Introduction

Due to the significant decline in value of real estate that was experienced as the recession deepened through 2008, 2009 and 2010, many real estate investment trusts (REITs) that held mortgages secured by real estate were faced with the prospect of failing to satisfy certain REIT qualification tests as they began exploring alternatives for restructuring such mortgages in an effort to rehabilitate the property and maximize their recoveries with respect to their investment. In addition, REITs considering making a possible investment in these depressed or troubled mortgage loans, either to hold for investment, or to acquire the underlying real estate, faced similar concerns. Further, there was uncertainty regarding the application of the “prohibited transaction” rules to restructurings and dispositions of such mortgage loans.

On January 1, 2011, the IRS issued Revenue Procedure 2011-161 in an effort to provide a measure of relief in complying with the REIT qualification tests to a REIT that holds and agrees to the modification of a troubled mortgage loan and, in some instances, to the acquisition of a troubled mortgage loan at a significant discount. While the relief is certainly welcome, not all actions that a REIT may take in connection with the acquisition and/or restructuring of a troubled mortgage loan will produce the desired results under the various income and asset tests applicable to a REIT. As such, prior to taking such actions, REITs and their tax advisers should take care to map out the various income tax consequences (including not only ongoing compliance with the REIT qualification tests, but also the implications under the 100-percent tax on prohibited transactions) of the acquisition and/or modification of a troubled mortgage loan.

The three principal REIT qualification tests that could impact a REIT that owns, acquires and/or restructures a troubled mortgage loan are the annual 75-Percent and 95-Percent Income Tests and the quarterly 75-Percent Asset Test.

The 75-Percent and 95-Percent Income Tests

At least 75 percent of a REIT’s annual gross income (not including gross income from prohibited transactions) must be derived from, among other specified sources (such as qualified rents from real property), interest on obligations secured by mortgages on real property and gain from the sale or other disposition of interests in mortgages on real property, which is not property described in Code Section 1221(a)(1).2 Prior to 1981, the interest income earned on all mortgage loans that were secured by both real and personal property was subject to apportionment and treated, in part, as interest income derived from a loan made with respect to real property and, in part, as interest income derived from a loan made with respect to personal property for purposes of the 75-Percent Income Test.3 The impact of this apportionment requirement was mitigated in 1981, when a regulation was issued requiring apportionment only in the case where the amount of the obligation exceeds the value of the underlying real property securing the mortgage loan.4 Once determined, the apportionment ratio for determining the amount of interest income that was qualifying gross income remained constant so long as the security for the loan was not modified.5

In the case of a loan secured by both real and personal property, the apportionment rules for determining the amount of interest income attributable to the real property generally worked to a REIT’s advantage in periods where real property values as a whole were rising or at least relatively stable. So long as the principal amount of the loan did not exceed the fair market value of the underlying real property at origination, purchase or at the time when the terms of the loan were substantially modified, 100 percent of the interest income from the loan was qualified income for purposes of the 75-Percent Income Test (and 95-Percent Income Test 6). For example, under these rules, if the principal amount of a mortgage loan was $200 and the fair market value of the real property securing the mortgage loan was $225 at the time the loan was originated, then all of the interest income realized with respect to the mortgage loan was attributed to the real property and none of the interest income was attributed to the personal property securing the mortgage loan.7 This mortgage loan’s initial apportionment ratio remained constant throughout the REIT’s holding period so long as the loan was not modified or restructured (which was seldom the case when the value of the underlying real estate was generally appreciating, and a relatively small percentage of loans became troubled). In addition,any gain from the disposition of such mortgage loan was (and still is) qualifying gross income for purposes of the 75-Percent Income Test (and 95-Percent Income Test). However, in periods of declining real estate values during which a much larger percentage of real estate mortgage loans are troubled and require restructuring, the amount of interest income derived by a REIT from a troubled mortgage loan (or gain from the disposition of such note that was previously acquired at a discount to face) that is qualified gross income for purposes of the 75-Percent Income Test can be substantially less than 100 percent after the application of the apportionment rules set forth above upon a restructuring of the terms of such loan. For example, if the principal amount of the mortgage loan is $200 and the fair market value of the real property securing the mortgage loan is $120 at the time the loan is acquired by the REIT,8 then only 60 percent of the interest income realized with respect to the mortgage loan is treated as qualified gross income for purposes of the 75-Percent Income Test.9

The IRS issued Revenue Procedure 2011-16 to provide relief under the income tests with respect to mortgage loans held by a REIT that are modified or restructured, or which are acquired at a discount by a REIT.10 However, the relief provided in the revenue procedure is basic and limited, leaving a number of situations possibly unanswered. Further, very little relief is provided to a REIT considering the purchase of a mortgage loan at a significant discount to face. In fact, a REIT considering an investment in a troubled mortgage loan may have difficulty meeting the 75-Percent Income Test unless the REIT intends to either negotiate a modification of the troubled mortgage loan or acquire the underlying real property through foreclosure shortly after acquiring such mortgage loan.

