said William McRae of Cleary Gottlieb Steen & Hamilton.

Instead, the new guidance is a gloss on the regulations’ standard of improper knowledge. Forbearance does not equal improper knowledge. A REMIC can buy mortgages, even after forbearance, if the servicer already made concessions because of the forbearance programs.

To the extent that there is a hint of guidance for would-be bottom fishers, the REMIC contemplating a purchase must ask whether there were fundamentals about the condition of this loan other than coronavirus. Unless the putative purchaser has other reasons to know the mortgage is bad, and forbearance is on the horizon, it would be under the revenue procedure. If other bad information is in the market, the purchase is covered by the improper knowledge standard of the regulations. So if the mortgage is on a shopping mall, and the anchor tenant is withholding rent, firing employees, and closing stores, that would be other bad information indicating that loan modifications are coming.

The revenue procedure also states that forbearance will not cause deemed reissuance of REMIC regular interests nor cause them to be contingent. Treated as debt for tax purposes, regular interests can’t be reissued or have a contingent principal amount. If a whole lot of a REMIC’s qualified mortgages are modified, that could change the yield and payments on the REMIC’s regular interests, so that those would be deemed reissued under section 1001. Even if the regular interests are not deemed reissued, they may be deemed not to have fixed terms (section 860G(a)(1)).

Likewise, grantor trust treatment could be jeopardized if loans subject to forbearance were deemed to have been modified. Consent to modification could be an impermissible power to vary the corpus on the part of the trustee. According to regulations and IRS ruling practice, grantor trust treatment for investors depends on the trust having a fixed pool of assets and no trustee power to vary them (reg. section 301.7701-4(c)). A trustee’s consent to changes in credit support for debt instruments held by a trust has been ruled not to be a power to vary (Rev. Rul. 90-63, 1990-2 C.B. 270).

In the revenue procedure, the IRS stated that forbearances will not be treated as indicative of a power to vary the trust investments if the forbearance was pursuant to the CARES Act or occasioned by the shutdown under some other relief program. This relief follows letter rulings that there was no power to vary when the trustee agreed to a debt exchange or agreed to changes in credit support (LTR 8221142, LTR 8707007).

REIT Problems

REITs have a similar problem maintaining qualifying assets. Unlike REMICs, REITs are not static vehicles. They have a lot of flexibility as long as they stay within the tax rules. They can manage their assets, buy and sell mortgages, and foreclose. They tend to specialize in physical real estate or mortgages. They can freely buy beaten-down assets — famed bottom fisher Sam Zell uses REITs.

REITs are also allowed to hold a certain amount of nonqualifying assets, like shares of subsidiaries, so depreciation in the value of the qualifying assets could upset the balance that keeps them qualified. At the close of each quarter, a REIT must hold at least 75 percent qualifying assets by value and no more than 25 percent nonqualifying assets by value (section 856(c)(4)).

Now, 25 percent is generous, and mortgage REITs tend to have their fingers in a lot of mortgage-related business pies. Mortgage servicing is lucrative, and REITs are allowed to do it in taxable REIT subsidiaries that count in the 25 percent limit. When those qualifying mortgages depreciate in value, REITs with large amounts of nonqualifying assets worry.

REITs also have a different set of problems because they operate more like mutual funds than REMICs do. REITs have to pay out 90 percent of their taxable income as dividends (section 857(a)(1)). Well, what’s the problem? If the REIT doesn’t have income, does it have to pay dividends? REITs would be accruing income that isn’t being collected from rents and mortgages in forbearance. And they’d have to pay out accrued income regardless of whether it was represented by actual cash collections.

So Nareit wrote to Treasury asking that REITs be allowed to substitute equity distributions for 90 percent of their dividend obligation, with the remaining 10 percent being cash. This privilege was granted during the 2008 meltdown and allows REITs to conserve cash. The IRS permitted a package of 90 percent equity and 10 percent cash to qualify for the REIT dividends paid deduction for dividends declared for tax years ending on or before December 31, 2009 (Rev. Proc. 2008-68, 2008-52 IRB 1373). Nareit noted that many REITs have cut dividends and need to conserve cash.

