IRS Modifies Guidance on Distressed Debt Held by REITs

Rev. Proc. 2014-51 corrects this problem by modifying the rules from Rev. Proc. 2011-16 for determining the value of a distressed mortgage that the taxpayer can include as a real estate asset for purposes of the Sec. 856(c)(4) asset test. However, critics of the new revenue procedure argue that it does not go far enough because it fails to modify the interest allocation method required under Rev. Proc. 2011-16 for the 75%-of-gross-income test under Sec. 856(c)(3) to take into account changes in the value of the property securing a distressed mortgage, which leads to an excess amount of income being allocated to non-real estate assets in periods of declining real property values.

Background

Sec. 856 provides both organizational and operational requirements for REITs. Among the operational requirements are the income and asset tests that REITs must satisfy. The income requirement consists of two tests, the 75% and 95% tests, both designed to ensure a REIT derives gross income during the tax year primarily from passive real estate activities.

Under the 75% test of Sec. 856(c)(3), at least 75% of total gross income (excluding gross income from prohibited transactions) must be derived from the following sources:

1. Rents from real property;
2. Interest on real property mortgages;
3. Gain from the sale or other disposition of interests or mortgages on real property that is not property under Sec. 1221(a)(1);
4. Dividends and gains from the disposal of other qualified REITs;
5. Abatements and refunds of real property taxes;
6. Income and gains derived from foreclosure property;
7. Amounts received or accrued as consideration for entering loan agreements secured by mortgages on real property or on interests in real property or entering agreements to purchase or lease real property;
8. Gain from the sale or other disposition of a real estate asset that is not a prohibited transaction solely by reason of Sec. 857(b)(6); and
9. Qualified temporary investment income.

A prohibited transaction means a sale or other disposition of property that is inventory or held primarily for sale to customers in the ordinary course of a taxpayer's trade or business and is not foreclosure property (Sec. 857(b)(6)).

Under the 95% test of Sec. 856(c)(2), at least 95% of total gross income (excluding gross income from prohibited transactions) must be derived from the following sources:

1. Sources 1 and 5 through 8 from the 75% test;
2. Source 3 from the 75% test but expanded to include gains from the sale or disposition of stocks and securities;
3. Dividends and interest from any source (expanding sources 2 and 4 from the 75% test); and
4. Mineral royalty income from real property a timber REIT owns, earned during the REIT's first tax year beginning after May 22, 2008.

Sec. 856(c)(6) provides a safe harbor preventing revocation of REIT status if a REIT fails to pass either of the income tests for any tax year. The safe harbor requires disclosing the specific failures on a separate schedule the IRS prescribed; meeting the requirement that the failures were due to reasonable cause and not willful neglect; and paying the tax described in Sec. 857(b)(5).

In addition, under Sec. 856(c)(4), a REIT must satisfy the asset test, which requires a REIT, at the close of each quarter, to have at least 75% of the value of its total assets be real estate assets, cash and cash items (including receivables), and government securities.

The term "value" means readily available market quotations for securities and good-faith fair value estimates for securities without readily available market quotations, except for securities in other REITs in which the fair value cannot exceed the greater of market value or asset value (Sec. 856(c)(5)(A)). The term "real estate assets" means real property (including interests in real property and interests in mortgages on real property) and shares in other REITs (Sec. 856(c)(5)(B)).

A safe harbor is also available for failure to satisfy the asset test. Under Sec. 856(c)(7), meeting the safe harbor requires disclosing on a separate schedule the specific asset(s) causing the failure for each quarter; disposing of the asset(s) causing the failure within six months of the last day of the quarter in which the failure occurred, meeting the requirement that the failure was due to reasonable cause and not due to willful neglect, and paying the tax described in Sec. 856(c)(7)(C).

Rev. Proc. 2011-16

The IRS issued Rev. Proc. 2011-16, which addressed the decline in the value of a mortgage loan secured by real property held by a REIT and provided an important safe harbor. First, the safe harbor granted protection against modifications of mortgage loans. Because significant modifications to a loan are deemed to be an exchange of the original debt for new debt under Regs. Sec. 1.1001-3(b), a significant modification could trigger a prohibited transaction resulting in tax (Sec. 857(b)(6)). However, Rev. Proc. 2011-16 provides that with respect to a mortgage loan, (1) if a modification is occasioned by default; or (2) based on all the facts and circumstance, a REIT or loan service provider believes 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, then the REIT has not made a new commitment to make or purchase a loan, the modification of the mortgage loan is not a prohibited transaction, and the loan value of real property securing the loan does not change.

