Mortgage REITs A Primer

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1 Volume 9 Issue By K. Peter Ritter Peter Ritter provides an overview of real estate investment trusts generally, and follows with a discussion of the unique tax issues that mortgage REITs present. This article is an update of an overview that first appeared in the Spring 2004 issue of the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS. Introduction The past few years saw a crumbling of the housing markets and a mortgage crisis, followed by a freezing of the credit markets, some major bankruptcies and a global recession. Several big players in the mortgage markets, including, for example, New Century Financial Corp. and Countrywide Financial Corp., are no longer in business. However, with the economy slowly recovering, and with interest rates still la at record low levels, real estate investment trusts (REITs) in general, and mortgage REITs in particular, are again experiencing a bit of a resurgence. Within the past couple of months, several new mortgage REITs have been formed and/or are preparing for securities offerings, 1 and many existing companies in mortgage-related businesses are considering converting into a REIT or forming a REIT as part of their corporate structure. A REIT is an entity that would otherwise be taxable as a corporation. But by virtue of special provisions set out in the Internal Revenue Code (Code), a REIT is entitled to a deduction for dividends paid to its shareholders. Thus, to the extent a REIT distributes all of its taxable income, no corporate-level taxes are due and a REIT effectively functions like a passthrough tax entity. However, as described in this article, a REIT is subject to a number of restrictions and limitations on the manner in which it engages in investment activities and the types of assets it may hold, as well as the types of income it may generate. K. Peter Ritter is a Tax Partner at O Melveny & Myers LLP, resident in its San Francisco office.* This article provides an overview of REITs generally, and then focuses on many of the unique tax issues that arise in the mortgage REIT context. REITs Generally Types of REITs REITs come in at least two flavors, namely equity REITs and mortgage REITs. Equity REITs own and operate income-producing real estate through a wide variety of activities, primarily including leasing activities, real estate development and various permitted tenant services. Mortgage REITs, on the other hand, generally do not own or operate such assets or properties, but rather lend money to real estate owners and operators, either directly or indirectly through secondary market purchases of real estate loans or mortgage-backed securities. Mortgage REITs, in turn, generally fall within two categories: those that act like arbitrageurs by investing in mortgages and mortgage-backed securities, often with significant leverage, and trying to profit from the spread between the yields produced by assets they hold and their costs, including interest costs from leverage, and those that act like banks by originating, holding and securitizing mortgages and mortgage-backed securities. Recently, some mortgage REITs have fallen into a new third category: investing in distressed debt, with the intent to workout such mortgages. In addition, many REITs have operated as hybrids that is, as both equity REITs and mortgage REITs. REIT Requirements In general, a REIT is an entity usually a corporation that owns and in most cases operates 2011 K.P. Ritter JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 29

2 income-producing real estate assets. An entity that qualifies as a REIT has a tax-advantaged status because it can deduct dividends paid to its shareholders, thereby essentially eliminating corporate-level taxes. Consequently, almost all REITs distribute all of their taxable income to shareholders annually and therefore owe no corporate income tax. 2 Taxes are then paid by shareholders on the dividends received. 3 Publicly traded REITs offer real estate investors the dual advantages of liquidity and diversification. For an entity to qualify as a REIT in any year, the entity must satisfy certain specified tests set forth in the Code. More specifically, the REIT must meet several organizational tests, two gross income tests, various asset tests and a distribution requirement. In general, to satisfy the organizational requirements, the entity must (1) be organized as a corporation, trust or association; (2) be managed by one or more trustees or directors; (3) have transferable shares or certificates; (4) be taxable as a domestic corporation but for the operation of the REIT provisions of the Code; (5) not be a financial institution or insurance company; (6) be owned by 100 or more persons for at least 335 days of the tax year; and (7) not be closely held, i.e., not more than 50 percent of the value of its shares can be owned directly or indirectly ir by or for five or fewer individuals at any time during the last half of the REIT s tax year. 4 The requirements described in (6) and (7) above do not apply during a REIT s first tax year. 5 In addition, a REIT must generally have a calendar tax year 6 and elect to be taxed as a REIT. 7 The gross income tests require that at least 75 percent of a REIT s gross income (75-percent Gross Income Test) be derived from real estate related sources, including interest on obligations secured by mortgages on real property and gain from the sale or disposition of such assets, 8 and that at least 95 percent of its gross income be derived from sources included in the 75-percent Gross Income Test as well as other specified sources, including dividends and other interest income (95-percent Gross Income Test). 9 A REIT is also required to satisfy certain asset tests at the close of each quarter of its tax year. Specifically, the asset tests require that real estate assets, government securities, cash items (including receivables) or cash comprise at least 75 percent of the REIT s assets (75-percent Assets Test). 10 For these purposes, real estate assets generally include interests in real property, interests in mortgage loans secured by real property, interests in other REITs 11 and interests in real estate mortgage 30 investment conduits (REMICs). 12 With certain exceptions, the asset tests also prohibit a REIT from owning the securities of any one issuer in an amount greater than five percent of the gross value of the REIT s assets, and from owning more than 10 percent of the outstanding securities (by vote or gross value) of any one issuer. 13 In essence, the gross income and asset tests require that the REIT function primarily as a passive entity that buys, holds and/or operates real estate-related investments and that therefore generates income primarily from real estate related interest and rents. In general, moreover, a REIT cannot function as a dealer with respect to its assets without being subject to a 100-percent prohibited transaction tax on any net income on such assets. 14 Finally, a REIT must distribute at least 90 percent of its taxable income to its shareholders annually, without regard to deductions for dividends paid and excluding net capital gains. 15 A REIT may retain capital gains and pay tax on them, or alternatively distribute capital gain dividends to its shareholders. 16 Any undistributed ordinary income and net capital gains are subject to tax at the REIT level. 17 A full discussion of the tax rules governing REITs is beyond the scope of this article. 18 Subsidiary Entities In general, REITs have three different types of subsidiary entities: partnerships, qualified REIT subsidiaries (QRSs) and taxable REIT subsidiaries (TRSs), each of which is discussed below. Many REITs own an interest or interests in entities classified as a partnership for federal income tax purposes (which typically include limited liability companies with more than one member). In general, partnerships are treated as separate tax entities, the income, gains, deductions and losses of which flow through to its partners. However, for purposes of satisfying the gross income and asset tests, a REIT that is a partner in a partnership looks through the partnership and is treated as owning its proportionate share of each of the assets of the partnership and is treated as earning its proportionate share of the income of the partnership, as determined in accordance with its capital (as opposed to its profits) interest in the partnership. 19 Although less prevalent with pure mortgage REITs, many equity REITs use a subsidiary partnership to acquire assets with built-in gain from third parties, who generally cannot contribute such assets directly to the REIT without triggering the built-in gain. Under this umbrella partnership REIT (UpREIT) structure, the

