On August 22, 2014, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2014-51, 2014-37 I.R.B. (the “New Guidance”), which provides helpful guidance to real estate investment trusts (“REITs”) that own distressed mortgage loans. The New Guidance modifies guidance the IRS had previously provided in Revenue Procedure 2011-16, 2011-5 I.R.B. The New Guidance is effective for all open tax years, and therefore has, as a taxpayer-friendly modification, retroactive effect.
To qualify as a REIT, an entity must meet, inter alia, three tests relating to the income it earns and the assets it owns. First, at least 95 percent of a REIT’s annual gross income must be derived from certain specified sources, generally including interest income from any source (the “95% Income Test”).1 Second, at least 75 percent of a REIT’s annual gross income must be derived from a narrower group of sources than permitted for purposes of the 95% Income Test (the “75% Income Test”).2 Specifically, only interest earned from obligations secured by mortgages on real property or on interests in real property qualifies as interest income for purposes of the 75% Income Test (“Qualifying Interest”).3 Third, at the close of each quarter, at least 75 percent of the value of a REIT’s total assets must be comprised of real estate assets, cash and cash items and Government securities (the “75% Asset Test”).4
For purposes of the 75% Income Test, if an obligation is secured by both real and personal property, the interest earned with respect to such obligation must be apportioned between Qualifying Interest and interest from an obligation that is not secured by real property (“Non-Qualifying Interest”), based on the ratio of the “loan value of the real property” to the “amount of the loan.”5 The loan value of the real property is generally the fair market value of the property, determined as of the date on which the commitment to make or purchase the loan becomes binding, and the “amount of the loan” is the highest principal amount of the loan outstanding during the taxable year.6 If the loan value of the real property securing the obligation equals or exceeds the amount of the loan, all of the interest is Qualifying Interest. If the amount of the loan exceeds the loan value of the real property securing the loan, the amount of Qualifying Interest7 is equal to the interest earned on the obligation multiplied by a fraction, the numerator of which is the loan value of the real property securing the loan and the denominator of which is the amount of the loan.8 The excess interest earned is Non-Qualifying Interest. If the value of the real estate securing the mortgage loan fluctuates during the term of the mortgage loan, the calculation of Qualifying Interest is not affected unless the rules regarding “loan modifications,” described below, apply.
Certain “significant” modifications of debt, including mortgage loans, are considered taxable exchanges of the “old,” unmodified debt for “new,” modified debt.” If there is a deemed exchange of a mortgage loan held by a REIT and it is treated as a new commitment to make or purchase a loan, then the loan value of the real property securing the loan would be redetermined as of the exchange date, and the REIT would be required to recalculate the amount of Qualifying Interest earned on the loan. If the real property value on the modification date is significantly less than the real property value on the original commitment date, the amount of Qualifying Interest after the modification could be significantly less than the pre-modification amount. Furthermore, any gain required to be recognized for tax purposes on the deemed exchange of old debt for new debt may be income from a prohibited transaction and subject to a 100 percent tax.9
Revenue Procedure 2011-16
Revenue Procedure 2011-16 provides a safe harbor for modifications of distressed mortgage loans held by REITs. To qualify for the safe harbor, the modification: (1) must be occasioned by a default or (2) based on all of the facts and circumstances, the REIT or loan servicer must reasonably believe that (a) there is a significant risk of default on the loan and (b) the modified loan, as compared to the unmodified loan, presents a substantially reduced risk of default.10
If the requirements of the safe harbor are met: (1) for purposes of determining the real property loan value, the REIT is not treated as having made a new commitment to make or purchase a loan as of the debt modification date, (2) the REIT is not treated as engaging in a prohibited transaction, and (3) for purposes of the 75% Asset Test, the IRS will not challenge a REIT’s determination of the amount of the loan that is a “real estate asset” for purposes of the 75% Asset Test if that amount is equal to the lesser of (a) the value of the loan and (b) the loan value of the real property securing the loan (determined as of the binding commitment date).11
The Revenue Procedure provided two examples illustrating the safe harbor. In the first example, X, a REIT, made a $100 mortgage loan to A in 2007. The loan was secured by both personal property and real property that had a value at that time of $115. At the end of the quarter in which the loan was made, the value of the loan was $100. At all times through the end of 2010, the amount of the loan was $100. Throughout 2009 and 2010, the fair market value of the real property was $55 and the personal property was $5, and the value of the loan was $60. In 2009, the loan was “significantly” modified in a manner that qualified for the safe harbor.
Because the loan value of the real property securing the loan before the modification ($115) exceeded the amount of the loan ($100), 100 percent of the interest earned before the modification is Qualifying Interest. Because the modification meets the safe harbor requirements, X is permitted to treat the loan value of the real property as $115 after the modification. Accordingly, all of the interest from the modified loan continues to be Qualifying Interest.
For purposes of the 75% Asset Test, at the end of the calendar quarter in 2007 in which X made the loan, it is permitted to treat $100 (the lesser of the value of the loan or the loan value of the real property) as the amount of the loan that is a good real estate asset. At the end of the quarter in 2009 in which X modified the mortgage loan, X is required to treat $60 as the amount of the loan that is a qualifying real estate asset for purposes of the 75% Asset Test (even though X’s original investment was $100).
