IRS modifies guidance on distressed debt held by REITs.

• Author: Ray, Richard
• Position: Real estate investment trusts

PREVIEW

* As discussed in this article, the IRS revised the safe harbor it introduced in Rev. Proc. 2011-16 for distressed debt held by REITs, to address situations in which the real property securing the debt increases in value.

* The revisions will prevent the anomalous result under the safe harbor of an increase in the value of the real property securing the debt from causing a decrease in the value of the real estate assets taken into account in the Sec. 856(c)(4) 75% asset test for REITs.

* However, the revisions do not correct a similar problem caused by the interest income allocation method required under the Rev. Proc. 201116 safe-harbor rules for purposes of the Sec. 856(c)(3) 75%-of-gross-income test for REITs.

Recently, the IRS issued Rev. Proc. 2014-51, which provides a welcome change to the treatment of distressed mortgage debt held by real estate investment trusts (REITs) from the guidance issued under Rev. Proc. 2011-16. The earlier guidance specifically addressed distressed mortgage debt secured by both real and personal property that declined in value after the mortgages were originated or the property was purchased, but it failed to address distressed mortgages secured by property that increased in value after the mortgage was purchased. As a result of this failure, Rev. Proc. 2011-16 produced unfavorable results for distressed mortgages where the value of the property securing the mortgages increased in value. Specifically, as discussed in more detail below, because the rules in Rev. Proc. 2011-16 did not take into account the increase in the value of the underlying property, the value of a distressed mortgage taken into account as a real estate asset in the Sec. 856(c)(4) asset test decreased as the value of the underlying property increased.

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%...