3 Volume 9 Issue REIT is the sole general partner and a limited partner in a limited partnership (Operating Partnership). The REIT s only assets are its partnership interests in the Operating Partnership. The Operating Partnership holds all of the operating assets and conducts many of the related business activities. The UpREIT structure generally permits third parties to contribute real property with built-in gain to the Operating Partnership for limited partnership interests (OP Units) without triggering immediate recognition of such gain. 20 The OP Units received by the contributor are usually exchangeable for shares of the parent REIT on a one-for-one basis (or cash, at the REIT s option) at any time after a one year lock-up period following the contribution. Although such an exchange is generally taxable, the contributor has deferred its taxes, diversified its holdings and at the same time effectively transformed an illiquid interest in real estate into OP Units exchangeable after the lock-up period into liquid publicly-traded stock, assuming the REIT is publicly traded. A QRS is a wholly owned subsidiary corporation of a REIT that has not elected TRS status. 21 A QRS is treated as a disregarded entity for tax purposes. 22 Thus, all of its assets, liabilities, income, gain, deductions and losses are treated as those of the parent REIT. Finally, ly, a TRS is a corporation other than a REIT for which the ecorporation and the REIT make a joint election. 23 As discussed above, a REIT generally may not own more than 10 percent of the securities of any issuer, and the value of those securities is limited to five percent of the gross assets of the REIT. These limitations do not apply to a TRS. However, the aggregate fair market value of the securities of one or more TRSs may not constitute more than 25 percent of the gross value of the REIT s assets (25- percent TRS Limit). 24 A TRS may not be consolidated with a REIT for tax purposes 25 ; rather, it is treated as a separate stand-alone corporation. Accordingly, income earned by a TRS will be subject to corporatelevel tax. Nonetheless, a TRS is useful because it can provide services or conduct business activities that a related REIT cannot provide or conduct without generating income that does not qualify for the gross income tests and that would jeopardize REIT status. 26 Dividends distributed by the TRS to a REIT will be qualifying income for purposes of the 95-percent Gross Income Test, but do not qualify for purposes of the 75-percent Gross Income Test. 27 Mortgage REITs sometimes establish TRSs to earn loan origination income and third-party servicing income, neither of which constitutes qualifying income for purposes of the gross income tests. In addition, TRSs have been used to conduct dealer activities that would be prohibited transactions subject to a 100-percent tax if performed directly by a REIT. Conversion to a REIT For an entity to qualify as a REIT in any year, the entity must satisfy certain specified tests set forth in the Code. More specifically, the REIT must meet several organizational tests, two gross income tests, various asset tests and a distribution requirement. For existing companies in the mortgage industry considering becoming a mortgage REIT, the tax issues of a conversion can be complex. First, if the existing company or its subsidiaries conduct activities or have assets that are inconsistent with the REIT rules, an internal restructuring may be required so that the entity making the REIT election can satisfy these rules after the conversion. Often, this restructuring entails a reshuffling of assets out of corporate solution, which generally cannot be done in a tax-efficient manner. However, in some cases, the entity that will make the REIT election may be able to achieve a tax-efficient restructuring by contributing nonqualifying assets to, and conducting nonqualifying business activities through, subsidiary entities that will elect TRS status. Second, a REIT election becomes effective on the first day of a calendar year. 28 Therefore, an existing entity generally cannot make a mid-year REIT election, and should take this fact into account in determining whether or when it can satisfy the REIT tests. If the entity cannot meet the REIT requirements for its current calendar year, it will generally be required to delay the conversion until the following year. Certain planning techniques are sometimes available, however, to facilitate a mid-year conversion. Third, if the existing entity has significant operations that will be conducted through TRSs after the conversion, the fair market value of such TRSs may not exceed the 25-percent TRS Limit at the end of JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 31

4 the REIT s first calendar quarter. The 25-percent TRS Limit may require the REIT to incur significant leverage or to have a sufficiently large public offering so that it may ramp up its gross value within such a short time period. Finally, if the existing entity has accumulated subchapter C earnings and profits (E&P), the entity must distribute all of its E&P before the close of the REIT s first tax year. 29 This requirement may be a significant impediment for existing entities wishing to convert to REIT status, because the entity may not know the exact amount of its E&P, and therefore may need to reconstruct the amount of its E&P. In addition, the distribution required to eliminate such E&P may be substantial. However, creative planning opportunities are available. 30 It should be noted that the REIT structure generally is beneficial only if the REIT is the parent entity. For example, it generally is not advantageous for a consolidated tax group to create a private REIT, i.e., a REIT subsidiary, because the group already is considered a single taxpayer and the non-reit parent will continue to be subject to tax. Thus, creating a private REIT in this situation will not result in any tax savings. However, such a REIT could still be used as a vehicle to raise capital from outside investors, for whom income from the subsidiary REIT would only be et taxed once. Mortgage REITs Beyond the general organizational and operating issues for REITs, mortgage REITs encounter several tax issues that equity REITs generally do not face, such as the following: Loan origination income Servicing income Real estate mortgages and related assets Distressed real estate mortgages Securitizations and sales Hedging transactions Foreclosure property TRS issues Phantom income Each of these issues is separately discussed below. Loan Origination Income Income earned from originating loans that represents a charge for loan origination services does not constitute qualifying income for either of the two REIT 32 gross income tests. Therefore, if a REIT s projected loan origination income, when combined with other nonqualifying gross income, is expected to exceed or approximate five percent of the REIT s gross income, the activities giving rise to such income should be conducted by a TRS of the REIT. Servicing Income Income earned from the servicing of mortgages held by third parties, including a REMIC, also does not constitute qualifying income for either of the two REIT gross income tests. Accordingly, mortgage REITs typically conduct such servicing activities through a TRS. However, a mortgage REIT can retain the servicing rights to its own loans: the income from such activities is treated as additional mortgage interest that qualifies under the REIT gross income tests. 