rr-98-34.pdf

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July 21, 1998

# ADVANCE COPY OF INTERNAL REVENUE BULLETIN ITEM

Attached is an advance copy of Revenue Ruling 98-34,
describing the treatment of loans with below-market interest
rates.

It will appear in Internal Revenue Bulletin 1998-31, dated
August 3, 1998.

You may release this rev. rul. immediately.

Communications Division

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## Section 7872. -- Treatment Of Loans With Below-Market Interest Rates

26 CFR 1.7872-5T: Exempted Loans (temporary) .

Rev. Rul. 98-34

ISSUE

If the Department of Housing and Urban Development ("HUD")
makes a below-market second mortgage loan in accordance with the
Multifamily Assisted Housing Reform and Affordability Act of
1997, 111 Stat. 1384 ("MAHRA Act"), is that loan exempt from
$ 7872 of the Internal Revenue Code?

FACTS

Limited partnership PRS owns a multifamily low-income rental
property subject to a first mortgage that secures a nonrecourse
first mortgage note with an outstanding principal balance of
$100x (the "Existing Mortgage loan") . The Existing Mortgage loan
is insured by the Federal Housing Administration ("FHA") . PRS,
as owner of the property, receives both rental payments from the
property's tenants and, under a project-based assistance
contract, certain additional payments from HUD. (Collectively,
the payments are referred to as "Contract Rents.") The Contract
Rents exceed the rents that would be received with respect to
comparable unassisted rental properties in the same housing
market ("Street Rents") . If the project-based assistance from

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HUD were reduced so that Contract Rents reflected Street Rents,
PRS would not be able to satisfy its debt service obligation on
the Existing Mortgage loan.

Congress enacted the MAHRA Act to reduce the federal
government's cost of rental subsidies, to minimize FHA mortgage
insurance risks, and to ensure the continued viability of
multifamily rental housing projects. See § 511 (b) of the MAHRA
Act; H.R. Conf. Rep. No. 297, 105th Cong., 1st Sess. 137-39
(1997) . To achieve these goals, the MAHRA Act permits owners of
eligible multifamily housing projects with expiring project-based
assistance contracts to enter into mortgage restructuring and
rental assistance sufficiency plans with HUD or a participating
administrative entity acting on behalf of HUD.

In accordance with the MAHRA Act, the following actions
occur :

(1) Project-based assistance payments to PRS are reduced so
that the Contract Rents received by PRS reflect Street Rents.

(2) HUD makes a $35x cash payment to the holder of the
Existing Mortgage loan on behalf of PRS to reduce the outstanding
principal balance of the Existing Mortgage loan to $65x.

(3) The terms of the Existing Mortgage loan are modified,
resulting in a new first mortgage loan with an outstanding
principal balance of $65x ("New First Mortgage loan") . The New
First Mortgage loan provides for interest above the applicable

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Federal rate under § 1274 (d) ("AFR") . Debt service on the New
First Mortgage loan is supportable by the reduced Contract Rents.

(4) In consideration for the payment in step (2), PRS
executes a nonrecourse note to HUD (the "Second Mortgage loan")
secured by a second mortgage. The Second Mortgage loan has a
principal balance of $35x, provides for interest below the AFR,
and qualifies as indebtedness under general principles of federal
income tax law. The Second Mortgage loan is made in accordance
with § 517 (a) (1) (B) of the MAHRA Act.

LAW AND ANALYSIS

In general, § 7872 defines a below-market loan as any loan
on which the interest rate charged is less than the AFR. Section
7872 (b) provides that the borrower of a below-market term loan is
treated as having received from the lender, on the date the loan
is made, cash in an amount equal to the excess of the amount
loaned over the present value of all payments required under the
loan (the "imputed transfer") . Section 7872 (b) further provides
that a below-market term loan is treated as having original issue
discount ("OID") in an amount equal to the imputed transfer,
which is in addition to any other OID on the loan determined
without regard to § 7872 (b) .

Section 1.7872-5T (a) (1) of the temporary Income Tax
Regulations provides that, notwithstanding any other provision of
\$ 7872 and the regulations thereunder, \$ 7872 does not apply to
the loans listed in § 1.7872-5T (b) because the interest

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arrangements of those loans do not have a significant effect on
the federal tax liability of the borrower or the lender. Section
1\. 7872-5T (a) (2) provides, however, that if a taxpayer structures
a transaction as a loan exempt under $ 1.7872-5T (b) and one of
the principal purposes of so structuring the transaction is the
avoidance of federal tax, then the transaction will be recharac-
terized as a tax avoidance loan under $ 7872 (c) (1) (D) .

Section 1.7872-5T (b) (5) provides an exemption for loans that
are subsidized by a federal, state, or municipal government (or
any agency or instrumentality thereof), and that are made
available under a program of general application to the public.

Under § 1.7872-5T (b) (15), other loans described in revenue
rulings or revenue procedures may be exempted from § 7872 if the
Commissioner finds that the factors justifying the exemption for
those loans are sufficiently similar to the factors justifying
the other exemptions listed in § 1.7872-5T.

The legislative history of $ 7872 indicates that most
government-subsidized loans, such as government-insured
residential mortgage loans, were intended to be exempt from
§ 7872. See 1 Senate Comm. on Finance, 98th Cong., 2d Sess.,
Deficit Reduction Act of 1984: Explanation of Provisions
Approved by the Committee on March 21, 1984, at 482 (S. Prt.
169) .

The factors justifying exemption of the Second Mortgage loan
from $ 7872 are similar to the factors justifying the exemption

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for government subsidized loans made available under a program of
general application to the public, which are exempt from § 7872
under $ 1. 7872-5T (b) (5) .

The MAHRA Act was enacted as a reform measure to reduce
HUD's cost of renewing project-based assistance contracts on
multifamily low-income rental properties while ensuring the
continued viability of these multifamily rental housing projects.
The interest arrangements of the Second Mortgage loan to PRS are,
therefore, not structured with a principal purpose of avoiding
federal tax.

HOLDING

The Second Mortgage loan is exempt from $ 7872.

### DRAFTING INFORMATION

The principal authors of this revenue ruling are David B.
Silber and Tina Jannotta of the Office of Assistant Chief Counsel
(Financial Institutions and Products) . However, other personnel
from the IRS and Treasury Department participated in its
development. For further information regarding this notice,
contact Tina Jannotta on (202) 622-3940 (not a toll-free call) .