PLR 200226013: Partnership interest backed loans may count as REIT real estate assets

Plain-English summary

A real estate investment trust made additional loans to owners of partnerships that borrowed against housing complexes. Because a program barred second mortgages, the loans were secured by pledges of the owners' partnership interests. The IRS ruled that the additional loans could count as real estate assets for the REIT asset test if the pledged interests' share of real property value covered all loans secured by that property plus the additional loan. Interest on the loans could also qualify for the REIT income test if the same coverage condition, measured by loan value, was met and the interest was not based on another person's income or profits except as section 856 allows. The conclusions depend on the submitted facts and those valuation conditions.

Ruling snapshot

• Question: Do loans secured by partnership interests qualify as REIT real estate assets, with interest qualifying for the REIT income test?
• Outcome: Approved to the extent the stated property value and interest conditions are met.
• Key authorities: IRC §§ 856(c)(3)(B), 856(c)(4)(A), 856(c)(5)(B), 856(f); Treas. Reg. §§ 1.856-3(g), 1.856-5(c).

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200226013
Washington, DC 20224
Release Date: 6/28/2002
Index Number: 856.00-00
Person to Contact:

Telephone Number:

Refer Reply To:
CC:FIP:B02-PLR-141272-01
Date:
March 21, 2002

Legend

Trust A
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B
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C
=

Type D
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Type E Investments =

F
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G
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G Program
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H
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H Loan
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Year 1
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Type I Obligation
=

Dear
:

This is in response to a ruling request submitted by your authorized representative dated July 31, 2001. Trust A requests rulings that:

1. Trust A Additional Loans, as described herein, secured by partnership interests
   qualify as “real estate assets” for purposes of Section 856(c)(4)(A) of the Code.

2. The interest income earned on such loans qualifies as “interest on obligations
   secured by mortgages on real property or on interests in real property” for
   purposes of Section 856(c)(3)(B) of the Code.

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                                   FACTS
   

Trust A is a real estate investment trust (a “REIT”) that invests directly in Type D loans and mortgage-backed securities. A portion of the investments of Trust A consists of Type E Investments. A Type E Investment consists of (1) an F mortgage-backed security (“MBS”) representing the securitized first mortgage loan on an underlying complex or a participation interest in a first mortgage loan on a complex originated under the G Program (the “Trust A First Mortgage Loan”), (2) an additional loan to the owners of the borrower of the Trust A First Mortgage Loan used to provide additional funds for the financing of the complex (the “Trust A Additional Loan”) and (3) a participation interest in the cash flow from and appreciation of the complex that was conveyed to Trust A through a subordinated promissory note (the “Trust A Subordinated Promissory Note”) and a subordinated mortgage on the property. The Trust A Additional Loan Agreements (or amendments thereto) normally provided for Trust A to make further loans in the event that there was insufficient funds to pay operating expenses, debt service on the Trust A First Mortgage Loans or Base Interest.

H insures the Trust A First Mortgage Loan and payments of principal and interest on the MBS are guaranteed by F. Amounts payable under the Trust A Additional Loans and the Trust A Subordinated Promissory Notes are not insured or guaranteed. Trust A presently has an interest in B Type E Investments. The borrowers under the Trust A First Mortgage Loans are partnerships, and the borrowers under the Trust A Additional Loans are the partners in the respective partnerships.

In Year 1, H issued a letter to all lenders involved in mortgage loan transactions insured by H (the “H Memorandum”) providing requirements regarding certain insured loans, such as the First Mortgage Loans described herein. A Type I Obligation is defined in the H Memorandum as a loan by a third-party source of loan funds (such as Trust A) of additional funds over and above the amount of the H Loan to the partner(s) or other principal(s) of the mortgagor to cover costs that are not financed with the proceeds of the H Loan. The H Memorandum states that the obligation to repay such Type I Obligation funds is typically secured by a pledge of the partners’ (or the mortgagor’s other owners’) rights to cash and a pledge of the partnership interest (or other ownership interest) of one or more of the partners (or other owners) of the mortgagor. The Trust A Additional Loans described herein constitute Type I Obligations under the H Memorandum.

The H Memorandum permits Type I Obligations in connection with first mortgage loans insured by H only if such obligations are structured in conformance with the specific requirements of the H Memorandum. The provisions of the H Memorandum applicable to Type I Obligations provide in part that: (1) a Type I Obligation cannot be secured by the first mortgage insured by H and (2) a Type I Obligation cannot be secured by a second mortgage, but may be collateralized by security agreements pledging the partners’ partnership interests (or the other interests of the owners of the mortgagor)

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and/or the partners’ (or other owners’) right to cash and the net proceeds resulting from any payment event.