31 Real Estate Mortgages and Related Assets Mortgage loans will qualify as real estate assets for purposes of the 75-percent Assets Test, and interest on these loans will qualify for purposes of both gross income tests, if (1) the highest principal amount of the loan during the tax year does not exceed the fair market value of the real property securing the loan, 32 and (2) any contingent or participating interest is determined or based on a fixed percentage or percentages of gross receipts or revenues, rather than net income or profits. 33 For purposes of (1) above, if the fair market value of the real property securing the loan equals or exceeds the principal amount of the loan, then 100 percent of the interest on the loan is treated as qualifying income (and the entire loan should qualify as a good real estate asset). If not, e.g., the loan is secured by real property and other property (e.g., personal property), then an apportionment is required to be made based on the loan value of the real property (generally, the fair market value of the real property, fixed as of the date on which the REIT s commitment to originate or acquire the loan becomes binding) and the amount of the loan (generally, the highest principal amount of the loan outstanding during the tax year). 34 In particular, in the case of interest income, the amount to be allocated to the real property is equal to the amount of 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. For example, if a REIT originates a $100,000 loan that is secured by real estate

5 Volume 9 Issue with a value of $90,000 and personal property with a value of $20,000, then 90 percent of the interest income on the loan is attributable to the real property (with the remaining 10 percent attributable to other property). A similar apportionment should apply for purposes of the 75-percent Assets Test. 35 The REIT provisions of the Code and Treasury regulations do not address the treatment of mezzanine loans (i.e., loans that are not directly secured by real property, but instead are secured by an interest in a special purpose vehicle owning real property). Rather, safe harbor guidance with respect to mezzanine loans was issued by the IRS. 36 If a REIT complies with this safe harbor, then the loan is treated as a good real estate asset for purposes of the 75-percent Assets Test and the interest on the loan will be treated as interest on an obligation secured by a mortgage on real property or on an interest in real property. Many mortgage REITs enter into sale and repurchase agreements (repos) whereby such REITs nominally sell mortgages or mortgage backed securities sto ac counterparty and simultaneously enter into an agreement to repurchase the sold assets for a purchase price that reflects a financing charge. For tax purposes, if properly structured, such agreements should be treated as borrowing transactions, notwithstanding the fact that the REIT may transfer record ownership to the assets to the counterparty during the term of the agreement. Accordingly, the REIT should be treated as the owner of the assets for purposes of the REIT income and assets tests. 37 In addition, mortgage REITs recently have been purchasing assets through to-be-announced forward contracts (TBAs). Pursuant to TBAs, a mortgage REIT agrees to purchase, for future delivery, certain assets (e.g., mortgage backed securities) with certain principal and interest terms and certain types of underlying collateral, but the exact assets to be delivered are not identified until shortly before the settlement date of the TBA contract. As with any forward contract, values may shift during the period between the contract date and the settlement date, and it is not entirely clear whether TBAs are qualifying assets for purposes of the 75-percent Assets Test. In addition, a Given the risks involved with distressed mortgages and satisfying the REIT asset and gross income requirements, it may be necessary for a REIT to hold certain distressed mortgages (for purposes of workouts, modifications, foreclosures and sales) in a TRS. REIT may recognize income or gains from the disposition of such TBAs, through dollar roll transactions 38 or otherwise. It is not clear whether such income or gains are other qualifying income for purposes of the 75-percent Gross Income Test. Interests in REMICs are qualifying real estate assets. 39 In addition, for purposes of both gross income tests, income from such interests constitutes qualifying income in proportion to the real estate assets held by the REMIC, except that if at least 95 percent of the REMIC s assets are real estate, then all of the income from such interests will qualify. 40 Furthermore, interest income derived from agency passthrough certificates and equity interests in owner trusts that issue collateralized mortgage obligations (CMOs) generally will constitute qualifying interest income for purposes of both gross income tests. However, income from a debt instrument issued by a CMO and held by the REIT as an asset, or any other debt obligation that is not directly secured by real property, generally will be qualifying income for purposes of the 95- percent Gross Income Test but not the 75-percent Gross Income Test. Moreover, such assets will not constitute qualifying real estate assets for purposes of the 75-percent Assets Test. Notes that are deeply subordinated or unrated, other than those issued by a REMIC, run the risk of being recharacterized as equity for tax purposes. If these notes are treated as equity, the REIT would need to ensure that it complies with the REIT requirements when the notes are treated as stock, a partnership interest or a trust interest in the applicable issuing entity. If a REIT holds REMIC residual interests as an investment, such interests generate noncash phantom income, which the Code refers to as excess inclusion income. 41 As further explained below, the Code provides that such excess inclusion income may flow through the REIT to its shareholders. More specifically, the amount of excess inclusions with respect to the REIT s REMIC residuals that exceed the REIT s undistributed REIT taxable income (which is generally zero, if the REIT distributes all of its income) is allocated proportionately among the REIT s shareholders, such that the REIT s dividends in effect may JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 33

