Compendium Memorandum 2011-01: Rev. Proc. 2011-16

Compendium References:
2.02a Interest - Obligations Secured by Mortgage or Interest in Real Property - 75% Test Interest
4.01 Asset Tests - 75% Test
4.02 Asset Tests - 10% Test
7.04 Prohibited Transactions - Defined & Tax Consequences

In response to NAREIT's August 2009 request for guidance, in Rev. Proc. 2011-16, the IRS provides a safe harbor applicable to modifications of existing mortgage loans and acquisitions of new mortgage loans in which the value of the real property securing the debt is less than the principal amount of the loan, which otherwise could create possible REIT asset or income test disqualification issues. The safe harbor is particularly helpful in connection with the modification of existing loans and satisfaction of the REIT gross income tests. As further described below, while the Revenue Procedure is somewhat helpful with respect to asset test issues in connection with both modifications of existing and acquisitions of new mortgage loans, it was not responsive with respect to the income test in connection with acquisitions of distressed debt. Further, the Revenue Procedure also leaves some unanswered questions. Nevertheless, NAREIT appreciates the IRS' efforts to address the REIT industry's concerns.

After NAREIT's Distressed Debt Task Force analyzes this guidance in more detail, NAREIT may evaluate taking appropriate action to clarify this guidance further.

BACKGROUND

Among other things, the REIT rules require that at least 75% of a REIT's annual income consist of "real estate related income," including interest on obligations secured by mortgages on real property or interests in real property. When a loan is secured by both real and other property, Treas. Reg. § 1.856-5(c) generally requires an apportionment to determine the portion of the interest income on the mortgage loan that will be treated as qualifying income for purposes of the 75% gross income test applicable to REITs. To the extent that the "loan value of the real property" securing the loan exceeds the "amount of the loan," all of the interest income on the loan will be treated as qualifying income. To the extent that the "amount of the loan" exceeds the "loan value of the real property," a portion of the interest income will be treated as non-qualifying. The "loan value of the real property" is generally the value of the real property securing the loan on the date the REIT committed to originate or acquire the mortgage loan. The "amount of the loan" is generally the highest principal amount of the loan during the applicable year. There is no regulatory guidance concerning application of the asset test to such a loan; however, PLR 199923006 provided that the apportionment method in Treas. Reg. §1.856-5(c) was a reasonable method to determine the value of such a loan.

Because of asset and income test qualification issues raised by the application of Treas. Reg. § 1.856-5(c) and the apportionment methodology in PLR 199923006 to modifications of existing mortgage loans and/or acquisitions of new mortgage loans when the fair market value property securing the loan is below the loan's outstanding principal amount, NAREIT's August 2009 submission requested the following with respect to the income and asset tests:

1) For modified mortgage loans, guidance that the "loan value of the real property" does not change following a deemed exchange under Treas. Reg. § 1.1001-3 when the loan was in default or default was reasonably foreseeable and

2) For newly acquired distressed mortgage loans, guidance that the "amount of the loan" under Treas. Reg. § 1.856-5(c) is the REIT's highest adjusted tax basis in the mortgage loan during the taxable year.

PROCEDURE

Effective for all calendar quarters and taxable years, Rev. Proc. 2011-16 provides a safe harbor with respect to both the income and asset tests concerning modifications of existing mortgage loans and acquisitions of distressed mortgage loans.

Income Test and Prohibited Transactions

Under a helpful safe harbor provided in Rev. Proc. 2011-16, if a REIT effects a "significant modification" of an existing mortgage loan, for purposes of ascertaining under Treas. Reg. § 1.856-5(c)(2), the "loan value of the real property" securing that loan, 1) the REIT may treat that modification as not being a new commitment to make or purchase a loan; and, 2) the modification will not be treated as a prohibited transaction so long as: A) the modification is occasioned by the borrower's default; or, B) both of the following are true:

1) Based on all the facts and circumstances, the REIT or servicer of the loan (the pre-modified loan) 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. This reasonable belief must be based on a diligent contemporaneous determination of that risk, which may take into account credible written factual representations made by the issuer of the loan if the REIT or servicer neither knows nor has reason to know that such representations are false; and,

2) Based on all the facts and circumstances, the REIT or servicer reasonably believes that the modified loan presents a substantially reduced risk of default, as compared with the pre-modified loan.


Asset Tests

Under Rev. Proc. 2011-16, the Service "will not challenge" a REIT's treatment of a loan as being in part a "real estate asset" for purposes of section 856(c)(4) if the REIT treats the loan as being a real estate asset in an amount equal to the lesser of:

1) The value of the loan as determined under § 1.856-3(a), or

2) The loan value of the real property securing the loan as determined under § 1.856–5(c) and this revenue procedure.

Note that NAREIT's August 2009 submission requested that, with respect to modifications of existing mortgage loans, the "loan value of real property" should not change upon a deemed modification under Treas. Reg. § 1.1001-3; in other words, a modification of an existing loan that, when originated,was fully secured by real property would continue to be considered entirely a real estate asset. With respect to acquisitions of new mortgage loans, NAREIT had assumed that the IRS would apply Treas. Reg. §1.856-5(c), and requested that the "amount of the loan" be considered to be the REIT's highest adjusted tax basis in the loan during the year. If so, assuming the value of the real property securing the loan equals or exceeds the amount paid the REIT, no apportionment would be required.