Application of the Relief Provided by Rev. Proc. 2011-16

Borrowing from guidance provided in the case of certain modifications of mortgage loans held by a real estate investment mortgage conduit (“REMIC”), the ability to take advantage of the relief provisions in Rev. Proc. 2011-16 in determining the amount of interest income from such a troubled loan for purposes of the 75-Percent and 95-Percent Income Tests requires that any modification of such a loan be either occasioned by (1) a default of the troubled loan or (2) a reasonably foreseeable default of the troubled loan, and the REIT or servicer reasonably believes that the modified loan presents a substantially reduced risk of default as compared to the pre-modified loan.11 If either condition is met, then the REIT will not be required to treat the modification of the troubled loan as being a commitment to make or purchase a "new" loan, which would require the re-determination of the underlying value of the real property securing the troubled loan under Treasury Regulation Section 1.856-5(c)(2), for purposes of determining the appropriate percentage of interest income realized from such loan that may be treated as interest income from a mortgage loan.12 Further, the modification of the troubled loan will not be treated as a prohibited transaction under Code Section 857(b)(6).13 Presumably, a REIT that acquires a troubled mortgage loan at a discount that is already in default can take advantage of the relief provided in Rev. Proc. 2011-16. As will be shown below, while the relief provisions may not help the REIT meet the 75-Percent Income Test, the relief in exempting any subsequent modification from prohibited transaction taxation may protect a REIT from taxation on a subsequent modification of a troubled mortgage loan that it acquired at a discount.

Rev. Proc. 2011-16 provides two examples to show how the relief provisions work.14 In the first example, REIT X made a $100 mortgage loan (secured by both real and personal property) in 2007 when the real property had a fair market value of $115. Thus, 100 percent of the interest income on the mortgage loan was considered to be qualified interest income for purposes of the 75-Percent Income Test under the apportionment rules. However, by the start of 2009, the loan was in default, the value of the real property had decreased to $55 and the personal property had a value of $5. REIT X and the borrower agreed to modification of the terms of the mortgage loan in 2009 that amounted to a significant modification of the mortgage loan under Treasury Regulation Section 1.1001-3. Since the loan was in default, the REIT could then choose to treat the modification of the mortgage loan as not being a commitment to make or purchase a new loan, and the fair market value of the modified mortgage loan for purposes of determining the portion of any interest income earned on the loan after modification could be determined as of the original commitment date of such mortgage loan.15 Accordingly, 100 percent of any interest income realized on the modified mortgage loan will be considered qualified mortgage interest for purposes of the 75-Percent Income Test going forward.

The second example borrows the facts from example 1 and provides further that REIT Y purchased the $100 mortgage loan from REIT X in 2010 for $60, the loan’s value. The example provides that, since REIT Y committed to purchase the modified mortgage loan at a time when the underlying value of the real estate was only $55 and the principal amount of the loan was still $100, the apportionment ratio under Treasury Regulation Section 1.856-5(c)(2) going forward that would be applied to any interest income realized on the mortgage loan by REIT Y that would be considered to be qualified mortgage interest for purposes of the 75-Percent Income Test would be only 55 percent. Despite the fact that the underlying real property represents more than 90 percent of the underlying value securing the mortgage loan, the IRS applied the long-standing regulation as written to determine the apportionment ratio, even though the personal property securing the loan clearly does not represent 45 percent of the value of the mortgage loan. The justification for the apportionment ratio established by the regulation presumably is that an under-collateralized mortgage loan is akin to making two loans, a fully-secured mortgage loan and an unsecured loan. However, at least in the current market, a property being under-collateralized does not necessarily equate to the source of the funds used to pay any principal and interest as being from a source other than (or mostly other than) real property. Nevertheless, given the deference generally accorded long-standing regulations, sustaining a challenge to such a regulation can be difficult.16 In any event, any REIT purchasing and holding a significant portfolio of mortgage loans hoping for above-market returns if the real estate market improves likely will have a difficult time satisfying the annual 75-Percent Income Test unless they can successfully challenge these apportionment rules.17

Although not answered in the revenue procedure, presumably, REIT Y could negotiate further modifications to the mortgage loan that would include a reduction in the principal amount of the loan due, which would improve the ratio of interest income considered to be qualified mortgage interest for purposes of the 75-Percent Income Test. Section 4.01(1) of the Revenue Procedure provides that a REIT may treat a modification of a mortgage loan as not being a new commitment to make or purchase a loan for purposes of ascertaining the loan value of the real property under Treasury Regulation Section §1.856-5(c). Thus, a modification that reduces the principal amount of a mortgage loan that was purchased by a REIT (similar to the facts in example 2) should increase the ratio of qualifying mortgage interest income for purposes of the 75-Percent Income Test.