As a result of the restrictions imposed by the H Memorandum, the Trust A Additional Loans could not be secured by a first mortgage or by a subordinated mortgage on the complex, but were instead secured by a pledge of the ownership interests in the borrowers under the Trust A First Mortgage Loans. All of the proceeds of each Trust A Additional Loan were contributed to the partnership that was the borrower under the Trust A First Mortgage Loan or otherwise used in connection with the respective complex. The Trust A Additional Loan amounts were required in order to close the Trust A First Mortgage Loan and to fund certain escrow and reserve accounts.

The Trust A Additional Loans normally provide for payments of fixed interest on the outstanding principal amount of the Trust A Additional Loans (“Base Interest”). The Trust A Additional Loans also typically provide for a payment of additional interest (“Additional Interest”) upon the maturity date of the Trust A First Mortgage Loan or upon the occurrence of certain other events, such as the disposition of the complex, the refinancing of the Trust A First Mortgage Loan or upon default or the exercise of prepayment options (the “Additional Interest Payment Date”). Additional Interest normally is computed as the amount necessary to yield simple interest of a specified rate, from the date that the first mortgage note was insured by H to the Additional Interest Payment Date, on the outstanding balance of the Trust A First Mortgage Loan and Trust A Additional Loan, taking into account interest received under the Trust A First Mortgage Loan, cash flow payments received under the Trust A Subordinated Promissory Note, Base Interest and certain amounts received upon the release of escrowed funds relating to the complex.

Pursuant to the Trust A Additional Loan Agreements and Pledge and Security Agreements, each of the borrowers under the Trust A Additional Loan Agreements granted a first priority security interest in their partnership interest as security for the obligations under the Trust A Additional Loans. Under the Pledge and Security Agreements, the pledging parties agreed not to dispose of their ownership interests or to allow the disposition of the assets of the borrower under the Trust A First Mortgage Loans outside of the ordinary course of business without the consent of Trust A. In addition, under the agreements between H and the borrower under the G First Mortgage Loans, the borrower cannot transfer the interest of any general partner without H’s approval, and under each agreement with H, the borrower under the Trust A First Mortgage Loan cannot convey, transfer or encumber the property that is the subject of the Trust A First Mortgage Loan without H’s consent or the mortgagee’s consent. The partnership agreements also normally contain prohibitions or restrictions on the transfer of partnership interests. In addition, in the case of each Type E Investment, a refinancing of the Trust A First Mortgage Loan or the sale of the complex would result in the acceleration of the principal of and all interest due in respect of the Trust A Additional Loan.

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Upon a default under a Trust A Additional Loan, Trust A can foreclose on the partnership interests of the borrowers in the partnership that is the borrower under the respective Trust A First Mortgage Loan and generally can dispose of and deal with all the property of the partnership, including the complex that is the subject of the Trust A First Mortgage Loan, to satisfy the borrowers’ obligations under the Trust A Additional Loan. Except to the extent that the pledged partnership interest is expended or otherwise disposed of or disbursed other than in accordance with the Additional Loan Agreements or the Pledge and Security Agreement, Trust A’s sole recourse in the event of a default is against the partnership interest.

The complex and related assets owned by each of the borrowers under the Trust A First Mortgage Loans have constituted at least C percent of the borrower’s total assets on a book basis. Because the partnership agreement of each partnership limits the partnership’s business either to owning and operating real property or in some cases to owning and operating the specific complex that is the subject of the Type E Investment, and due to the provisions of an agreement entered into by each Trust A First Mortgage Loan borrower that do not allow the borrower to engage in any other business or actitivity, including the operation of any other similar project, without H’s consent for so long as the H insurance remains in effect, the complex owned by each such borrower will continue to constitute substantially all of the assets of such entity during the period that the Trust A First Mortgage Loan and/or the Additional Loan are outstanding.

Under the H Memorandum, no additional mortgages can be placed on the complexes that are the subject of the Type E Investments, and pursuant to the subordinated mortgage on each complex, no inferior liens can be placed on the complex without the prior consent of Trust A. Additionally, the agreements with respect to the Trust A First Mortgage Loans contain restrictions with respect to the incurrence of liabilities and generally only permit funds to be paid out from cash.

LAW AND ANALYSIS

Section 856(a) of the Code provides that a trust shall not be considered a real estate investment trust (a “REIT”) for any taxable year unless certain requirements are satisfied.

Section 856(c)(4)(A) of the Code provides that at the close of each quarter of the taxable year at least 75 percent of the value of a REIT’s total assets must be represented by real estate assets, cash and cash items (including receivables), and government securities.

Section 856(c)(5)(B) of the Code provides that the term “real estate assets” means real property (including interests in real property and interests in mortgages on real property) and shares (or transferable certificates of beneficial interest) in other REITs that meet the requirements of section 856 through 859.