APPLICATION

Application of Rev. Proc. 2011-16 to Modifications of Existing Mortgage Loans

Income Tests

Absent the Rev. Proc. 2011-16 safe harbor, a modification of an existing loan in which the fair market value of the real property securing the loan has fallen below the loan's outstanding principal amount could be viewed as causing a debt-for-debt exchange under Treas. Reg. § 1.1001-3(c). If so, even if all of the interest on such a loan had previously constituted qualifying 75% real estate income, a portion of the interest paid after the modification would not be considered 75% real estate income. The Revenue Procedure's safe harbor allows all of such a loan's interest to remain qualifying real estate income because it does not treat the modifications as a debt-for-debt exchange (provided the terms of the Revenue Procedure are satisfied).

Asset Tests

Absent the Rev. Proc. 2011-16 safe harbor, the exact application of the asset test to modification of an existing mortgage loan (fully treated as a real estate asset when made) was unclear. Although PLR 199923006 indicated that the apportionment method in Treas. Reg. § 1.856-5(c) was a reasonable method for determining the value of the modified loan for purposes of the asset test, applying this methodology could cause a significant portion of the modified loan to be a non-qualifying real estate asset. If the loan is considered a "security" that is not "straight debt", this treatment could cause the REIT to fail the 10% value test of § 856(c)(4)(B)(iii)(III) (10% Value Test).

Because Treas. Reg. § 1.856-3(e) excludes from the term "securities" "real estate assets" as defined in § 856 and Treas. Reg.§ 1.856-3, any qualifying mortgage debt in the issuer held by the REIT would not be counted as part of the issuer's outstanding securities, thereby increasing the percentage of the issuer's outstanding securities the REIT may own by virtue of ownership of the issuer's non-secured debt.Cf. PLRs 200630010 (In a positive development for REITs that make loans to their taxable REIT subsidiaries (TRSs), the IRS holds that such loans, if secured by real estate, would be considered "real estate assets" and not "securities" for purposes of the rule in § 856(c)(4)(B)(ii) that a REIT cannot hold TRS "securities" amounting to more than 20% of its total assets) and 200936026 (although an issuer's debt secured by mortgages is not considered a "security", mortgage debt owned by non-REIT third parties are included in the calculation of an issuer's outstanding securities).

Although the safe harbor in Rev. Proc. 2011-16 likely results in a larger portion of the modified debt's being considered a qualifying real estate asset because it establishes a floor equal to the lesser of the fair market value of the loan or the fair market value of the real property securing the loan at the time the loan commitment is made, the safe harbor does not eliminate the 10% Value Test issue discussed above if the non-qualifying debt held by the REIT is not "straight debt" (or otherwise excluded from "securities" for purposes of the 10% Value Test). However, a similar result would obtain if the REIT in fact originated the loan that was secured by both real and other property.

Application of Rev. Proc. 2011-16 to Newly Acquired Distressed Debt

Unfortunately, Rev. Proc. 2011-16 does not provide the guidance NAREIT had requested with respect to newly acquired mortgage loans. Specifically, Rev. Proc. 2011-16 continues to require that the apportionment methodology of Treas. Reg. § 1.856-5(c) be applied to determine the proportion of qualifying real estate interest income is generated by such a loan. Rev. Proc. 2011-16 also provides that the same safe harbor described above can be used for purposes of calculating satisfaction of the REIT asset tests.

Income Tests

Under Rev. Proc. 2011-16, interest income with respect to newly acquired distressed debt will be considered qualifying real estate income based on the proportion that the fair market value of real property securing the loan determined on the date that the commitment to purchase the loan becomes binding bears to the outstanding principal amount of the loan.

In Example 2 of Rev. Proc. 2011-16, a REIT purchases a mortgage loan for $60 in 2010 at a time when the fair market value of the real property securing the loan is worth $55, the associated personal property securing the loan is worth $5, and the loan's principal amount is $100. Because the amount of the loan ($100) exceeds the loan value of the real property ($55), the interest income apportioned to the real property is an amount equal to the interest income multiplied by a fraction the numerator of which is the loan value of the real property ($55) and the denominator of which is the amount of the loan ($100). Therefore, 55% of the interest income from Y's loan is apportioned to the real property securing the loan.

Asset Tests

As in the case of modifications of existing loans, Rev. Proc. 2011-16 establishes a safe harbor that permits a REIT to consider a newly acquired loan as a real estate asset with a value equal to the lesser of the value of the loan or the loan value of the real property at the time the REIT's commitment to purchase becomes binding.

Using the facts of Example 2 of Rev. Proc. 2011-16, the REIT would apply the lesser of value of the loan ($60) or loan value of real property securing the loan ($55). As a result, Rev. Proc. 2011-16 would permit the REIT to treat the $60 asset as a real estate asset worth $55 and a non real estate asset worth $5. As noted above, if the loan is the issuer's only debt, this treatment still could cause difficulties satisfying the 10% Value Test. The discussion of Example 2 appears to indicate that the measurement date for the determining the loan value of the real property is at the end of the relevant calendar quarter (which in the Example is unchanged from the date of acquisition). However, the rules of the actual safe harbor in Section 4.02(2) reference "loan value as determined under Treas. Reg. § 1.856-5(c) and this revenue procedure," which would seem to indicate that the loan value is measured when the REIT's commitment to acquire the loan becomes binding. NAREIT may seek additional clarification in this area.

Register for REITWise 2011

REITWise 2011: NAREIT's Law, Accounting & Finance Conference® will be held March 23-25 at the San Francisco Marriott Marquis. REITWise brings together REIT executives and leading service providers that support their legal, financial and accounting needs. This year's meeting has 25 percent more CPE credits than last year's REITWise. Registration and updated information now available at the REITWise 2011 home page.

(Contact: Beth Aiken at baiken@nareit.com)

Contact

If you have any questions regarding this ruling, please contact Dara Bernstein at dbernstein@nareit.com.

Disclaimer

Private letter rulings should not be relied upon as general authority, but should only be used as guides to the IRS' thinking on the subjects covered.