Also unanswered in the revenue procedure is how to view various types of modifications that may be agreed to by the REIT and the borrower. For example, what if, under the facts in the revenue procedure, REIT Y and the borrower agree to further modify the mortgage loan by dividing the loan into two notes, both secured by the real and personal property, with the first note providing for amortization of principal and interest at a stated interest rate and having a stated principal amount of $60, and a second note, which is subordinated from a cash flow perspective to new, unsecured debt that is used to improve the property, that has a maximum principal amount, and payments of principal and interest that are contingent on cash flow and/or sale proceeds from the property? Can the approximately 91.3 percent (i.e., 55/60ths) of the interest income realized on the first note be treated as qualifying mortgage interest for purposes of the 75-Percent Income Test, or must the two notes be treated as a single combined note? If the two notes must be treated as a single note, can the contingent amount due under the second note be disregarded under the principles of Treasury Regulation Section 1.1275-4(c) until the principal payment becomes fixed or otherwise due? Obviously, there are any number of terms that can be agreed to by the parties that can impact the tax analysis, a detailed discussion of which is beyond the scope of this article. Given the complexity of terms that are accompanying the restructuring of troubled mortgage loans, it is doubtful that the relief provided in Rev. Proc. 2011-16 is of much help to a REIT in determining whether it is in compliance with the 75-Percent Income Test if it is engaging in the purchase of troubled mortgage loans and the restructuring and holding of such restructured mortgage debt for investment.

The 75-Percent Asset Test

In addition to the income tests, a REIT must have at least 75 percent of the value of its total assets invested in real estate assets, cash, cash items and government securities, measured as of the close of each quarter of its tax year.18 The term "real estate assets" includes an interest in a mortgage loan secured by real property.19 It has long been accepted that if the mortgage loan is secured by both real and personal property, only that portion of the loan secured by the real property is treated as a qualified real estate asset, even though the rules requiring apportionment can be found only in the Treasury Regulations addressing whether interest income on a mortgage loan is qualifying interest for purposes of the 75-Percent Income Test and are not included in the Treasury Regulations addressing qualified assets for purposes of the 75-Percent Asset Test.20 The determination of whether apportionment of a mortgage loan is required is made based on the relative fair market values of the real and personal property securing the loan at the time the commitment to make or purchase the loan is made by the REIT, the same basis used in apportioning for purposes of the income tests.21 As discussed previously, the impact of the apportionment requirement was mitigated in 1981 when a regulation was issued requiring apportionment only in the case when the amount of the obligation exceeds the value of the underlying real estate assets securing the mortgage loan.22

Again, as one might expect, the apportionment rules could be quite problematic in the case of a modification of a troubled real estate loan absent the relief provided in Rev. Proc. 2011-16. The mere change or decline in market value of real estate mortgage loans owned by a REIT due to such loans becoming "troubled" will not cause a violation of the 75-Percent Asset Test unless the REIT subsequently acquires securities or other nonqualifying assets.23 However, absent the relief in Rev. Proc. 2011-16, only a portion of a troubled real estate mortgage loan owned by a REIT that is substantially modified would be considered a qualified real estate asset for purposes of the 75-Percent Asset Test if the loan is under-collateralized. For example, under the facts in example 1, only 55 percent (i.e., the value of the underlying real property divided by the principal amount of the loan) of the value of the mortgage loan held by REIT X would be treated as a qualifying real estate asset for purposes of the 75-Percent Asset Test after its modification in 2009 based on the rules in the regulations. However, Rev. Proc. 2011-16 allows REIT X to use the lesser of (1) the apportioned value of the real estate loan as of the original commitment date (i.e., as if the modification is not a commitment to make or purchase a new loan) or (2) the value of the loan on the measuring date (which, presumably, prevents an artificial inflation of the amount of qualifying assets since in most, if not all, instances the value of the underlying real estate on the original commitment date will be greater).

The relief in Rev. Proc. 2011-16 in the case of a REIT purchasing a troubled real estate mortgage loan does not appear to be as generous. In example 2 in the revenue procedure, REIT Y purchased a modified real estate mortgage loan at a time when the principal amount of the loan was $100, the loan’s value was $60 and the value of the underlying real estate was $55. The revenue procedure allows the REIT to treat the lesser of the loan’s value ($60) or the value of the underlying real estate ($55) as a qualifying asset for purposes of the 75-Percent Asset Test. While this is not a particularly harsh result, what if the troubled real estate mortgage loan had been purchased by REIT Y prior to its modification? Under the apportionment rules contained in the Treasury Regulations, the portion of the mortgage loan that would be considered to be a qualifying asset for purposes of the 75-Percent Asset Test would be only 55 percent. Again, many of the same questions raised above in the discussion of the 75-Percent Income Test are equally applicable here. Is this result justified simply because the troubled real estate loan is under-collateralized? Should the REIT be required to modify the mortgage loan in order to avoid a violation of the asset test if the loan is mostly nonrecourse and the underlying real property represents a substantial portion (well in excess of 75 percent) of the secured value?

