IRS has privately ruled that interest earned on tax loans is treated as interest for purposes of the Code Sec. 856(c) real estate investment trust (REIT) qualifying income tests. Tax loans are a specialized financing device used to pay for real property tax liabilities when property owners can't pay what they owe to the taxing authority.
Background. To qualify as a REIT for a tax year, the Code Sec. 856(c)(4) assets qualification test requires that, as of the close of each quarter of the tax year: (1) at least 75% of the value of the REIT's total assets must be real estate assets as defined by Code Sec. 856(c)(5)(B), government securities, and cash or cash items (including receivables); (2) no more than 25% of the value of a REIT's total assets can be securities other than those that qualify under the 75% test; and (3) no more than 25% of the value of a REIT's total assets can be securities of one or more taxable REIT subsidiaries.
At least 95% of the REIT's gross income must be derived from the types of qualifying income listed in Code Sec. 856(c)(2), and at least 75% of its gross income must be derived from the types of qualifying income listed in Code Sec. 856(c)(3). Interest is one of the sources of income that qualifies under Code Sec. 856(c)(2).
“Interest” excludes any amount received or accrued, directly or indirectly, if the determination of such amount depends in whole or in part on the income or profits of any person, but any amount so received or accrued will not be excluded from the term “interest” solely because of being based on a fixed percentage or percentage of receipts or sales. (Code Sec. 856(f)) Where a mortgage covers both real and other property, the interest must be apportioned for purposes of the Code Sec. 856(c)(3) 75% income test. If the realty's loan value equals or exceeds the loan amount, then the entire interest income is apportioned to the realty. The loan value of the real property is its fair market value, generally determined as of the date on which the commitment by the trust to make the loan becomes binding on the trust. (Reg. §1.856-5(c))
Facts. The principal mechanism for Tax Units (such as counties and municipalities) to collect real property taxes and related interest, penalties and fees is a tax lien. If the tax is not paid by a due date, a statutory lien is created in favor of the Tax Unit on the real property that is senior in priority (a super priority lien) to a lien held by the first mortgage holder. In some states, the real property owner can resolve a tax liability with the assistance of a third party, such as Taxpayer, that advances funds to the tax unit on behalf of the owner in the amount of the tax liability. The owner gradually repays the tax loan to Taxpayer with interest. If Taxpayer approves a tax loan, the owner signs and delivers an interest-bearing note to Taxpayer and also signs a deed of trust and an affidavit authorizing the transfer of a lien on the real property from the Tax Unit. Taxpayer then pays the amount of the tax liability to the Tax Unit on behalf of the owner. As security, the Tax Unit signs a document transferring its super priority lien on the real property to Taxpayer (the tax lien transfer). The deed of trust and tax lien transfer are then recorded in the local land records.
There are many safeguards in place to ensure that the tax loan is adequately secured by real property: by state law it has priority over any mortgage loans previously recorded against the real property, including first lien mortgages; Taxpayer cannot make a tax loan in an amount exceeding the tax liability and related closing costs; Taxpayer gathers information about the owner and the value and condition of the real property to determine whether it will provide sufficient collateral for the tax loan; and Taxpayer only makes tax loans when certain underwriting criteria are satisfied (e.g., owner's credit worthiness and the real property's value and condition).
Earlier, IRS had privately ruled that Taxpayer's tax loans qualified as real estate assets under Code Sec. 856(c)(5)(B) (PLR 201113002). Now, Taxpayer wanted IRS to rule that interest on the tax loans qualifies as interest on obligations secured by mortgages on real property or interests in real property for purposes of Code Sec. 856(c)(2) and as interest for purposes of Code Sec. 856(c)(3).
Favorable ruling. IRS privately ruled that interest income earned by Taxpayer from a tax loan qualifies as interest on obligations secured by mortgages on real property or on interests in real property under Code Sec. 856(c)(2) to the extent that the tax loan is secured by real property, the value of which is at least equal to the total amount of the tax loan. This assumes that the amount of interest income does not depend in whole or in part on the income or profits of any person, except as provided in Code Sec. 856(f). In addition, interest income earned by Taxpayer from tax loans qualifies as interest under Code Sec. 856(c)(2), as long as the amount of such income does not depend in whole or in part on the income or profits of any person, except as provided in Code Sec. 856(f).
IRS expressed no opinion on (a) the other federal tax consequences of the transactions, (b) the valuation of any real property securing a tax loan and whether any tax loan is fully secured by real property; and (c) whether Taxpayer otherwise qualifies as a REIT.
References: For two-part gross income test for REIT qualification, see FTC 2d/FIN ¶E-6521; United States Tax Reporter ¶8654.03; TG ¶20576.