REITs have been bedeviled during the recent economic decline over the application of the REIT income and asset tests if a REIT modifies distressed debt that it holds or purchases such debt from a third party.

Under the REIT income test, interest on a real estate mortgage is allocated between “good” real estate income and other interest income by comparing the amount of the loan to the “loan value” of the property. The loan value of the property is defined by regulation to be the fair market value of the real property determined on the date on which the commitment by the REIT to make or purchase the loan becomes binding. The regulations also set forth a favorable “stacking” rule to the effect that the full amount of the loan value of the property will be applied to the amount of the loan first for purposes of determining how much of the interest income will be treated as real estate income rather than as other interest income. Thus, if the loan value of the property is equal to or greater than the amount of the loan, all of the interest earned on the loan will be treated as real estate income. If the loan value of the property is less than the amount of the loan, the amount of interest income will be apportioned between real estate income and other income in proportion to the ratio of such loan value to the amount of the loan.

The regulations do not provide guidance with respect to how to determine how much of the real estate mortgage ought to be treated as a real property asset for purposes of the REIT asset test if the mortgage is secured by both real property and other property. However, the IRS has indicated in letter rulings that the method set forth in the regulations regarding the REIT income test is a reasonable method for purposes of applying the REIT asset test.

These rules have created a dilemma for REITs that either hold distressed debt and are considering modifying the debt or are interested in purchasing distressed debt. A REIT interested in modifying distressed debt so as to enhance the likelihood that it will become performing faces the problem that under existing regulations a significant modification will be treated as an exchange of “old” debt for “new” debt, triggering a redetermination of the “loan value” of the underlying real estate at that time. The result often is that, since the value of the underlying property has declined considerably, the amount of the loan will substantially exceed the value of the underlying real property, giving rise to issues under both the REIT income and asset tests. Similarly, a REIT interested in purchasing distressed debt faces issues under the income and asset tests because the value of the underlying real estate will often be considerably less than the amount of the loan. Finally, if the modifications to existing debt cause a deemed disposition of the old debt for the new debt, there has been concern that such a deemed disposition could be a “prohibited transaction” under the REIT rules, which raises other issues.

In Rev. Proc. 2011-16, the IRS has set forth some safe harbors for REITs in dealing with these problems. In connection with modifications of debt, the revenue procedure provides that if the modification was occasioned by default or the REIT or the servicer of the loan reasonably believes that (a) there is a significant risk of default of the pre-modified loan upon maturity or an earlier date and (b) the modified loan presents a substantially reduced risk of default as compared with the pre-modified loan, the REIT may treat the modification as not being a new commitment to make or purchase a loan. The result is that the “loan value” of the property securing the loan does not need to be adjusted to its then-current fair market value. Such a rule means that the treatment of the interest income on the loan as real estate income for purposes of the REIT income test should in many instances essentially remain as it was before. The revenue procedure also provides that the loan modification will not be treated as prohibited transaction. The IRS’ flexibility here mirrors the flexibility it provided REMICs in 2009.

The revenue procedure also sets forth a safe harbor for purposes of determining the extent to which a loan secured by real estate and other property or not fully secured by real estate will be treated as a real estate asset for purposes of the REIT asset test. This safe harbor provides that the loan will be treated as a real estate asset to the lesser of the value of the loan or the loan value of the underlying property as determined under the regulations dealing with the REIT income test and the revenue procedure. As a result, the revenue procedure sets forth the same favorable “stacking rule” for purposes of the application of the REIT asset test as is found in the regulations with respect to the REIT income test. Further, by providing that the “loan value” of the underlying real estate can be determined according to the revenue procedure, it means that if the REIT modifies distressed debt, the loan value of the property will not have to be stepped down to then-current fair market value for purposes of applying the REIT asset test.

The safe harbors set forth in the revenue procedure are also helpful, but not as helpful as some might have wished, for REITs purchasing distressed debt. Because of the favorable stacking rule that the revenue procedure sets forth for purposes of the application of the REIT asset test, REITs can now treat distressed debt as a good real estate asset for purposes of the REIT asset test up to the lesser of the value of the loan or the value of the underlying real estate at the time the loan was purchased. For large loans, this safe harbor avoids the need to somehow apportion the loan between the real estate asset and other assets based on a pro rata comparison of the value of the real property and the amount of the loan. However, this safe harbor contains a hidden hazard. If the value of the property recovers and the value of the loan also recovers accordingly, the increase in the value of the loan most likely will not be treated as a good real estate asset since the loan value of the underlying property will be fixed as of the time the REIT purchased the distressed debt.

The revenue procedure does not provide REITs purchasing distressed debt with as helpful a rule in applying the REIT income test. Under the revenue procedure, the REIT income test is still applied by comparing the “loan value” of the underlying real property to the amount of the loan, not the price paid for it. Many have previously urged that for purposes of applying the REIT income test when distressed debt is purchased, the relevant comparison should be between the loan value of the real property and the price paid for the debt. By maintaining the rule that the appropriate comparison is between the loan value of the property and the amount of the debt, the effect of the revenue procedure is to treat much more of the interest income earned on the loan as other interest income rather than good real estate income for purposes of the REIT income test.

Remaining unanswered is another question that has also troubled many REITs. That is, what is the treatment if and when the REIT forecloses on distressed debt that it purchased? Under income tax concepts, such a foreclosure is treated as a taxable disposition by the REIT of the loan. Many have been concerned that such a disposition could be characterized as a prohibited transaction, particularly if the REIT does not satisfy the two-year holding period set forth in Section 856(b)(6)(C) or 857(b)(6)(B). However, the fact that the revenue procedure states that a deemed disposition of “old” debt for “new” debt if such debt is significantly modified when it is in default or default is reasonably anticipated does not constitute a prohibited transaction gives hope that the IRS might conclude in the future that the purchase of distressed debt followed shortly thereafter by foreclosure in order to obtain the underlying property also should not be treated as a prohibited transaction.

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