Treasury is in an accommodating mood, so observers expect a rerun of Rev. Proc. 2008-68. Historically, REITs were intended to bring retail investors to commercial real estate. Although they have become a tool of sophisticated investors, REITs attract investors looking for cash dividends. For a cash-strapped REIT, making in-kind dividends usually is accomplished using a consent dividend, with equity holders informed of the amount of cash available for distribution. That is, they’ll get an in-kind distribution with limited cash whether they consented or not (for example, LTR 200348020). Conceivably this distribution could change proportionate equity ownership, but it rarely does (Eisner v. Macomber, 252 U.S. 189 (1920)).

Would a REIT that owns a building outright throw good money after bad by taking an equity interest in a tenant? Financially, a net lease is almost the equivalent. And here’s the dirty little secret of mall leases — if an anchor tenant leaves, then the littler stores have the right to terminate their leases. So REITs that own malls may want to support tenants by taking equity, but there are limits on what they can do. “These are issues that people are considering,” said McRae.

REITs aren’t allowed to own too much equity in a tenant because it would be a nonqualifying asset for the asset test and related-party rent for the gross income test. A REIT cannot own more than 10 percent of the equity of a tenant (section 856(c)(4)(B)(vi)(III), (d)(2)(B)). The IRS ruled that a bankruptcy court award of tenant equity to a REIT did not violate this rule because the REIT promised to transfer the excess shares to a liquidating trust, which would distribute the shares to the REIT’s investors (LTR 200132008).

What do sophisticated investors want? Returns goosed by leverage! So REITs are often debt issuers themselves. What if a REIT works out its own debt with its banks or investors or other lenders? Well, obviously, it might have COD income, but Congress planned for that. To the extent it exceeds 5 percent of the REIT’s taxable income, COD income is excess noncash income, a term of art in the REIT world (section 857(e)(2)(D)). Excess noncash income is a mixed blessing. A REIT is not required to distribute excess noncash income, but it must pay corporate income tax on any amounts it doesn’t choose to distribute (section 857(e)(1)).

Authority?

Where’s the legal authority for all this creditor relief? Well, er, um, where was the legal authority for some of the tax relief granted to financial intermediaries in the 2008 financial meltdown? There are no atheists in foxholes, and no legal fussbudgets in financial crises.

Congress created special vehicles for real estate investments. These vehicles have highly specific qualification rules but grant very generous tax benefits, notably no entity-level taxation and no recognition of built-in gain on contribution of assets. Does the tax administrator have authority to go around these rules in a short-term financial crisis?

Why didn’t the IRS instead issue a notice and promise to rewrite its own regulations to handle the surprises of this and future financial crises? The REMIC improper knowledge standard is a function of regulations. The statute merely limits the permitted category called foreclosure property. Moreover, Congress is in a forgiving mood and could be persuaded to make statutory fixes on the next round of relief.

The answer is that it’s easier and quicker to redo older guidance. Rev. Proc. 2020-26 is a reworking of guidance issued in the wake of the 2008 meltdown. And back then, the IRS dodged the section 1001 question of the changes to mortgages — in that case, the release of a lien on collateral.

The IRS permitted a REMIC to continue to treat a mortgage as qualified following the release of a lien on real property securing the loan (section 860G(a)(3)(A) and reg. section 1.860G-2(a)(8)). Technically a qualified mortgage must be principally secured by real estate, that is, collateral must be worth 80 percent of loan value (reg. section 1.860G-2(b)(7)). For the loan to continue to be treated as qualified, the lien release had to occur by operation of the mortgage terms or be proportionate to a qualified pay-down of the mortgage (Rev. Proc. 2010-30, 2010-36 IRB 316).

In the REIT area, previous guidance indicates that a retread will be coming. Rev. Proc. 2008-68 was preceded by a bunch of letter rulings permitting in-kind dividends. The IRS ruled that there was a dividend, provided it was backed by E&P, and that it qualified for the dividends paid deduction (section 857). But the IRS expressed no opinion on the qualification of the payer as a REIT (LTR 200122001). Later rulings only promised dividend treatment and included caveats about REIT qualification (LTR 200832009, LTR 200817031, and LTR 200615024). So Rev. Proc. 2008-68 could be viewed as a generally applicable reaffirmation of rulings some REITs were already getting.

