The Home Affordable Mortgage Program and Related Tax Issues

The Home Affordable Mortgage Program (HAMP) is a government program designed to slow the increasing rate of mortgage foreclosures in the United States; the Treasury Department Oct. 9, 2009, announced that it had reached its goal of 500,000 trial mortgage modifications before November under HAMP. ¹Cheyenne Hopkins, “Loan-Mod Goal Met Early, Treasury Says,” American Banker (10/9/09).

As with any loan modification, there are tax issues that need to be considered when reviewing a loan modified pursuant to HAMP. In order to address these consequences, we must understand the types of modifications being made under HAMP.

For a mortgage to qualify for modification under HAMP, a homeowner must meet several requirements ²Department of the Treasury, Home Affordable Modification Program Guidelines (3/4/09), available at http://www.treas.gov/press/releases/reports/modification_program_guidelines.pdf.:

• First, the taxpayer must be the owner-occupant of a single–family, one- to four-unit property. ³The term “property” includes condominiums, cooperatives, and manufactured homes fixed to a foundation and treated as real property under state law.
• Second, the home must be a primary residence. ⁴This requirement will be verified using a tax return or a credit report and other documentation such as utility bills.
• Third, the home must not be investor-owned, vacant, or condemned.
• Fourth, the mortgage to be modified must be a first-lien mortgage and must have been originated on or before Jan. 1, 2009.
• Fifth, the mortgage to be modified must have an unpaid principal balance that is equal to or less than $729,750 for one-unit dwellings, $934,200 for two-unit dwellings, $1,129,250 for three-unit dwellings, and $1,403,400 for four-unit dwellings.
• Sixth, the mortgage payments, including taxes, insurance, and homeowner’s association dues, must be greater than 31 percent of the taxpayer’s monthly gross income, which is the amount before any payroll deductions and includes wages, commissions, tips, and other compensation such as Social Security payments and retirement funds.
• Finally, the taxpayer must have a mortgage payment that is not affordable because of a financial hardship that can be documented.

HAMP dictates the exact manner in which mortgage loans will be modified. Not all mortgage servicers are required to participate in HAMP; only those servicers that service loans owned or guaranteed by the Federal National Mortgage Association (Fannie Mae) or Federal Home Loan Mortgage Corporation (Freddie Mac) are required to participate in the program. ⁵Home Affordable Modification Program Guidelines, note 2, above. Other servicers may elect to participate to receive various incentives being offered by the federal government.

Specifically, servicers receive a $1,000 cash payment for each eligible loan that is modified, an additional $500 bonus for modifications made while the borrower is still current (or less than 30 days delinquent) on mortgage payments, and an annual $1,000 payment for each year (up to three) that the borrower remains in the program. ⁶Id.

HAMP requires lenders first to reduce the taxpayer’s monthly payments on mortgages to 38% of the taxpayer’s monthly gross income. ⁷Department of the Treasury, Making Home Affordable Updated Detailed Program Description (3/4/09), available at http://www.treas.gov/press/releases/reports/housing_fact_sheet.pdf. The program will then match, dollar for dollar, further reductions in monthly payments from 38% to 31% of the taxpayer’s monthly income. ⁸Id.

To reach this 31% affordability level, interest payments will first be reduced to a floor of 2%. ⁹Id. If this reduction in interest is not enough to reduce monthly payments to the 31% affordability level, lenders then have the option to increase the term of the loan or amortization period to 40 years, and, finally, the option to forbear principal, without interest, until the payment meets the 31 percent-of-income target. ¹⁰Id.

Once the payments are set, they will not change for a period of five years, after which the interest rate can be gradually increased by 1% per year to a maximum rate set at the time of the modification. ¹¹Id.

These modifications could have tax consequences under the loan modification rules of Regs. §1.1001-3. Specifically, if it is determined that there is a significant modification of a loan, the old, unmodified loan is treated as if exchanged for the new, modified loan, and gain or loss is recognized on the exchange.

Regs. §1.1001-3 contains the rules for determining whether there has been a modification of a debt instrument and whether the modification is significant. According to the regulations, there are a number of modifications that, if made pursuant to the debt instrument’s original terms, are not modifications. ¹²Regs. §1.1001-3(c)(1)(i). However, as the modifications to a loan under HAMP generally include changes in interest rate, principal amount, and payment schedule that are not being made pursuant to the debt instrument’s original terms, the changes to the terms of the loan will likely be “modifications” for purposes of Regs. §1.1001-3.

Generally, a modification is a significant modification “if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.” ¹³Regs. §1.1001-3(e)(1). In determining whether a modification is a significant modification for purposes of this general rule, all modifications to a debt instrument are considered collectively, such that a series of modifications can be a significant modification even though no individual modification in and of itself is a significant modification. ¹⁴Id.

In addition to the general rule above, the regulations provide five specific rules to determine if a modification is in fact significant. ¹⁵Regs. §1.1001-3(e)(1). If one of the five specific rules applies to the modification, then the general rule discussed above does not apply. These specific rules address, in part, changes in yield ¹⁶Regs. §1.1001-3(e)(2). and changes in the timing and amount of payments. ¹⁷Regs. §1.1001-3(e)(3).

A change in yield is not significant if it results in a change that is less than or equal to the greater of 25 basis points or 5% of the annual yield of the unmodified instrument. ¹⁸Regs. §1.1001-3(e)(2). The yield used to test whether a change in yield is significant is the annual yield of an instrument whose issue price is equal to the adjusted issue price on the original instrument—increased by any accrued but unpaid interest, decreased by any bond issuance premium not yet accounted for, and increased or decreased to reflect payments made between the issuer and holder as compensation for the modification—and whose payments are equal to the payments on the modified instrument following the modification. ¹⁹Regs. §1.1001-3(e)(2)(iii).