6 be tainted, resulting in adverse tax consequences to them. 42 That amount generally (1) cannot be offset by any net operating losses otherwise available to the shareholder, 43 (2) is treated as unrelated business taxable income for shareholders otherwise exempt from tax, 44 and (3) is subject to a 30-percent gross withholding tax for non-u.s. shareholders without regard to otherwise applicable income tax treaty provisions. 45 In addition, the REIT itself can be subject to tax on excess inclusion income allocable to shareholders that are disqualified organizations, defined generally as nontaxable governmental organizations. 46 For this reason, some mortgage REITs often will avoid holding REMIC residual interests or will in fact prohibit disqualified organizations from holding their stock. 47 Distressed Real Estate Mortgages In the current economic environment, many mortgage REITs may be acquiring mortgages at a time when the value of the real estate collateral securing such mortgages may have dropped significantly since the mortgage was first originated. In addition, mortgage REITs may hold or invest in mortgages where there is a default or a likelihood of default, thereby requiring either a modification of such mortgages or perhaps even en foreclosure osu ( distressed mortgages ). A number of REIT Ttax issues arise in this context. First, the acquisition of distressed mortgages may cause a REIT to encounter difficulty in satisfying certain of the assets and income tests that it must satisfy on an ongoing basis in order to maintain its REIT status. As mentioned above, if a REIT purchases an existing mortgage that has an outstanding principal balance in excess of the fair market value of the underlying real estate on the purchase date and the loan also is secured by other property, then on account of the special apportionment rule, some portion of the mortgage may not qualify as a good real estate asset for purposes of the 75-percent Assets Test and some portion of the interest on the mortgage may not qualify as qualifying income for purposes of the 75-percent Gross Income Test. However, where such loan is secured solely by real estate assets (such that the apportionment rule technically does not apply), then it appears that even if the value of the real estate assets securing the loan is less than the face amount of the loan, the loan may nonetheless qualify as a good real estate mortgage (and all of the income, as qualifying income) for purposes of both tests. For example, suppose a REIT acquires for $60,000 a 34 mortgage with a principal balance of $100,000 that is secured solely by real property valued at $60,000. In such case, it appears that 100 percent of the interest on this mortgage would be qualifying income for purposes of the 75-percent Gross Income Test and 100 percent of the mortgage may be treated as satisfying the 75-percent Asset Test. Second, issues can arise when the terms of a distressed mortgage are modified, e.g., through a workout. For U.S. federal income tax purposes, the modification of a distressed mortgage may be treated as a deemed taxable exchange of the pre-modified mortgage for the modified mortgage. This can occur where, for example, the modification of a mortgage results in a change in its yield, a material deferral of scheduled payments, a change in the collateral or the addition or removal of a co-obligor, and such change is considered to be a significant modification (as defined for tax purposes). 48 A REIT may recognize gain on a mortgage that is acquired at a discount and subsequently modified if the modification is treated as a deemed exchange (under the rules discussed above). In that case, the amount of gain recognized by the REIT on the exchange will generally be equal to the excess of the stated principal amount of the modified mortgage over the amount originally paid by the REIT to acquire the pre-modified mortgage. 49 This gain would be phantom income or gain (i.e., taxable income or gain without any corresponding cash flow), and the REIT may need to take such phantom income into account for purposes of determining compliance with the REIT distribution requirements. For example, suppose a REIT acquires a mortgage for $60,000 and modifies such mortgage in a manner that results in a deemed exchange for tax purposes. If the stated principal amount of the modified mortgage is $100,000, the REIT may recognize $40,000 of income ($100,000 amount realized $60,000 basis) as a result of the modification. If a REIT modifies too many loans, it is conceivable that the REIT could be treated as a dealer for purposes of the prohibited transaction rules, on account of each modification resulting in a taxable disposition of the loan. If the modification is treated as a prohibited transaction, a 100-percent tax on such phantom income would apply. If the mortgage is held by a TRS at the time of modification, the prohibited transaction tax generally should not apply, but the TRS may have a corporate tax liability as a result of the modification. In addition, a portion of

7 Volume 9 Issue any gain realized may be characterized as ordinary (and not capital) gain under the market discount rules (discussed below). If a REIT modifies a mortgage loan as part of a loan modification program or other workout and such modification is treated as a deemed taxable exchange of the pre-modified mortgage for a new one, difficulties satisfying the assets and income test likewise can arise. In particular, if the modification results in a deemed taxable exchange, the REIT could be treated as originating a new loan for tax purposes, with the result that the value of the real estate securing the loan would need to be retested. If the value of the real estate is less than the face amount of the loan, then problems could arise. For example, assume that a REIT originated a mortgage seven years ago with a principal balance of $100,000, which at the time was secured by real estate with a value of $100,000 and personal property of $5,000. In 2011, when the value of the real estate was worth only $60,000 and the personal property $3,000, the loan is modified (i.e., interest estrate lowered and/ or the term ermextended) extended) with those modifications resulting in a deemed taxable exchange of the loan. If such deemed exchange results in a new loan for tax purposes, then after applying the apportionment rule only 60 percent of the interest on the new mortgage would qualify as qualifying income for purposes of the 75-percent Gross Income Test and only 60 percent of the mortgage would be treated as satisfying the 75-percent Asset Test. However, the IRS recently issued some guidance, in an effort to facilitate loan workouts and avoid the result described above. Pursuant to this guidance, if certain conditions are met (i.e., the modification was occasioned by a default or a significant risk of default), then (1) the REIT does not need to treat the new modified loan as triggering a re-testing of the value of the real estate, and (2) the modification will not be treated as a prohibited transaction. 50 However, even where this guidance applies, certain ambiguities remain, including in situations where the real property value increases in the future. 51 REITs in general, and mortgage REITs in particular, are complicated creatures of the Code. Given all of the requirements that must be satisfied on a continuing basis to maintain REIT status, it is clear that mortgage REITs are not the optimal structure for all circumstances. Third, where the REIT (or one of its TRSs) holds a nonperforming loan, it is possible that the REIT (or TRS) may need to accrue (and report) interest income on such loan notwithstanding the fact that no interest is actually being paid. 52 In such case, the REIT may need to consider such phantom income accruals for purposes of determining compliance with the REIT distribution requirements, and if the loan is held by a TRS, such TRS may need to fund corresponding tax payments with cash from other sources. Fourth, consideration should be given to the market discount rules of the Code. In general, under the tax law, a mortgage loan will be treated as acquired with market discount if such loan is purchased in the secondary market for an amount less than its issue price (which, in the case of most mortgages, generally is equal to its principal amount). 53 Under these rules, any payment of principal (as well as any gain upon a later disposition of a loan) is generally required to be treated as ordinary income to the extent of any market discount that has accrued on the loan since its purchase. Any market discount is considered to accrue ratably during the period from the date of acquisition of the loan, unless the taxpayer elects to accrue on a constant yield method. In addition, a taxpayer can also elect to include market discount in income currently as it accrues (on either a ratable or constant yield basis). 54 Accordingly, because most mortgages provide for monthly principal payments, a mortgage REIT (or TRS if it holds mortgages) may be required to report accrued market discount (as ordinary income) as such payments are made. In addition, if the REIT (or TRS) subsequently disposes of a mortgage loan (directly, or indirectly on account of a deemed taxable exchange resulting from a loan modification), a portion of any gain may be characterized as ordinary (and not capital) gain. It appears that any such market discount is treated as qualifying interest income for REIT purposes, assuming the underlying mortgage otherwise produces qualifying interest income. 55 In the distressed mortgage market environment, the market discount may reflect doubts as to collectability rather than changes solely with JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 35

