In a recently-released letter ruling, the IRS determined that certain management fees that a mortgage REIT will receive from its subsidiary (“Operating Partnership”) will be excluded from gross income for purposes of the REIT gross income tests of Code §§856(c)(2) and (c)(3). There are at least three interesting aspects of PLR 201620001 to consider in light of the Operating Partnership’s plan to manage nonperforming loans by acquiring the underlying single-family residential properties through foreclosure, and then selling the homes to third parties quickly after acquisition.
Dispositions of Foreclosure Property
The Operating Partnership is described as having a primary business of acquiring and managing a portfolio of “re-performing” and nonperforming mortgage loans secured by single-family residences. Nonperforming loans are ones in which the borrower has not made payments for over 90 days, and has not resumed repayment of the loan. Re-performing loans are ones that were at least 90 days delinquent, but are now performing again, perhaps due to a mortgage modification. PLR 201620001 notes that when the Operating Partnership identifies mortgages as nonperforming, it will foreclose on the properties securing the debt, and then promptly dispose of the properties (“REOs acquired by Operating Partnership … will be sold to third parties soon after they are acquired”). The rental of REO property is not a focus of the Operating Partnership, and will be only a small part of the its activities.
While foreclosure is a commonly-encountered collection procedure when other options for nonperforming mortgages have failed, holding an asset that is properly characterized as “foreclosure property” has significant implications under the REIT rules. For example, 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 the property and, if the 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 the property. §§857(b)(4)(A) and (B). Foreclosure property is defined as any real property, and any personal property incident to the real property, acquired by a REIT as a result of the REIT having bid on the property at foreclosure, or having otherwise reduced the property to ownership or possession by agreement or process of law, after there was a default (or default was imminent) on a lease of the property or an indebtedness that the property secured. §856(e)(1).
The treatment of property by a REIT as foreclosure property requires an irrevocable election. §856(e)(5). While Congress intended that the foreclosure property rules would provide relief to a REIT holding foreclosure property, the legislative history provides explicitly that the relief rules “are not intended to apply with respect to real property acquired under a mortgage or lease that was entered into by the REIT (or acquired by the REIT) with an intent to foreclose or evict.” S. Rep. No. 1357, 93rd Cong., 2d. Sess. 13 (1974), 1975-1 C.B. 524, 525. Similarly, “where a REIT acquires a mortgage … when it knew or had reason to know that default would occur, the foreclosure rules are not to apply.” Id.; see also Reg. §1.856-6(b)(3) (noting that “improper knowledge” makes property ineligible for foreclosure property election). Given Operating Partnership’s business plan, there may be some risk that the REIT might be found to have had improper knowledge that default on the re-performing and nonperforming mortgages would occur, and thus Operating Partnership’s ability to elect to treat foreclosure property treatment may be at risk.
Further, REITs, as passive investors in real estate assets, may incur a 100% prohibited transaction tax on net income from certain sources, including sales or other dispositions of inventory which is not qualified foreclosure property. §857(b)(6). When Operating Partnership acquires single-family residences after foreclosure, in some cases (or perhaps in many cases) the residences may be inventory in its hands. The sale of a property that constitutes inventory under §1221(a)(1) will be taxed as a prohibited transaction if the REIT did not, or could not, elect to treat the property as foreclosure property under §856(e)(5).
Exclusion of Management Fees
PLR 201620001 appears to be the first IRS pronouncement excluding management fees from the REIT gross income tests under the authority of §856(c)(5)(J), a relatively new provision that provides the government with statutory authority to recharacterize items of REIT income. To date, the IRS has released about 30 letter rulings applying its §856(c)(5)(J) authority; all were written by the IRS Office of Associate Chief Counsel (Financial Institutions & Products). Of these rulings, PLR 201620001 is the first utilizing §856(c)(5)(J) to recharacterize income from management activities received by a REIT.