A change in the timing and amount of payments is significant if it materially defers scheduled payments due under a debt instrument. ²⁰Regs. §1.1001-3(e)(3). The regulations provide for a safe harbor period that is not a material deferral of scheduled payments if the deferred payments are unconditionally payable no later than the end of the safe harbor period. The safe harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50% of the term of the unmodified debt instrument. ²¹Regs. §1.1001-3(e)(3)(ii).

Consequences of HAMP to REMICs

Real estate mortgage investment conduits (REMICs) are securitization vehicles used to hold commercial or residential real estate mortgages. REMICs are governed by §§860A to 860G, under which an entity will not be subject to an entity-level tax if it qualifies as a REMIC for tax purposes.

To qualify as a REMIC, an entity must meet a number of requirements. One such requirement is expressed in §860D(a)(4), which states that an entity will qualify as a REMIC only if, as of the close of the third month beginning after the start-up day and at all times thereafter, substantially all of the REMIC’s assets are “qualified mortgages” and other permitted investments. A REMIC’s asset pool will meet the “substantially all” requirement if the aggregate of the adjusted bases of investments other than qualified mortgages and other permitted investments is less than 1 percent of the aggregate adjusted bases of all of the REMIC’s assets. ²²Regs. §1.860D-1(b)(3)(ii).

Under Regs. §1.860G-2(b)(1), if a mortgage loan held by a REMIC undergoes a significant modification (such as the type that may occur under HAMP), the REMIC is treated as obtaining a new mortgage loan in exchange for the unmodified mortgage loan. With limited exceptions, the rules under Regs. §1.1001-3(e) apply to determine whether a modification is significant. An exception exists for a change in terms “occasioned by default or a reasonably foreseeable default.” Under Regs. §1.860G-2(b)(3)(i), a change in terms under such circumstances will not be a significant modification.

Because a significant modification of a debt generally will result in the REMIC acquiring a new mortgage loan that for tax purposes will not be a “qualified mortgage” (because it was not acquired within the three-month period beginning after the start-up day) to the REMIC, the significant modification of one or more mortgages held by the REMIC may cause the REMIC to no longer meet the “substantially all” test, thus losing its qualification as a REMIC. To prevent this undesired result and to encourage REMICs to modify loans of troubled borrowers, the Internal Revenue Service has issued a series of revenue procedures pursuant to which, under certain circumstances, it will not challenge an entity’s qualification as a REMIC due to loan modifications resulting in the deemed acquisition of new loans.

Rev. Proc. 2009-23
²³2009-17 I.R.B. 884. provides that IRS will not challenge a REMIC’s entity classification, nor will IRS contend that the transactions are prohibited transactions under §860F(a)(2), because of the modification of residential mortgage loans under HAMP. The revenue procedure applies to loan modifications effected on or after March 4, 2009.

Another potential tax concern for REMICs that have loans modified through HAMP is the treatment of the government’s incentive payments to lenders. Section 860G(d)(1) generally imposes a 100% tax on contributions to a REMIC after the start-up day. Notice 2009-36 addresses the risk that the government’s payments to the REMIC as a lender could be subject to this tax. ²⁴2009-17 I.R.B. 883. Specifically, the notice states that if a payment is made to a REMIC under HAMP on or after March 4, 2009, that payment will not be subject to the 100% tax set forth in §860G(d)(1). The notice provides that regulations will be issued to this effect. ²⁵Id.

KPMG Observations

Holders and issuers of mortgages must determine, on a loan-by-loan basis, whether any modification made to a loan constitutes a significant modification. The reduction of the interest rate on a loan to 2%, so as to reduce monthly payments from 38% of gross income to 31% of gross income, may cause a significant modification of the debt. Further, changing the amortization of a loan to 40 years or changing the maturity of a loan to 40 years will likely be a significant modification.

If a modification to a debt instrument is significant, the modification results in a deemed exchange of the unmodified or old mortgage for a new mortgage. The borrower may realize cancellation of indebtedness income if the issue price of the new or modified debt instrument is less than the adjusted issue price of the unmodified debt instrument. ²⁶§108(e)(1), §1272(a)(4); Regs. §1.1275-1(b). See also
§6050P (requiring financial institutions to file a report with IRS regarding certain discharges of indebtedness). Borrowers may be eligible to exclude any cancellation of indebtedness income if the mortgage is qualified principal residence indebtedness. §108(a)(1)(E), (h). Conversely, the lender will recognize gain or loss if the lender’s basis in the old debt instrument does not equal the issue price of the new debt instrument.

The issue price of a mortgage modified under HAMP will likely be determined pursuant to §1274, which provides for the issue price of nonpublicly traded debt instruments issued for nonpublicly traded property. The issue price of debt instruments subject to §1274 is:

• the stated principal amount,
• the imputed principal amount if the debt does not have adequate stated interest, or
• the fair market value of the property received in a potentially abusive situation. ²⁷§1274(a), (b)(3).

If a loan is modified such that the interest rate is reduced to 2% or there is a forbearance of principal, it is likely that the issue price will be the imputed principal amount as determined under §1274. If this is the result, the lender will likely recognize gain or loss, and the difference between the stated principal amount and the imputed principal amount will be recognized over the life of the loan as original issue discount.