8 respect to interest rates. 56 To the extent a mortgage REIT (or TRS) included market discount in income with respect to (monthly) principal payments, but eventually collected less on the mortgage than the amount paid for the mortgage plus the market discount previously included in income, the REIT or TRS may be entitled to a bad debt deduction. Finally, and as is further discussed below, issues can arise with distressed mortgages upon foreclosure. Given the risks involved with distressed mortgages and satisfying the REIT asset and gross income requirements, it may be necessary for a REIT to hold certain distressed mortgages (for purposes of workouts, modifications, foreclosures and sales) in a TRS. Securitizations and Sales are issued in multiple classes and which are treated as debt for tax purposes; and a residual equity interest. 58 The REMIC avoids an entity-level tax if it satisfies the detailed rules set forth in the Code, even if it would otherwise constitute a taxable mortgage pool, as discussed below. 59 These requirements generally seek to ensure that a REMIC remains a fairly passive investment vehicle that essentially holds a fixed pool, and not a revolving pool, of real estate mortgages. One of the primary benefits of the REMIC structure, apart from the relief from entity-level taxes, is the automatic characterization of regular interests as debt for tax purposes, regardless of whether they are deeply subordinated or are not supported by substantial equity. 60 The price for this convenience is that the use of a REMIC causes the sponsor/transferor to be taxed upon the securitization. In a typical transaction, a REMIC sponsor transfers the real estate mortgages to the REMIC and takes back the regular and residual interests, which are then sold to investors. The sponsor does not recognize taxable gain upon the transfer of the mortgages to the REMIC, but recognizes gain or loss when it sells the regular and residual interests to investors. Because a securitization through a REMIC results in the creation and sale to investors of new securities, i.e., the regular and residual interests, the securitization could be a prohibited transaction if performed directly by a REIT. 61 For this reason, almost all existing mortgage REITs conduct REMIC securitizations through a TRS. Although a REIT generally cannot securitize mortgages through a REMIC structure, except through a TRS, the REIT can directly conduct securitizations using a CMO structure. The basic CMO structure essentially involves the formation of a trust owned by the REIT that issues notes collateralized by a pool of mortgages. In this structure, the REIT would hold all of the equity in the trust and the notes issued by the trust would need to qualify as debt for tax purposes. Unlike with the REMIC rules, debt qualification is not automatic and generally requires that there be some equity (so-called overcollateralization ) behind the notes, i.e., one cannot have a noneconomic residual in the CMO structure. The primary tax issue in a CMO securitization is whether the trust constitutes a taxable mortgage pool (TMP) within the meaning of the Code. If the trust is a TMP, it is treated as a separate stand-alone corporation for tax purposes and subject to entity- In general, a REIT must distribute at least 90 percent of its taxable income each year. Because of this distribution requirement, most REITs cannot rely on profits to generate capital and must find alternative forms of financing for future investment acquisitions. For a mortgage REIT, the distribution requirement essentially means that a mortgage REIT can reinvest principal payments received on its mortgage loans, but must distribute most or all of the earnings, typically interest, from those loans. Thus, the REIT may wish either to sell or securitize its mortgage eloans to generate proceeds for new investments ents and acquisitions. However, sales and securitizations risk being characterized as prohibited transactions, for which the REIT would be subject to a 100-percent prohibited transactions tax on any resulting gain. A prohibited transaction is generally defined as sales or dispositions of property that a REIT holds primarily for sale to customers in the ordinary course of a trade or business, such as inventory. 57 If a REIT sells the mortgage loans that it originates, the REIT may be deemed to have created and sold inventory, and therefore entered into a prohibited transaction. Therefore, such loan sales, including whole loan sales, are typically conducted through a TRS. Securitization transactions by REITs also raise similar issues. The basic securitization transaction involves pooling receivables and issuing new securities to investors, usually debt secured by the pool of receivables. There are two available structures for securitizing mortgage loans: the REMIC and the CMO structures. A REMIC is simply a creature of the Code that owns a fixed pool of real estate mortgages and has two ownership classes: regular interests, which often 36

9 level taxes. 62 This is generally an unfavorable result because entity-level taxes reduce the amount of cash available for payment on the securities issued by the trust. TMP issues arise with CMO structures where the trust issues time-tranched notes, i.e., multiple classes of notes whereby a more senior class of notes is entitled to receive a return of its entire principal amount prior to the next class receiving any principal payments. 63 In general, the TMP rules were enacted to ensure that all time-tranched CMO securitizations would be effected as REMICs. However, special rules apply in the REIT context. Where a REIT engages in a time-tranched CMO securitization in the manner described above, a portion of the REIT (in particular, the segregated pool of mortgages held by the trust) itself becomes a TMP under a special rule in the Code. 64 That TMP, however, is treated as a separate standalone corporate subsidiary owned by the REIT. Because the REIT owns 100 percent of this corporate subsidiary, the subsidiary is generally classified as a QRS, and therefore is ignored for all tax purposes. 65 Thus, the trust in effect is not treated as a separate stand-alone corporation after all, but rather as part of the REIT itself. Therefore, TMP status does not disqualify the REIT per se, and no entity-level taxes are imposed on the TMP However, the REIT must continue to own all l of fthe equity interests in the CMO trust for this characterization to continue to apply. Otherwise, the trust will no longer be a QRS, because the REIT would no longer hold 100 percent of the trust. In that case, the trust becomes a separate stand-alone corporation for tax purposes, subject to entity-level tax, and the REIT must elect to treat the trust as a TRS. Nonetheless, treatment of a portion of the REIT as a TMP can be disadvantageous for REIT shareholders even when entity-level taxes do not apply. Much like with REMIC residual interests, the equity interests in a TMP generate excess inclusion income, 67 and there are special provisions in the Code to ensure that such phantom income does not end up in the hands of a nontaxpaying entity. Given that REITs generally are not subject to tax, these special provisions generally require that REIT dividends be treated as excess inclusions in part, so that the taint in effect flows through to REIT shareholders in a manner (and with the consequences) similar to that with REMIC residual interests held by a REIT explained above. 