In the second example, all of the facts are the same as the first example except that during the first quarter of 2010, Y, a REIT, committed to purchase, and did purchase, the $100 distressed mortgage loan from X for $60. Because the loan value of the real property, at the time the commitment to purchase the loan became binding, was $55 and the amount of the loan was $100 (and not $60), Y is only permitted to treat 55% ($55/$100) of the interest earned as Qualifying Interest (as opposed to 91.67% ($55/$60)). For purposes of the 75% Asset Test, Y is required to treat the lesser of the value of the loan ($60) or the loan value of the real property securing the loan ($55) as a good real estate asset (i.e., $55). Because the loan value of the real property is determined at the time the commitment to make or purchase the loan became binding, the loan value of the real property remains fixed for purposes of the 75% Asset Test calculation.
Revenue Procedure 2014-51
Revenue Procedure 2014-51 was issued in response to concerns raised by commentators that the situation in example two (described above) could cause the portion of the acquired distressed mortgage loan that is treated as a real estate asset for purposes of the 75% Asset Test to actually decrease in situations where the value of the real property later increases. Revenue Procedure 2014-51 does not change the requirements of the debt modification safe harbor described in Revenue Procedure 2011-16, or the result that if the safe harbor is met, a REIT is not required to revalue the real property on the modification date or treat the modification as a prohibited transaction. For purposes of the 75% Asset Test, however, if a loan secured by a mortgage on real property is modified and that modification meets the requirements of the safe harbor, the REIT is permitted to treat the loan as a good real estate asset in an amount equal to the lesser of: (1) the value of the loan or (2) the greater of (a) the current value of the real property securing the loan or (b) the loan value of the real property securing the loan.
The New Guidance describes three examples illustrating the revised safe harbor. The first two examples describe the same facts and conclusions as the two examples in Revenue Procedure 2011-16. In the new third example, Z, a REIT, purchased a distressed mortgage loan with a face amount of $100 for $60 on January 1, 2011. During all of 2011, the amount of the loan was $100. On the day Z committed to buy the loan, the value of the real property and personal property securing the loan was $55 and $5, respectively. At the end of the first calendar quarter of 2011, the value of the real property securing the loan remained $55 and the value of the loan was $60. Therefore, at the end of the first quarter, Z may treat $55 of the loan as a good real estate asset for purposes of the 75% Asset Test, because it is the lesser of (1) the value of the loan ($60) or (2) the greater of (a) the current value of the real property securing the loan ($55) and (b) the loan value of the real property securing the loan ($55). At the end of the second quarter of 2011, the value of the real property securing the loan increased to $65 and the value of the loan increased to $70. Thus, for purposes of the 75% Asset Test, Z may treat $65 of the loan as a real estate asset, because it is the lesser of (1) the value of the loan ($70) or (2) the greater of (a) the current value of the real property securing the loan ($65) and (b) the loan value of the real property securing the loan ($55).
We have the following initial observations:
- Revenue Procedure 2014-51 is generally REIT-friendly with respect to the 75% Asset Test. If the IRS had not modified the 75% Asset Test, the portion of a loan that could be treated as a real estate asset for purposes of the 75% Asset Test would decrease if the value of the loan subsequently increased, even if that increase was caused solely by an increase in the value of the real property securing such loan. Revenue Procedure 2014-51 avoids this incorrect result by allowing the amount of the loan treated as a real estate asset to increase when the value of the real estate securing the loan increases.
- Under example 2 of both revenue procedures, only 55% of the interest income is Qualifying Interest. This result has been criticized by commentators, as 91.67% (i.e., $55/$60) of the loan value is secured by real property. Furthermore, commentators noted that a REIT that purchases a loan with market discount is generally required to treat the market discount as interest, and not as principal, for all federal income tax purposes (including the REIT rules). The market discount rules were enacted after the enactment of the relevant REIT regulations interpreted in Revenue Procedure 2011-16 and the New Guidance and, therefore, the market discount rules should, under the “later in time” rule, supersede any conflicting prior rules. Accordingly, commentators argued that market discount should not be included as “principal” for purposes of determining the amount of the loan under the REIT rules. If market discount was instead treated as interest for purposes of calculating the amount of the loan, the loan amount in example two would be $60 and, pursuant to the interest apportionment regulation, 91.67% of the interest income would be Qualifying Interest. Despite significant criticism, the IRS did not change the conclusions reached in example two of Revenue Procedure 2011-16 when it issued Revenue Procedure 2014-51. REITs that own distressed debt are encouraged to consider the applicability and effect of the interest apportionment regulation on their REIT qualification testing, if they have not previously done so.
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1References to the “Code” or to “Sections” herein are to the Internal Revenue Code of 1986, as amended, or the Treasury Regulations promulgated or proposed thereunder.
2Section 856(c)(3). Treasury Regulation Section 1.856-5(a) defines interest for purposes of the 95% and 75% Income Tests as “compensation for the use or forbearance of money.”
5Treas. Reg. § 1.856-5(c)(1).
6Treas. Reg. § 1.856-5(c)(2), (3).
7Treas. Reg. § 1.856-5(c)(1)(i).
8Treas. Reg. § 1.856-5(c)(1)(ii).
10“Reasonable belief” must be based on “diligent contemporaneous determination of that risk.”
11The “value” of the loan is determined under Treasury Regulation Section 1.856-3(a) and means: (1) with respect to securities for which market quotations are readily available, the market value of such securities or (2) with respect to securities and assets not described in (1), the fair value of the securities and assets as determined by the trustees of the REIT in good faith.
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