The safe harbor also protected REITs from failing the asset test if the underlying value of a mortgage declined after it was originated or purchased. Under the safe harbor, the IRS would not challenge a REIT's treatment of a loan as being a real estate asset for purposes of the asset test if the loan's value was the lesser of (1) the value of the loan as determined under Regs. Sec. 1.856-3(a); or (2) the loan value of the real property securing the loan, which is the value of the real property on the date the REIT commits to originate or purchase the loan (Regs. Sec. 1.856-5(c)(2)). Under this safe harbor, the lesser value addresses the numerator of the equation

Value of Real Estate Assets
Value of All Assets

of the 75% asset test; whereas the current value of real estate assets affects the denominator of the equation (Rev. Proc. 2014-51, §2.14). (The real estate assets include cash, cash items, and government securities.)

Rev. Proc. 2011-16 offers two examples illustrating the safe-harbor rules. In the first, X, a REIT, originates a $100 mortgage loan secured by both real property and personal property (a nonqualifying asset) to A in 2007. When X's commitment became binding on X, the real property had a fair market value (FMV) of $115. At the end of the quarter in which the loan was made, the value of the loan was $100 (loan amount) (Regs. Sec. 1.856-3(a)). At all times through the end of 2010, the loan amount remained at $100. However, throughout 2009 and 2010, the FMV of the real property declined to $55 and the fair value of the personal property was $5, making the value of the loan $60. During 2009, X and A made a qualifying safe-harbor modification to the loan agreement.

For the 75% income test, all the interest income from the mortgage loan is qualifying interest and apportioned to the real property because the fair value of the real property, $115, at the time of the commitment, exceeded the amount of the loan, $100 (Regs. Sec. 1.856-5(c)(1)(i)). In 2009, the subsequent modification of the loan will not change this apportionment because qualified modifications do not affect the loan value of the real property securing that loan.

For purposes of the asset test at the end of the quarter in 2007 when the mortgage loan was made, X is permitted to use $100 (the lesser of the value of the loan, $100, or the loan value of the real property securing the loan, $115, determined on X's commitment date) as a qualified real estate asset. Therefore, the percentage for the asset test would be 100% ($100 value of the loan ÷ $100 current loan value). In 2009, at the end of the quarter in which the modification was made, X is required to use $60 as the real estate asset value (the lesser of the value of the loan, $60, or the loan value of the real property securing the loan, which remains fixed at $115). The percentage remains at 100% ($60 value of the loan ÷ $60 current loan value).

In the second example, the same facts are assumed, except in the first quarter of 2010, Y, another REIT, committed to purchase the mortgage loan from X for $60. For purposes of the 75% income test, Y must apportion the interest income from the mortgage, in accordance with Regs. Sec. 1.856-5(c)(1)(ii), since the amount of the loan ($100) exceeds the value of the real property determined at the date of Y's commitment ($55). Therefore, Y must use the value of the real property of $55 as the numerator and the amount of the loan, $100, as the denominator and allocate only 55% of the mortgage interest income as qualifying income for the 75% income test. For purposes of the asset test, Y may use $55 as a real estate asset (the lesser of the value of the loan, $60, or the loan value of the real property securing the loan determined at Y's commitment date, $55), which yields 91.67% ($55 value of the real property determined at Y's commitment date ÷ $60 current loan value).

Rev. Proc. 2014-51

Rev. Proc. 2014-51, which modifies and supersedes Rev. Proc. 2011-16, addresses anomalous results that Rev. Proc. 2011-16 could produce if the value of the real property securing the mortgage loan increased. The new procedure does not change any of the loan modification rules of the earlier procedure, but it does change the safe harbor for the amount used for the real estate asset.