68 These consequences, and TMP status itself, generally can be avoided in a CMO securitization simply by not using a time-tranched structure. 69 Volume 9 Issue Hedging Transactions Almost all mortgage REITs engage in various hedging activities to protect themselves against interest rate fluctuations that may affect their profitability as a result of changes in spreads between interest rates on their borrowings and those on their mortgage-related assets. The Code, however, imposes limits on a REIT s ability to be fully hedged. Generally, income of a REIT from a hedging transaction is excluded from the REIT s gross income for purposes of both the 75-percent and the 95-percent Gross Income Tests. For purposes of these rules, however, a hedging transaction is defined somewhat narrowly to include a transaction entered into to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made (or to be made) or ordinary obligations incurred (or to be incurred) by the REIT, but only to the extent that such transaction (1) is clearly identified as a hedging transaction in accordance with detailed identification requirements, and (2) hedges indebtedness incurred or to be incurred to acquire or carry real estate assets. 70 Therefore, hedging income or gain qualifies for this special rule only if the hedge relates to debt incurred by the REIT, and then only if the debt was incurred or is to be incurred to acquire or carry real estate assets. All other hedging income, such as income from hedges with respect to the REIT s assets, is not excluded and does not constitute qualifying income for purposes of the two REIT gross income tests. As a result, gross income from other hedging activities, when combined with all other non-qualifying income for purposes of the 75-percent Gross Income Test, must be less than 25 percent of the REIT s gross income, and gross income from such hedging activities, when combined with all other nonqualifying income for purposes of the 95-percent Gross Income Test, must be less than five percent of the REIT s gross income. Accordingly, there are limits on a REIT s ability to hedge, including especially with respect to hedging transactions related to a REIT s assets (e.g., mortgages). Finally, any asset created by means of the REIT s hedging activities would not constitute a qualifying asset for purposes of the 75-percent Assets Test. Foreclosure Property Under the REIT rules, and as explained further below, an asset that is properly characterized as foreclosure property carries a special status. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 37

10 Foreclosure property is defined as any real property (including interests in real property) and any personal property incident to such real property acquired by a REIT as a result of the REIT having bid on such property at foreclosure, or having otherwise reduced such property to ownership or possession by agreement or process of law, after there was a default (or default was imminent) on a lease of such property or an indebtedness that the property secured. 71 A REIT must elect to treat property acquired in such manner as foreclosure property. 72 Foreclosure property would generally include real property obtained by the REIT following a default of an underlying mortgage. It is important to note that property will not be treated as foreclosure property if the loan (or lease) with respect to which the default occurs (or is imminent) was made or entered into (or the loan or lease was acquired) by a REIT with an intent to evict or foreclose, or when the REIT knew or had reason to know that default 73 would occur ( improper knowledge ). 74 Whether a REIT has such improper knowledge with respect to a particular loan is determined at the time that the REIT enters into a binding commitment to acquire that loan. Thus, if a REIT acquires distressed or nonperforming loans and ultimately acquires underlying real property through foreclosure and the IRS successfully asserts that the REIT had improper knowledge, the real property would not qualify as foreclosure property. 75 A property s status as foreclosure property terminates according to certain specified time periods and can terminate earlier if certain specified activities with respect to the property occur. In particular, foreclosure property generally ceases to be foreclosure property at the end of the third full tax year following its acquisition. 76 In addition, property ceases to be foreclosure property if, among other reasons, the property is used in a trade or business conducted by the REIT, other than during an initial 90-day period or through an independent contractor (as defined in the Code) from whom the REIT does not derive or receive any income. 77 Treatment of property as foreclosure property carries certain benefits, including the following: (1) the sale of foreclosure property cannot be treated as a prohibited transaction (which would generally subject gain from such sale to a 100-percent tax) 78 ; and (2) income and gain from foreclosure property is treated as qualifying income for purposes of the REIT gross income tests even if such income would not have qualified as permissible REIT income had 38 the property not been characterized as foreclosure property. 79 However, net income from foreclosure property, less tax thereon, is subject to the minimum distribution requirements. 80 While income earned from foreclosure property counts as permissible REIT income for purposes of the REIT gross income tests, the REIT nonetheless is taxed (at the highest corporate tax rate) on income from such property and, if such property is considered held primarily for sale to customers in the ordinary course of a trade or business, on any gain from the sale or other disposition of such property. 81 Given the uncertainty surrounding the improper knowledge requirement and the 100-percent prohibited transactions tax that may apply to sale of property obtained through a foreclosure if it is not treated as foreclosure property, it may be necessary for a REIT to hold certain distressed mortgages in TRS. TRS Issues As indicated above, mortgage REITs often conduct activities that they cannot conduct directly through one or more TRSs. Using a TRS presents several potential pitfalls. First, all transactions between the REIT and its TRS, e.g., loans or sales of mortgages, must be conducted at arm s length. The IRS has several tools at its disposal to attack transactions that are not conducted at arm s length. For example, the deductibility of interest paid or accrued by a TRS to its parent REIT is subject to certain limits. 82 In addition, a 100-percent excise tax can be imposed on certain transactions between a TRS and its parent REIT that are not conducted in an arm s-length manner. 83 As indicated above, another issue that frequently arises is ensuring that the aggregate value of the REIT s TRSs do not violate the 25-percent TRS Limit. The REIT asset tests are conducted on a quarterly basis. Therefore, where a mortgage REIT engages in significant activities through TRSs, it will need to monitor carefully, on an ongoing basis, the value of its TRS interest so that the 25-percent TRS Limit is not exceeded at the end of any calendar quarter. Dividends that a REIT receives from a TRS will qualify for the 95-percent Gross Income Test, but not the 75-percent Gross Income Test. Because TRS income is fully subject to corporate-level income tax, the TRS will not have to distribute its after-tax earnings to its affiliated REIT. However, the TRS s retention of after-tax earnings will increase its value for purposes

