rp-11-16.pdf

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Part III

Administrative, Procedural, and Miscellaneous

26 CFR 601.105: Examination of returns and claims for refund, credit, or abatement;
determination of correct tax liability.

(Also Part I, §§ 856(c), 1001; 1.856–3, 1.856–5, 1.1001–3.)

Rev. Proc. 2011-16

SECTION 1. PURPOSE
This revenue procedure provides guidance r
egarding aspects of a taxpayer’s
qualification as a real estate investment trust (REIT) in the context of transactions
involving debt secured by real estate the fair market value of which has declined.
SECTION 2. BACKGROUND
.01 To qualify as a REIT for a taxable year, at least 95 percent of an entity’s
gross income must be derived from the types of qualifying incom
e listed in
section 856(c)(2) of the Internal Revenue Code, and at least 75 percent of its gross

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income must be derived from the types of qualifying income listed in section 856(c)(3).
Specifically, all interest is qualifying income for the 95 percent income test under section
856(c)(2); and interest on obligations secured by mortgages on real property or on
interests in real property is qualifying income for purposes of the 75 percent income test
under section 856(c)(3).
.02 Section 856(c)(4)(A) provides that at the close of each quarter of its 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.
.03 Under section 856(c)(5)(B), the term “real estate assets” includes 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.
.04 Section 856(c)(5)(C) provides that the term “interests in real property”
includes fee ownership and co-ownership of land or improvements thereon, leaseholds
of land or improvements thereon, options to acquire land or improvements thereon, and
options to acquire leaseholds of land or improvements thereon, but does not include
mineral, oil, or gas royalty interests.
.05 If a mortgage loan is secured by both real property and other property, then,
for purposes of section 856(c)(3), § 1.856–5(c) of the Income Tax Regulations provides
rules for apportioning the interest on the loan between interest on an obligation that is
secured by real property (or by an interest in real property) and interest on an obligation
that is not so secured. Under this apportionment test, the “loan value of the real

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property” is compared to the “amount of the loan.” If the loan value of the real property
is equal to or exceeds the amount of the loan, then all of the interest income from the
loan is apportioned to the real property. If the amount of the loan exceeds the loan
value of the real property, 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 the excess of the total
interest income over the interest income apportioned to the real property.
.06 For purposes of the apportionment test, § 1.856–5(c)(2) generally defines the
“loan value of the real property” that secures a loan as the fair market value of the real
property, determined as of the date on which a commitment became binding on the
REIT either to make the loan or to purchase the loan, as the case may be.
Section 1.856-5(c)(3) defines the “amount of the loan” as the highest principal amount
of the loan outstanding during the taxable year.
.07 Section 1.1001–3(c)(1)(i) defines a “modification” of a debt instrument as any
alteration, including any deletion or addition, in whole or in part, of a legal right or
obligation of the issuer or holder of the debt instrument, whether the alteration is
evidenced by an express agreement (oral or written), conduct of the parties, or
otherwise. Section 1.1001–3(e) governs which modifications of debt instruments are
“significant.” Under § 1.1001–3(b), for most federal income tax purposes, a significant
modification produces a deemed exchange of the original debt instrument for a new
debt instrument.

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.08 Section 1.860G–2(b)(1) concerns modifications of mortgages held by real
estate mortgage investment conduits (REMICs). Certain loan modifications are not
significant for purposes of § 1.860G-2(b)(1) even if the modifications are significant
under the rules in § 1.1001-3. In particular, under § 1.860G-2(b)(3)(i), if a change in the
terms of an obligation is “occasioned by default or a reasonably foreseeable default,”
the change is not a significant modification for purposes of § 1.860G-2(b)(1), regardless
of the modification's status under § 1.1001-3.
.09 Section 857(b)(6) imposes a tax equal to 100 percent of the net income
derived from “prohibited transactions.” Section 857(b)(6)(B)(iii) defines the term
“prohibited transaction” as a sale or other disposition of property that is described in
section 1221(a)(1) and that is not foreclosure property.
SECTION 3. SCOPE
.01 Section 4.01 of this revenue procedure applies to a modification of a
mortgage loan which (or an interest in which) is held by a REIT if –
(1) The modification was occasioned by default; or
(2) The modification satisfies both of the following conditions:
(a) Based on all the facts and circumstances, the REIT or servicer of the loan
(the “pre-modified loan”) reasonably believes that there is a significant risk of default
of the pre-modified loan upon maturity of the loan or at an earlier date. This
reasonable belief must be based on a diligent contemporaneous determination of
that risk, which may take into account credible written factual representations made
by the issuer of the loan if the REIT or servicer neither knows nor has reason to

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know that such representations are false. In a determination of the significance of
the risk of a default, one relevant factor is how far in the future the possible default
may be. There is no maximum period, however, after which default is per se not
foreseeable. For example, in appropriate circumstances, a REIT or servicer may
reasonably believe that there is a significant risk of default even though the foreseen
default is more than one year in the future. Similarly, although past performance is
another relevant factor for assessing default risk, in appropriate circumstances, a
REIT or servicer may reasonably believe that there is a significant risk of default
even if the loan is performing, and
(b) Based on all the facts and circumstances, the REIT or servicer reasonably
believes that the modified loan presents a substantially reduced risk of default, as
compared with the pre-modified loan.
.02 Section 4.02 of this revenue procedure applies to any corporation that has
elected to be taxed as a REIT.
SECTION 4. APPLICATION
.01 Modifications. If a modification of a mortgage loan is described in
section 3.01 of this revenue proc
edure—
(1) For purposes of ascertaining under § 1.856-5(c)(2) the “loan value of the real
property” securing that loan, a REIT may treat the modification as not being a new
commitment to make or purchase a loan; and
(2) The modification of the mortgage loan will not be treated as a prohibited
transaction under section 857(b)(6).

