IRS Guidance on Distressed Debt Investments by REITs: IRS Issues Guidance on Application of Income & Asset Tests for REIT Qualification to Modifications of Debt Held by REITs and to Purchases of Distressed Debt by REITs

Sullivan & Cromwell LLP - January 6, 2011
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On January 5, 2011, the IRS issued Rev. Proc. 2011-16 (the “Revenue Procedure”), addressing certain issues related to the treatment of debt modifications and debt acquisitions for purposes of the 75%-income and 75%-asset tests for REIT qualification. The Revenue Procedure (1) provides taxpayer-favorable guidance with respect to mortgage loans held by a REIT that are subsequently modified in connection with a default or anticipated default and (2) provides guidance that makes qualification under the 75%-income test more difficult for REITs that purchase distressed debt at a discount where the value of the real property securing the debt is less than the face amount of the debt as of the date of purchase or commitment to purchase.

For purposes of the 75%-income test, all interest from a mortgage loan is treated as qualifying income if the value of the real property securing the debt equals or exceeds the principal amount of the debt at the time the REIT commits to make or acquire the loan. If, however, the value of the real property securing the debt is less than the principal amount of the debt at the time of origination or purchase and there is any other property securing the debt, then only a portion of the interest income is qualifying income (namely, an amount equal to the product of the interest income and a fraction, the numerator of which is the value of the real property and the denominator of which is the face amount of the debt). The Revenue Procedure provides that a modification of a loan in connection with a default or anticipated default on the loan will not constitute a new commitment to make or acquire a loan, and therefore, in such circumstances, a REIT will not be required at such time to re-determine the value of the real property securing the loan for the purpose of the 75%-income test. Accordingly, where a loan held by a REIT is modified in connection with a default or anticipated default, all of the interest will remain qualifying income for purposes of the 75%-income test if the value of the real estate securing the debt was equal to or exceeded the principal amount of the debt at the time of the original issuance or purchase, even if the value of the real property securing the debt is less than the face amount of the debt at the time of modification.

On the other hand, if a REIT purchases a loan, the value of the real property securing the loan is compared to the face amount of the loan (and not the purchase price of the loan) in determining what portion of the interest income qualifies under the 75%-income test. Thus, for example, if a REIT purchases for $60 a loan with a face amount of $100 at a time when the value of the real estate securing the loan is $55 and the value of the other property securing the loan is $5, only 55% of the interest income on the loan (55/100, instead of 55/60) will qualify under the 75%-income test.

For purposes of the 75%-asset test for REIT qualification, a REIT should treat as a qualifying real estate asset the lesser of (1) the value of the loan, and (2) the value of the real property securing the loan pursuant to the rules described above.

The modification of a real estate loan related to a default or anticipated default on the loan will not be treated as a prohibited transaction under Code Section 857(b)(6), and the gain thereon will not be subject to the 100% tax.