11 of the 25-percent TRS Limit. Therefore, a mortgage REIT may need to balance, carefully, the 75-percent Gross Income Test and the 25-percent TRS Limit, through leveraging or otherwise. Phantom Income If a REIT has phantom income, i.e., taxable income without any corresponding cash, such as original issue discount interest, cancellation of indebtedness income, or excess inclusion income from securitization transactions, such phantom income can be excluded from the 90-percent distribution requirement to the extent such income exceeds five percent of the REIT s taxable income. 84 A REIT that relies on this rule will, however, be subject to corporate-level tax on the amounts of income not distributed, even if it is phantom income. * The author gratefully acknowledges the assistance of Winston Chang, a Tax Partner in the Newport Beach office of O Melveny & Myers LLP, in preparing this article. 1 See, e.g., AG Mortgage Investment Trust, Inc., Apollo Residential Mortgage, Inc., Arbolada Capital Management Company, Colony Financial, Inc., Plymouth Opportunity REIT, Inc. and Provident Mortgage Capital Associates, Inc. 2 To ot the extent ent a REIT does not distribute all of fits taxable ab income to its shareholders, the undistributed income will be taxed at the REIT (or entity) level at corporate income tax rates. 3 The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the maximum individual tax rate for long-term capital gains generally from 20 percent to 15 percent and for dividends generally from 38.6 percent to 15 percent. However, because REITs are not generally subject to federal income tax on the portion of their taxable income or capital gains distributed to stockholders, REIT dividends generally are not eligible for the lower tax rate. Certain exceptions apply, including for dividends to the extent attributable to income upon which the REIT has paid corporate income tax or to the extent received as qualified dividends. 4 See Code Sec. 856(a). 5 See Code Sec. 856(h)(2). 6 See Code Sec. 859(a). 7 See Code Sec. 856(c)(1). 8 See Code Sec. 856(c)(3). 9 See Code Sec. 856(c)(2). 10 See Code Sec. 856(c)(4)(A). 11 See Code Sec. 856(c)(5)(B). 12 See Code Sec. 856(c)(5)(E). 13 See Code Sec. 856(c)(4)(B). 14 See Code Sec. 857(b)(6). 15 See Code Sec. 857(a). ENDNOTES Conclusion 16 See Code Sec. 857(b)(3). 17 See Code Sec. 857(b)(1) and (b)(2). 18 See, e.g., PETER M. FASS, MICHAEL E. SHAFF & DONALD B. ZIEF, REAL ESTATE INVESTMENT TRUSTS HANDBOOK: A PASS-THROUGH ENTITY TO OWN AND OPERATE REAL ESTATE AND MAKE MORTGAGE LOANS ( ed.); MICHAEL K. CARENVALE, JAMES P. DE BREE, ET AL., TAX MANAGEMENT PORTFOLIOS: REAL ESTATE INVESTMENT TRUSTS, No d (2011); Ira Akselrad and Robert S. Bernstein, UPREITs: A Structure for All Seasons? 21 J. CORP. TAX N 68 (1994); Stephen F. Mount, Tax Checklist for Formation of UPREIT, 35 TAX MGMT. MEMO. NO. 3, 51 (1994), Joseph G. Howe III, The REIT Modernization Act: Interpretative Issues Abound, 18 TAX MGMT. REAL EST. J. 3 (2001). See also information at 19 See Reg (g). 20 Frequently, the Operating Partnership will enter into a tax protection agreement with the contributor in which it agrees to indemnify the contributor under certain circumstances. 21 See Code Sec. 856(i)(2). 22 See Code Sec. 856(i)(1)(B). 23 See Code Sec. 856(l). 24 See Code Sec. 856(c)(4)(B)(ii). 25 See Code Sec. 1504(b)(6). 26 A TRS, however, cannot be used to operate or manage a health care facility or lodging facility. See Code Sec. 856(l)(3). 27 See Code Sec. 856(c)(2)(A) and (3)(D). 28 See Code Sec. 859(a). The REIT election is made by filing IRS Form 1120-REIT and computing taxable income as a REIT. 29 See Code Sec. 857(a)(2)(B). 30 For example, it may be possible to satisfy the distribution requirement through a stock distribution that is treated as a dividend because shareholders have the right to elect to receive part or all of the distribution in cash. See LTR Volume 9 Issue REITs in general, and mortgage REITs in particular, are complicated creatures of the Code. Given all of the requirements that must be satisfied on a continuing basis to maintain REIT status, it is clear that mortgage REITs are not the optimal structure for all circumstances. Compliance with these requirements clearly prevents an entity from operating solely with the goal of maximizing profits and given the nature of the REIT gross income and asset tests generally, REIT status may be incompatible for active mortgage related companies. However, in circumstances where the REIT requirements are consistent with the proposed or existing operations of the entity desiring REIT status, the tax and other benefits achieved by REIT status are warranted (Jan. 28, 2008), LTR (Nov. 3, 2005), LTR (Jan. 10, 2006), LTR (Oct. 29, 2003) and LTR (Aug. 26, 2003). In addition, the IRS recently published guidance in this regard. Pursuant to this guidance, a REIT may treat the entire amount of a distribution consisting of both stock and cash as a qualifying distribution for purposes of the REIT distribution requirement if the distribution satisfies certain requirements, including the following: (1) the stock of the REIT is publicly traded on an established securities market in the United States; (2) the distribution is declared with respect to a tax year ending on or before December 31, 2011; and (3) the REIT s shareholders may elect to receive their proportionate shares of the declared distribution in either cash or stock of the REIT with an equivalent value, subject to a limitation on the amount of cash to be distributed in the aggregate. However, (a) such cash limitation may not be less than 10 percent of the aggregate declared distribution, (b) if too many shareholders elect to receive cash, each shareholder electing to receive cash must receive a pro rata amount of cash corresponding to such shareholder s respective distribution entitlement, and (c) each shareholder electing to receive cash must in no event receive less than 10 percent of the stockholder s entire distribution in cash. See Rev. Proc , IRB , 302, amplifying and superseding Rev. Proc , IRB , See Rev. Rul , CB See Reg (c). 33 See Code Sec. 856(f)(1)(A). Special rules apply to shared appreciation provisions, pursuant to which the lender receives a share of any increase in the value of the collateral during the term of the loan. See Code Sec. 856(j). JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 39