Rev. Proc. 2011-16 produces acceptable results as long as the current value of the real property decreases from the original value of the real property at the commitment date because property with a decreasing value will always be the lower of the two values under the safe-harbor rule. Both the numerator and denominator will then reflect a current decreased value of the property. However, if the real property increases in value above its original value at the commitment date, then the lower commitment date value will always be used as the numerator; whereas the denominator will reflect the current higher value, decreasing the percentage used for the asset test (Rev. Proc. 2014-51, §2.14).

Example: Z, a REIT, purchased for $60 a distressed mortgage with a principal amount of $100 on Jan. 1, 2011. During the 2011 tax year, the amount of the loan remained at $100. The value of the real property securing the loan on the date Z committed to purchase the loan was $55, and the value of the personal property was $5. At the end of the second quarter of 2011, the current value of the real property securing the loan increased to $75, while the value of the personal property remained at $5. Therefore, the value of the loan was $80.

Under the old rules, Z must treat the loan at $55 as the real estate asset at the end of the second quarter because it is the lesser of (1) the value of the loan, $80, or (2) the fixed loan value of the real property securing the loan, $55. Therefore, Z would include $55, the undervalued commitment date amount, as the numerator and $80 as the denominator, which is the estimated value of the loan. This produces 68.75% ($55 ÷ $80) for the asset test, assuming there are no other real estate assets, a result that did not sit well with many in the industry.

To fix this result, the IRS modified the rule. Under the new rule, the IRS would not challenge a REIT's treatment of a mortgage loan as being a real estate asset for purposes of the asset test if the loan's value was the lesser of (1) the value of the loan as determined under Regs. Sec. 1.856-3(a), 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, which, again, is the fair value of the real property securing the loan on the date the REIT commits to originate or purchase the loan.

Under this new rule, at the end of the second quarter, Z may treat $75 of the mortgage loan as a real estate asset because this amount is the lesser of (1) the value of the loan, $80, or (2) the greater of (a) the current value of the real property securing the loan, $75, or (b) the loan value of the real property securing the loan, $55 determined at the commitment date. Therefore, $75 goes into the numerator and $80 goes into the denominator for the 75% asset test. This produces 93.75% for the asset test.

Even though this new guidance addresses the issue of increased values post-commitment date, the issue of the income allocation for the 75% income test is still being criticized and needs to be addressed. As illustrated in the second example of Rev. Proc. 2011-16, Y must use 55% of the mortgage interest income as qualifying income for the 75% income test. Under Regs. Sec. 1.856-5(c)(1)(ii), if the amount of the loan, $100, exceeds the loan value of the real property, $55, then 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. The interest income apportioned to the personal property is an amount equal to the excess of the total interest income over the interest income apportioned to the real property, or 45%.

Many critics argue that the allocation percentage should be based on the underlying current value of the property securing the loan, which in this case was $55 for the real property and $5 for the personal property with a $60 loan value. Therefore, 91.67% ($55 ÷ $60) of the mortgage interest should be qualifying income for the 75% income test. Critics contend using the amount of the loan or $100 produces a constant or a slowly decreasing denominator when the numerator may decrease more rapidly because of the decreasing value of the real property securing the loan.

Conclusion

Rev. Proc. 2014-51 is a major step toward fixing one of the issues not resolved in Rev. Proc. 2011-16. The new guidance provides an acceptable treatment for distressed mortgages that increase in value after the commitment date that was not addressed in the old guidance. This new safe harbor allows the numerator of the asset test to increase when the value of the real property securing the debt increases. Under the old guidance, the numerator would have to remain fixed at the value of the real property securing the debt on the commitment date even if the current value of this real property increased above the commitment date value.

However, the IRS still has not modified its income allocation method described in Regs. Sec. 1.856-5(c)(1)(ii) for the 75% income test. Currently, the IRS prescribes using the loan value of the real property as the numerator and the loan amount as the denominator. In periods of declining real property values, the numerator could decrease at a quicker rate than the denominator, requiring more and more income to be allocated to the non-real estate assets. Even though Rev. Proc. 2014-51 failed to address this income allocation issue with distressed mortgages, the issue is listed on the Treasury's priority plan guidance for 2014–2015.

	Contributor
	Richard Ray is an assistant professor in the College of Business at California State University in Chico, Calif. For more information on this article, contact Prof. Ray at rwray@csuchico.edu.