SECTION 2. BACKGROUND

.01 For an entity to qualify as a REIT for a taxable year, section 856(c)(4)(A) of the Internal Revenue Code requires that at the close of each quarter of its taxable year at least 75 percent of the value of the entity’s total assets must be represented by real estate assets, cash and cash items (including receivables), and Government securities (75% Asset Test). That is, the 75% Asset Test involves a fraction the denominator of which is the value of a REIT’s total assets and the numerator of which is the value of the REIT’s real estate assets, cash and cash items (including receivables), and Government securities.

.02 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.

.03 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.

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(whether the loan is secured by real property or by other property)).

.08 To effect apportionment under § 1.856–5(c), the loan value of the real property is compared to the amount of the loan.

(1) 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.

(2) If the amount of the loan exceeds the loan value of the real property, then—

(a) 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; and

(b) 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.

.09 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.

.10 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.

.11 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.

.12 Section 4.01 of Rev. Proc. 2011–16 provided a safe harbor to allow REITs to treat certain loan modifications occasioned by default or reasonably foreseeable default as not being a new commitment to make or purchase a loan for purposes of the 75% Income Test.

.13 Section 4.02 of Rev. Proc. 2011–16 also provided a safe harbor (the Asset Test Safe Harbor) for determining the extent to which a REIT may treat certain loans as real estate assets for purposes of the 75% Asset Test. Under this safe harbor, the Internal Revenue Service (Service) will not challenge a REIT’s treatment of a loan as being in part a “real estate asset” for purposes of the 75% Asset Test 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) (see section 2.04 of this revenue procedure); or

(2) The loan value of the real property securing the loan as determined under § 1.856–5(c) and section 4.01 of Rev. Proc. 2011–16 (see section 2.07(2) of this revenue procedure).

.14 The Service has become aware that when the value of the real property securing the loan (and, thus, generally the value of the loan as well) increases after the REIT originates or acquires the loan, the Asset Test Safe Harbor may produce anomalous results.

(1) The Asset Test Safe Harbor addresses the numerator of the 75% Asset Test (the value of a REIT’s real estate assets, cash and cash items, and Government securities, see section 2.01 and 2.02 of this revenue procedure). As is described in section 2.13 of this revenue procedure, under this safe harbor, the numerator is the lesser of the value of the loan (under § 1.856–3(a)) or the loan value of the real property securing the loan (under § 1.856–5(c) and section 4.01 of Rev. Proc. 2011–16). Although the “value of the loan” generally rises with increases in the value of the real property securing a distressed loan, the “loan value of the real property securing the loan” is fixed as of the date that the REIT commits to make or purchase the loan. The loan value of the real property securing the

loan, therefore, does not vary with changes in the value of the loan’s real property collateral. Thus, the numerator (the lesser of the value of the loan or the loan value of real property securing the loan) will generally not vary with increases in the value of the real property collateral.

(2) On the other hand, if there is an increase in the value of the real property collateral, that increase often results in a corresponding increase in the value of the loan and thus in the denominator of the 75% Asset Test (the value of the REIT’s total assets, see section 2.01 of this revenue procedure).

(3) Thus, when the value of the real property collateral increases, the portion of a distressed mortgage loan that is treated as a qualifying asset for the 75% Asset Test is the generally constant numerator described above, divided by an increasing denominator. Under the formula in section 4.02 of Rev. Proc. 2011– 16, therefore, the portion of a mortgage loan that is treated as a qualifying asset for this purpose generally decreases as the value of the real property securing the loan increases .

(4) To prevent this anomaly, this revenue procedure modifies the Asset Test Safe Harbor in section 4.02 of Rev. Proc. 2011–16. This revenue procedure also modifies section 5 of Rev. Proc. 2011–16 by amending Examples 1 and 2 and adding a new Example 3 to illustrate the modified Asset Test Safe Harbor.