12 40 ENDNOTES 34 See Reg (c). Because the value of the real property is fixed as of the date the REIT commits to either originate or purchase the loan, the REIT does not need to retest (in the future) such value. Accordingly, any decline in the value of the real property does not cause a decrease in the amount of interest income that could be treated as qualifying income. 35 See LTR (Feb. 19, 1999) and Rev. Proc , IRB , Rev. Proc , CB See Rev. Rul , CB 196 and FSA (Mar. 5, 1996). 38 In general, a dollar roll transaction is a form of a repurchase agreement, whereby the REIT sells an asset during one period and repurchases in a later period. 39 See Code Sec. 856(c)(5)(E). 40 See id. 41 In general, excess inclusions are simply the amounts the holder of a REMIC residual interest has to include in income in excess of a statutory defined and assumed economic rate of return on the amount invested in the REMIC residual interest (defined as its adjusted issue price). The assumed return is calculated at a rate equal to 120 percent of the long-term federal rate (a designated Treasury interest rate). See Code Sec. 860E(c). In many cases, a holder of a REMIC regular interest is not entitled to any distributions but must still include in income its ratable portion nof the REMIC s net income. The holder makes no investment but instead receives an inducement fee for undertaking that obligation; and the entire amount included in income is excess inclusion income. 42 See Code Sec. 860E(d). See also Reg E-1(b) and Notice , CB 904. The precise manner in which excess inclusion income is calculated (and allocated to shareholders, including in situations where a REIT has multiple classes of stock) is not entirely clear under current law. 43 See Code Sec. 860E(a)(3). 44 See Code Sec. 860E(b). 45 See Code Sec. 860G(b). 46 See Code Sec. 860E(e)(6). A charitable remainder trust is also treated as a disqualified organization for this purpose. See Rev. Rul , CB Some REIT charters expressly prohibit any ownership of their stock by a disqualified organization, whether such ownership is direct or indirect (e.g., through an intervening entity). Others prohibit only direct ownership, while yet others do not contain any prohibition at all. Technically, it appears that the REIT is subject to tax only if a disqualified organization is a record holder of REIT stock. See Code Sec. 860E(e)(6)(A). 48 See Reg Gain is generally measured by the difference between the issue price of the new debt instrument and the holder s basis (i.e., generally its cost). See Reg (g). In the case of debt that is not publicly traded, the issue price of the new debt is generally equally to its face amount (and not its fair market value). See Code Sec. 1273(b)(4). 50 See Rev. Proc , IRB , 1. In particular, the IRS will not challenge a REIT s treatment of a loan as being part of a real estate asset for purposes of the 75-percent Assets test in an amount equal to the lesser of (1) the value of the loan as determined under Reg (a), or (2) the loan value of the real property securing the loan as determined under Reg (c) and Rev. Proc See Robert J. Le Duc and Weiying (Sarah) Wang, Recent Developments for REITs Owning or Investing in Distressed Mortgages and Related Assets, Vol. 9 Issue 3 J. TAX N FIN L PRODS., at 31 (2011). 51 See NAREIT s response to Rev. Proc , which can be found at Portals/0/NAREITDistressedDebt pdf. 52 In some cases, a REIT may be able to cease accruing interest under the so-called doubtful collectability doctrine. See Rev. Rul , CB 164. The IRS appears to take the view that such doctrine, however, does not apply in the case of interest that accrues as original issue discount. See TAM (Sept. 22, 1995). See also John Kaufmann, The Treatment of Payments on Distressed Debt Instruments, 26 J. TAX N INV. 13 (2008). 53 See Code Sec Absent such election, however, market discount does not give rise to phantom income given that income recognition occurs only upon a principal payment or sale. 55 See Code Sec. 1276(a)(4) and LTR (June 30, 1986). 56 In the case of deeply distressed debt, there may be an argument that the market discount rules of the Code do not apply. See Andrew W. Needham, Do the Market Discount Rules Apply to Distressed Debt? Probably Not, 8 J. TAX N FIN L PRODS. 25 (2009). 57 See Code Sec. 857(b)(6)(B). 58 For excellent discussion of mortgage-backed securities transactions and securitization transactions in general, see JAMES M. PEA- SLEE & DAVID Z. NIRENBERG, FEDERAL INCOME TAXATION OF SECURITIZATION TRANSACTIONS AND RELATED TOPICS (4th ed. 2011). 59 See Code Sec. 860A(a). 60 See Code Sec. 860B(a). 61 See Melanie J. Gnazzo, Mortgage REITs Pruning Portfolios and Prohibited Transaction Taxes, REAL EST. TAX N, Vol. 37, No. 4, 3d Quarter, See Code Sec. 7701(i)(1). 63 Time-tranched securities are sometimes referred to as sequential pay or fast pay, slow pay securities. 64 See Code Sec. 7701(i)(2)(B). 65 See H.R. CONF. REP. NO , at II-240, note 26, reprinted in 1986 U.S.C.C.A.N. 4075, 4328, note Code Sec. 7701(i)(3). 67 See note 40 supra. Determining the excess inclusion income for a TMP, which may not be a separate legal entity, can be a challenging exercise. 68 See Code Secs. 7701(i)(3) and 860E(d). Code Sec. 7701(i)(3) provides generally that, under Regulations prescribed by the IRS, when a REIT or a QRS is a TMP, adjustments similar to those applicable when a REIT holds a REMIC residual interest shall apply. To date no Regulations under Code Sec. 7701(i) (3) have been issued, and it is not entirely clear how the adjustments under Code Sec. 7701(i)(3) are to be made. However, it appears that the statute is self-executing, and IRS has confirmed this view through the issuance of interim guidance on the proper treatment and reporting of excess inclusion income. See Notice , CB 904, as well as a paper prepared by NAREIT, which can be found at media/portals/0/files/nareit/htdocs/members/policy/government/submission%20 re%20notice% ashx. See also, e.g., Kirk Van Brunt, Tax Aspects of REMIC Residual Interests, 94 TNT (1994) and Robert J. Crnkovich & Kenneth H. Heller, To the Extent Provisions: When Do They Operate Without Regulations? 76 J. TAX N 176 (1992). 69 However, such single class CMO securitizations may not be as efficient or valuable from the REIT s perspective. 70 See Code Sec. 856(c)(5)(G)(i). In addition, a hedging transaction includes a transaction entered into primarily to manage risk of currency fluctuations with respect to any item of income or gain that constitutes qualifying income for purposes of the 75-percent and the 95-percent Gross Income Tests (or any property which generates such income or gain), provided that such transaction is clearly identified as such before the close of the day on which it was acquired, originated, or entered into. See Code Sec. 856(c)(5)(G)(ii). 71 See Code Sec. 856(e)(1). 72 See Code Sec. 856(e)(5). 73 In general, the type of default referenced in this rule is the type of default that would ordinarily give rise to foreclosure. 74 See Reg (b)(3). 75 A leading treatise in the area notes the following: the bar to foreclosure property treatment in effect prevents a REIT from

13 Volume 9 Issue acquiring a portfolio of nonperforming mortgage loans from an entity with the intent to quickly foreclose and dispose of unwanted properties. See REAL ESTATE INVESTMENT TRUSTS HANDBOOK, supra 18, at 5: See Code Sec. 856(e)(2). 77 See Code Sec. 856(e)(4). 78 See Code Sec. 857(b)(6)(B)(iii). If property ceases to be treated as foreclosure property, however, the prohibited transactions tax could apply to any gain from the sale of such ENDNOTES property, depending on the highly factual determination of whether the property is held primarily for sale to customers in the ordinary course of a trade or business. 79 See Code Sec. 856(c)(2)(F) and (3)(F). 80 See Code Sec. 857(a)(1)(A)(ii). 81 See Code Sec. 857(b)(4)(A) and (B). 82 See Code Sec. 163(j)(3)(C). 83 See Code Sec. 857(b)(7). If the 100-percent excise tax applies, the transfer pricing regime of Code Sec. 482 does not apply. See Code Sec. 857(b)(7)(E). A REIT is presumed to meet its burden of proof of properly allocating costs between it and its TRSs under tests to be developed by the Treasury. However, to date, no such guidance has been issued, and until guidance is issued, a REIT and its subsidiaries will likely be able to rely on any reasonable allocation method. 84 See Code Sec. 857(e)(1). The market discount rules, however, are not covered by this special rule. This article is reprinted with the publisher s permission from the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS, a quarterly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the JOURNAL OF TAXATION OF FINANCIAL PRODUCTS or other CCH Journals please call or visit All views expressed in the articles and columns are those of the author and not necessarily those of CCH. JOURNAL OF TAXATION OF FINANCIAL PRODUCTS 41