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.02 Asset test. The Service will not challenge a REIT’s treatment of a loan as
being in part a “real estate asset” for purposes of section 856(c)(4) if the REIT treats the
loan as being a real estate asset in an amount equal to the lesser of—
(1) The value of the loan as determined under § 1.856-3(a), or
(2) The loan value of the real property securing the loan as determined
under § 1.856–5(c) and this revenue procedure.
SECTION 5. EXAMPLES
.01 Exam
ple 1. In 2007, X, a REIT, made a $100 mortgage loan to A. X’s loan
to A was secured by both real property and personal property. When X’s commitment
to make the loan became binding on X, the real property had a fair market value of
$115. At the end of the calendar quarter in which X made the loan, the value of the loan
as determined under § 1.856-3(a) was $100. At all times through the end of 2010,
under § 1.856–5(c)(3), the amount of the loan continued to be $100.

By the start of 2009, the fair market value of the real property had fallen to $55
and the fair market value of the personal property was $5. They remained at these
levels throughout 2009 and 2010. Throughout 2009 and 2010, the value of the loan, as
determined under § 1.856-3(a), was $60.

During 2009, X and A modified the terms of the mortgage loan. The modification
of the loan is described in section 3.01 of this revenue procedure and is a significant
modification under § 1.1001-3.

(1) Income Test. When X made the mortgage loan in 2007, the loan value of the
real property for purposes of § 1.856–5(c) was its fair market value ($115) determined
as of the date on which the commitment to make the loan became binding on X. This
amount exceeded the amount of the loan for that year ($100). Accordingly, in the year
that the loan was made, all of the interest from the loan was apportioned to the real
property. See § 1.856–5(c)(1).

Between the time that the loan was made and the time of the modification, the
loan value of the real property continued to be $115, notwithstanding changes in the fair
market value of that real property. See § 1.856–5(c)(2). Similarly, the amount of the
loan continued to be $100. Accordingly, the loan value of the real property ($115)
continued to exceed the amount of the loan ($100), and all of the interest on the loan
continued to be apportioned to the real property.

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The fair market value of the real property that secured the mortgage loan had
fallen to $55 by the time that X and A modified the loan in 2009. That modification,
however, is described in section 3.01, and X chose to treat the modification as not being
a new commitment to make or purchase a loan. Therefore, the loan value of the real
property ($115) does not change. Because the loan value of the real property ($115)
continued to exceed the amount of the loan for the year of modification ($100), all of the
interest from the loan during that year is apportioned to real property.

(2) Asset Test. In 2007, at the end of the calendar quarter in which X made the
mortgage loan, the value of the loan (as determined under § 1.856-3(a)) was $100, and
the loan value of the real property securing the loan (as determined under § 1.856–
5(c)(2)) was $115. For this calendar quarter, under section 4.02 of this revenue
procedure, X may treat the lesser of these two values ($100) as the amount of the loan
that is a real estate asset for purposes of section 856(c)(4).

In 2009, at the end of the calendar quarter in which X modified the mortgage
loan, the value of the loan (as determined under § 1.856-3(a)) was $60, and the loan
value of the real property securing the loan (as determined under § 1.856–5(c) and
section 4.01 of this revenue procedure) was $115. For this calendar quarter, under
section 4.02 of this revenue procedure, X may treat the lesser of these two values ($60)
as the amount of the loan that is a real estate asset for purposes of section 856(c)(4).

.02 Example 2. The facts include all of the facts in Example 1. Additionally,
during the first quarter of 2010, Y, a REIT, committed to purchase, and purchased, the
mortgage loan from X for $60.

(1) Income Test. Under § 1.856–5(c)(2), the loan value of the real property
securing the loan is the fair market value of the real property determined as of the date
on which Y’s commitment to purchase the loan became binding on Y ($55). This value
is compared to the amount of the loan for the year ($100). Because the amount of the
loan exceeds the loan value of the real property, 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 ($55) and the denominator of
which is the amount of the loan ($100). Therefore, 55 percent of the interest income
from Y’s loan is apportioned to the real property securing the loan. Interest income
apportioned to the other property is the excess of the total interest income over the
interest income apportioned to the real property. See § 1.856–5(c)(2).

(2) Asset T
est. At the end of every calendar quarter during 2010, the value of the
loan (as determined under § 1.856-3(a)) was $60, and the loan value of the real
property securing the loan (as determined under § 1.856–5(c) and this revenue
procedure) was $55. For every calendar quarter during 2010, under section 4.02 of this

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revenue procedure, Y may treat the lesser of these two values ($55) as the amount of
the loan that is a real estate asset for purposes of section 856(c)(4).

SECTION 6. EFFECTIVE DATE
This revenue procedure is effecti
ve for all calendar quarters and all taxable
years.
SECTION 7. DRAFTING INFORMATION
The principal author of this revenue procedure is Jonathan D. Silv
er of the Office
of Associate Chief Counsel (Financial Institutions & Products). For further information
regarding this revenue procedure contact Jonathan D. Silver on (202) 622-3930 (not a
toll free call).