Section 856(c)(5)(J) was added to the Code by the Housing and Economic Recovery Act of 2008, Pub. L. No. 110-289, and provides the Department of the Treasury and the IRS statutory authority to determine that an item of income or gain that does not qualify under §§856(c)(2) and (c)(3) (i.e., does not satisfy the 95% and 75% gross income tests) may nevertheless be deemed to be qualifying REIT gross income. Alternatively, under §856(c)(5)(J), Treasury and the IRS may determine that an item of income or gain that does not qualify under §§856(c)(2) and (c)(3) does not constitute gross income for purposes of these tests. The latter approach is taken in PLR 201620001.
In enacting the REIT rules, Congress intended that REIT income should be overwhelmingly passive and not derived from the active operation of a business, and the §§856(c)(2) and (c)(3) income tests ensure that passive income constitutes the vast majority of the income of a REIT. The Code deems any amount received directly or indirectly by a REIT for “managing or operating [real estate] property” to be impermissible tenant service income excluded from rents from real property. §856(d)(2)(C) and §856(d)(7)(A)(ii). If impermissible tenant service income exceeds 1% of all amounts received by a REIT from a property during a tax year, then all income received by the REIT from that property in the tax year is treated as non-qualifying income for purposes of the §§856(c)(2) and (c)(3) tests. §856(d)(7)(B).
While the directors or trustees of a REIT are fiduciaries under state law, and generally are obligated to manage and conduct the affairs of the REIT itself, the regulations distinguish managing or operating the REIT’s properties as activities the directors or trustees should not perform. See, e.g., Reg. §1.856-4(b)(5)(ii) (“[t]he trustees or directors of the real estate investment trust are not required to delegate or contract out their fiduciary duty to manage the trust itself, as distinguished from rendering or furnishing services to the tenants of its property or managing or operating the property” [emphasis added]). Nonetheless, it appears the Operating Partnership in PLR 201620001 will be directly involved in managing REIT property.
PLR 201620001 notes that an independent contractor will perform mortgage servicing, property management, lease management, and renovation management services, and includes a representation that the REIT will use the independent contractor (or a taxable REIT subsidiary) “to ensure that any impermissible tenant service income does not exceed the de minimis amount in §856(d)(7)(B).” However, since a substantial portion of the Operating Partnership’s (and thus the REIT’s) business plan is foreclosure on nonperforming mortgages, and flipping the borrowers’ homes, it appears there will be substantial management or operational activities beyond the activities ascribed to the independent contractor (e.g., deciding which properties to foreclose on, and the order and timing of both foreclosure, and subsequent disposition, proceedings). Further, PLR 201620001 details the REIT’s restructuring through which it eliminated Company Y, its taxable REIT subsidiary (TRS), and it is not apparent that any management activities would be performed by a TRS.
The analysis in PLR 201620001 is not ultimately focused on either of the preceding issues, but instead is on the risk of double counting income in applying the REIT qualification tests.
The letter ruling states that the double counting of management fee income could occur “[b]ecause the Management Fees are derived from the same Investments that generate the Investment Income” and thus “including the Management Fees in Taxpayer’s gross income would cause the amounts to be counted twice for purposes of the gross income tests under section 856(c).” One might say that avoidance of double counting is treated as the bookkeeping tail that will wag the foreclosure dog, and save the day for the REIT in this ruling. Under this logic, a REIT might receive all sorts of nonqualified income from an affiliated entity that would be excluded from the gross income tests where double counting is a risk on the horizon.
The ruling notes that Operating Partnership is an entity treated as a partnership for federal income tax purposes; accordingly, it will prepare a Schedule K for each partner. If these Schedule Ks clearly reflect income, as they should and presumably will, one would assume that the risk of double counting could effectively be managed at the Operating Partnership level. Moreover, double counting of income received from an affiliated entity would seem to always be a risk when a pass-through entity both owns investment assets and pays an entity that it partly owns to manage the REIT’s assets (thus effectively paying itself for services).
All things considered, double counting seems to be a rather thin reed to support the outcomes in PLR 201620001.
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