IRS issues guidance on distressed mortgage loans held by REITs
TAX ALERT |
On Aug. 22, 2014, the IRS issued Rev. Proc. 2014-51, which modifies and supersedes Rev. Proc. 2011-16 with respect to the qualification of entities as real estate investment trusts (REITs). Specifically, Rev. Proc. 2014-51 addresses situations where a REIT acquires debt secured by real estate with a decreased fair market value (e.g., a distressed mortgage) and the implications related to the REIT asset test. The revenue procedure modifies two existing examples and adds a third for further clarification. Rev. Proc. 2014-51 is effective for all open tax years.
REITs are taxed as corporations, yet escape the double taxation of corporations through a dividends-paid deduction. However, REIT tax compliance is highly complicated and designed to ensure that REITs are only investing in real estate. As such, a REIT must pass many tests in order to maintain its tax-advantaged REIT status. Under one specific test, at the close of each quarter, 75 percent of the REIT's asset value must be comprised of real estate assets, cash, certain cash equivalents, and government securities (the asset test). Similarly, the REIT also must earn 75 percent of its gross income from rents from real property, gain from the sale of real property, interest on obligations secured by real property, and other real estate related income (the 75 percent income test). While Rev. Proc. 2014-51 comes as welcome guidance to REITs for asset test purposes, it fails to address the implications of distressed mortgage investments under the REIT 75 percent income test rules.
The modified and superseded revenue procedure, Rev. Proc. 2011-16, provided a safe harbor for REITs wishing to invest in mortgages secured by real property. This safe harbor, in effect, allowed these loans to qualify as real estate assets for purposes of the asset test. The safe harbor protected REITs from failing the asset test if the underlying value of the real property declined after the mortgage was originated or purchased. However, the safe harbor produced undesirable results if the value of the real property increased after the loan origination or acquisition.
Under this old safe harbor, the amount of the loan that could be treated as a real estate asset for purposes of the asset test was the lesser of:
- The value of the loan (if publicly traded, the "value" was the market value; if privately held, the value was the fair market value as determined in good faith by the REIT trustees); or
- The loan value of real property (the fair market value of the underlying property on the date at which the commitment to purchase the loan was binding.)
The lesser of the two amounts above was the numerator for purposes of determining the asset test. The denominator was the value of the REIT's total assets. Therefore, in a situation where a REIT purchased a distressed loan and, over time, the underlying real property increased in value, the numerator of the asset test was the loan value of real property at the time of the purchase (using the formula, this would be less than the value of the loan), while the denominator increased, resulting in a distorted and unfavorable asset test result. Essentially, the portion of the loan treated as a real estate asset decreased as the value of the underlying real property securing the loan increased.
To address this anomaly, Rev. Proc. 2014-51 modifies the safe harbor to include a revised calculation method. As revised, the amount of the loan treated as a real estate asset for purposes of the asset test is the lesser of:
- The value of the loan (this remains the same as the old safe harbor); or
- The greater of:
- The current value of the real property securing the loan (a new addition to the calculation); or
- The loan value of real property (the fair market value of the underlying property on the date at which the commitment to purchase the loan is binding – no change from the old safe harbor.)
By modifying the calculation to include the current value of real property securing the loan, the IRS effectively addressed the asset test issue.
There was no change to the income test calculation under Reg. section 1.856-5(c)(1)(ii), which requires that interest income be apportioned to real property based on the loan value of the real property as compared to the amount of the loan.
Loan modification safe harbor
The REIT laws and regulations attempt to prevent REITs from being dealers in real property by imposing a 100 percent tax on defined prohibited transactions. Rev. Proc. 2014-51 provides the same safe harbor as the one found in Rev. Proc. 2011-16 for prohibited transactions related to loan modifications. For purposes of ascertaining the loan value of the real property securing the loan, a REIT may treat a modification as not being a new commitment to make or purchase a loan, and the modification of the mortgage loan is not treated as a prohibited transaction if:
- The modification was occasioned by default; or
- The modification satisfies the following two conditions:
- Based on all facts and circumstances, the REIT reasonably believes that there is a significant risk of default of the pre-modified loan upon maturity or at an earlier date.
- Based on all facts and circumstances, the REIT reasonably believes that the modified loan presents a substantially reduced risk of default, as compared with the pre-modified loan.
This benefits REITs with respect to the asset and income tests because the loan value of real property when a REIT originally purchased or originated the loan will not decrease even if the value of real property decreases at the time of the loan modification.
The revised distressed mortgage asset test calculation in Rev. Proc. 2014-51 serves as welcome clarifying guidance for REITs that have invested in distressed debt obligations. While the IRS resolved certain asset test issues that could arise, it failed to address the related 75 percent income test issues. Though the Treasury has listed income test treatment as an item in the 2014-2015 priority guidance plan, until the new guidance is issued, taxpayers must rely on existing law for the definition of qualifying income for REIT 75 percent income test purposes. Taxpayers should contact their tax advisors to discuss the implications of Rev. Proc. 2014-51 for asset test purposes and the definition of income from obligations secured by real property for the REIT 75 percent income test.