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Under section 1.856-3(a) of the Income Tax Regulations, the term “value” means, with respect to securities for which market quotations are readily available, the market value of such securities; and with respect to other securities and assets, fair value as determined in good faith by the trustees of the REIT.

Section 1.856-3(g) of the regulations provides that in the case of a REIT that is a partner in a partnership, the REIT will be deemed to own its proportionate share of each of the assets of the partnership and will be deemed to be entitled to the income of the partnership attributable to such share. Under the regulations, for purposes of section 856, the interest of a partner in the partnership’s assets will be determined in accordance with his capital interest in the partnership, and the character of such assets in the hands of the partner will be the same as the character of the assets to the partnership.

In Revenue Ruling 77-459, 1977-2 C.B. 239, a REIT made a construction loan to a partnership and as security for the loan, the partnership assigned its interest in an Illinois land trust to the real estate investment trust. The partnership was the sole beneficiary of the land trust and the sole asset of the land trust was real property. In that instance, the Service concluded that the loan constituted a “real estate asset” under section 856(c)(4)(A) of the Code.

Section 856(c)(3) of the Code provides that a REIT must derive at least 75 percent of its gross income from certain categories of income, one of which is interest on obligations secured by mortgages on real property or on interests in real property.

Section 856(f) of the Code provides, in part, that the term “interest” excludes any amount received or accrued, directly or indirectly, if the determination of such amount depends in whole or in part, on the income or profits of any person except that any amount so received or accrued will not be excluded from the term “interest” solely by reason of being based on a fixed percentage or percentage of receipts or sales. Section 856(f) also provides a special rule with regard to qualified rents.

Section 1.856-5(c)(1) of the regulations provides that where a mortgage covers both real and other property an apportionment of the interest income must be made for purposes of the 75-percent requirement. This provision would be applicable in the event that the underlying assets of a partnership is made up of real estate assets as well as other assets. The regulations provide that for purposes of the 75-percent requirement if the Loan value of the real property is equal to or exceeds the amount of the loan, then the entire interest income shall be apportioned to the real property. If the amount of the loan exceeds the loan value of the real property, 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, and the denominator of which is the amount of the loan. The interest income apportioned to the other property is an amount equal to the excess of the total interest income over the interest income apportioned to the real property.

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Section 1.856-5(c)(2) of the regulations provides, in part, that the loan value of the real property is the fair market value of the property, determined as of the date on which the commitment by the trust to make the loan becomes binding on the trust. However, in the case of a construction loan or other loan made for purposes of improving or developing real property, the loan value of the real property is the fair market value of the land plus the reasonably estimated cost of the improvements or developments (other than personal property) which will secure the loan and which are to be constructed from the loan proceeds of the loan. The fair market value of the land and the reasonably estimated cost of improvements or developments shall be determined as of the date on which a commitment to make the loan becomes binding on the trust.

Section 1.856-3(g) of the regulations recognizes that if a real estate investment trust is a partner in a partnership, the real estate investment trust will be considered to own the partnership’s real estate assets in the same proportion as its capital interest in the partnership. Based on the facts presented, the principles of section 1.856-3(g) of the regulations provide a sufficient nexus between the Trust A Additional Loans and the complexes underlying the partnership interests used as security for the Trust A Additional Loans to qualify the Trust A Additional Loans as “real estate assets” under section 856(c)(5)(B) of the Code.

CONCLUSIONS

Based on the facts and representations submitted, we conclude as follows:

1. To the extent that the fair value of the pledged partnership interests’ share of the
   real property included in each complex as of the date on which Trust A entered
   into the Trust A Additional Loan with respect to such property, and on the date of
   any additional borrowings, was at least equal to the total aggregate amount of
   any and all loans secured by the real property as well as the amount of the Trust
   A Additional Loan, the Trust A Additional Loans described herein qualify as “real
   estate assets” for purposes of section 856(c)(4)(A) of the Code.

2. The interest income earned on such loans qualifies as “interest on obligations
   secured by mortgages on real property or on interests in real property” for
   purposes of Section 856(c)(3)(B) of the Code to the extent that the pledged
   partnership interests’ share of the loan value of the real property is at least equal
   to the total aggregate amount of any and all loans secured by the real property
   as well as the amount of the Trust A Additional Loan, provided that the amount
   of such income does not depend in whole or in part on the income or profits of
   any person, except as provided in section 856(f).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

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This ruling is directed only to the taxpayer(s) requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.

Sincerely,
William E. Coppersmith
Chief, Branch 2
Office of Office of Associate Chief Counsel (Financial Institutions and Products)