Revenue procedures are declarations of how the IRS will administer the law, even if the result contravenes it. They do not state the IRS legal position on the issue and do not commit the tax administrator to a particular reading of the law. Rather, revenue procedures are aimed at simplifying tax administration and ensuring uniform application of the law. Revenue procedures are substantial authority, and taxpayers are entitled to rely on them. But they are not entitled to deference in court (Rauenhorst v. Commissioner, 119 T.C. 157 (2002)). IRS litigators are bound to follow published guidance (CC-2002-043).

But in giving relief to REMICs and possibly also REITs, the IRS may be contravening the Internal Revenue Manual, which states, “In certain cases a revenue procedure can provide a holding on substantive tax issues where it sets forth safe harbors, guidelines, or conditions. . . . These situations should be rare” (IRM section 32.2.2.4 (Aug. 11, 2004)). Readers, financial meltdowns occur with some regularity, as JPMorgan Chase CEO Jamie Dimon pointed out to Congress during the last one.

The manual cites as an example of good practice a revenue procedure that was well within the statute being applied and merely simplified its application (Rev. Proc. 97-13, 1997-1 C.B. 632). It outlined examples of management contracts with private service providers that did not create private businesses for purposes of the private activity bond private business use rules (sections 103, 141, 145). It permits managers to be compensated on the basis of gross revenues and allows productivity awards. Private activity bonds are a constitutionally sensitive area of the law, so the IRS is perhaps justified in making indulgent readings of the law.

It’s possible that the IRS doesn’t see tweaks to arcane REMIC and REIT rules as too substantive. Overarching the problem of loans going bad in these vehicles is the section 1001 issue. The Cottage Savings regulations are completely artificial. They’re effectively a giant revenue procedure that the IRS used to partially reverse a politically motivated Supreme Court decision that a pin dropping is a recognition event. Thus the IRS could change those rules to say that COVID-19 forbearance and subsequent payment deferrals are not recognition events.

There’s precedent for crisis-inspired divergence from clear statutes. During the 2008 meltdown, the IRS issued guidance that was directly contrary to section 382 to enable banks and government-backed mortgage purchasers to use net operating losses that would otherwise be unavailable. Fannie and Freddie incurred an ownership change when the government took them over, but their loss carryovers were valuable assets that the government wanted to preserve (reg. section 1.382-2(a)(4)). So the IRS said that there should be no ownership change by preventing any testing date from occurring on or after the date the government took over the corporations (Notice 2008-76, 2008-39 IRB 768).

The IRS also liberalized and enabled the use of built-in asset losses by acquired banks. The IRS said any deduction properly allowed after an ownership change shall not be treated as a built-in loss (section 382(g), (h)). Hence current deductions for built-in losses on bad debts were allowed in excess of the section 382 limits. Moreover, the notice allowed the preservation of the acquired bank’s built-in losses as deferred tax assets (Notice 2008-83, 2008-42 IRB 905). And if Treasury purchased equity in a bank, that purchase was not treated as contributing to an ownership change (Notice 2008-100, 2008-44 IRB 1081).

Well, gee, where was the authority for these extravagant moves? Congress was considering the first bank bailout bill when the notices were issued, and was not given a heads-up beforehand. The Senate Finance Committee ranking member read about the notices in the news media. In contrast, REIT and REMIC guidance will be absorbed by the specialist financial communities that use these vehicles and is unlikely to be noticed by general interest press.

Obscurity doesn’t make overstepping legal authority harmless. “These revenue procedures, notices, and other guidance most likely lack authority, but given the taxpayer-favorable outcome, who will challenge them?” Monte A. Jackel of Jackel Tax Law asked rhetorically.

“As results-oriented guidance, they cannot be used against the government or for the taxpayer in other contexts and so, as they say inside the government, what’s the harm?” Jackel continued. “The tax purist would say that guidance such as this harms the tax system, but the tax realist would say the ends justify the means. This is not the first time guidance such as this has been issued, and it is not the last time either.”

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