The 100-Percent Prohibited Transactions Tax

A tax equal to 100 percent of the net income derived from prohibited transactions during a tax year is imposed on a REIT.24 The term "net income derived from prohibited transactions" means the excess of the gain from prohibited transactions over the deductions that are directly connected with such prohibited transactions.25 The term "prohibited transaction" means a sale or other disposition of property described in Code Section 1221(a)(1) which is not foreclosure property.26 Property that is described in Code Section 1221(a)(1) is property that is stock in trade of the taxpayer (i.e., inventory) or other property of a kind that would be included in the inventory of a taxpayer if on hand at the close of the tax year, or property held by a taxpayer primarily for sale to customers in the ordinary course of his trade or business.27

There is a myriad of case law addressing when property, for example, a real estate mortgage loan held by a REIT, is property that is primarily held for sale to customers in the ordinary course of a trade or business.28 So much so that substantial uncertainty existed requiring Congress to enact rules providing certain safe harbors for REITs from the 100-percent prohibited transaction tax in the case of certain sales of property by a REIT. The safe harbor provides that gains from the sale of property otherwise held for sale by a REIT will be exempted from the 100-percent tax on prohibited transactions if, among other requirements, the property has been held for more than two years and all sales of property that are otherwise held for sale by the REIT during such tax year either (1) do not exceed seven, (2) the aggregate bases of all such disposed of properties do not exceed 10 percent of the aggregate adjusted bases of all of the REIT’s properties as of the beginning of the year, or (3) the aggregate fair market value of all such disposed of properties does not exceed 10 percent of the fair market value of all of the REIT’s properties as of the beginning of the year.29

Rev. Proc. 2011-16 again provides a measure of relief (or at least a measure of clarity) by stating that the modification of a mortgage loan that falls within the scope of Section 3 of the revenue procedure will not be treated as a prohibited transaction under Code Section 857(b)(6). Presumably, in most cases in which the troubled real estate mortgage loan was originated by the REIT, a modification of the mortgage loan would result in a loss, and the exemption from the prohibited transaction tax in many cases would not be needed.30 However, again, a number of questions remain unanswered. For example, what if a REIT acquires the troubled mortgage loan prior to any modification and then subsequently modifies such mortgage loan? It is possible that a gain could result from any subsequent modification since the loan most likely was purchased at a significant discount to its principal amount. Further, it may be that the loan may not have been held for more than two years, one of the requirements for being exempted under the safe harbor discussed above. Presumably, so long as the reasons for such modification fall within the scope set forth in Section 3 of the revenue procedure (i.e., a default or reasonable belief of a risk of default and that modification substantially reduces such risk), a REIT that recognizes a gain on the purchase and modification of a mortgage loan at a discount can take advantage of the exemption from the prohibited transaction tax provided in the revenue procedure. On the other hand, what if the REIT is simply purchasing the troubled mortgage loan in order to acquire the underlying real property? Since the mortgage loan is being purchased at a substantial discount to the principal amount of the mortgage loan and gain or loss is recognized by the REIT upon foreclosure in an amount equal to the difference between the fair market value of the underlying real and personal property and the REIT’s basis in the mortgage note, it is possible that the REIT could recognize gain at the time of foreclosure. Presumably, the troubled mortgage loan is not being acquired by the REIT as property held for sale to customers in the ordinary course of the REIT’s trade or business (i.e., Code Section 1221(a)(1) property), so the prohibited transaction tax arguably should not apply. Not surprisingly, however, the revenue procedure does not answer that question since it does not address the tax consequences to a REIT that acquires a troubled mortgage loan for purposes of securing ownership of the underlying property.

Conclusion

In conclusion, the relief provided in Rev. Proc. 2011-16 is certainly welcome, but is limited to only the most basic of restructurings of troubled real estate mortgage loans that may be held or purchased at a discount by a REIT. More often than not, a REIT that holds or purchases troubled mortgage loans and that in an effort to rehabilitate the mortgaged property is looking to restructure the loan in an effort to rehabilitate the property will be faced with a complex tax analysis in determining the consequences to the REIT due to the complexity of most financing structures being used to rehabilitate troubled real property in today’s market.