REIT Developments Distressed Debt by iht11609

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									                                 REIT Developments:
                                 Distressed Debt
                                 PLI Real Estate Forum


                                 January 2010 | David Levy




Overview of U.S. Treasury Regulation
(Treas. Reg.) § 1.856-5(c)
•   Governs the allocation of interest income between “real estate interest”
    that qualifies under the 75 percent income test and “other interest” that
    qualifies under the 95 percent, but not the 75 percent, income test.
•   Requires a REIT to apportion interest income between real estate
    interest and other interest in situations where a mortgage covers both
    real property and other property.
•   No apportionment is required where the mortgage covers only real
    property.




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Overview of Treas. Reg. § 1.856-5(c)
•   Apportionment method under Treas. Reg. § 1.856-5(c)
       – If the “loan value” of the real property exceeds the “amount of the
         loan,” then all interest income is treated as real estate interest.
       – If the “loan value” of the real property is less than the “amount of
         the loan,” then:
               • Interest income is apportioned to real estate interest based upon the
                 proportionate relationship between the value of the real property and
                 the “amount of the loan”; and
               • All remaining interest income is apportioned to other interest.




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Overview of Treas. Reg. § 1.856-5(c)
•    “Loan value of real property” is equal to the value of the real
     property on the date there is a “binding commitment” by the
     REIT to make or purchase the loan.
•    “Amount of the loan” is equal to the highest principal amount of
     the loan outstanding during the taxable year.
•    The term “principal amount” is critical to the application of the
     regulation but is not defined.




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Consequences of Treas. Reg. § 1.856-5(c)
Apportionment
•   REIT Income Test
       – The portion of the interest that is treated as real estate interest is qualifying
         income under both the 75 percent and 95 percent gross income tests.
       – The portion of the interest that is treated as other income is non-qualifying
         income under the 75 percent test and qualifying income under the 95
         percent test.
•   REIT Asset Test
       – No guidance on whether or how to bifurcate a mortgage into two
         obligations, one of which is a real estate asset that qualifies for purposes of
         the 75 percent asset test, and one of which is a non-real estate security that
         must be tested for purposes of the five, 10 and 25 percent asset tests.
       – PLR 199923006 permits taxpayers to use the allocation method under
         Treas. Reg. § 1.856-5(c) to determine the extent to which a mortgage is a
         real estate asset.



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Example of Apportionment
•    Timing
       – Day 1
            • Bank makes a mortgage loan (Mortgage X)
            • Principal amount = $100
            • FMV of real property securing the loan = $100
            • FMV of other property under the mortgage= $50
       – Day 150
            • REIT acquires Mortgage X for $60
            • Principal amount = $100
            • FMV of real property securing the loan = $60
            • FMV of other property securing the loan = $5

•    Apportionment
      – If the “loan amount” is $60
             • Loan value of real property is equal to the amount of the loan
             • All interest is treated as qualifying 75 percent interest
             • Mortgage X is a real estate asset for purposes of the asset test
      – If the “loan amount” is $100
             • Loan value of property is $60, which is less than the amount of the loan;
               apportionment is required
             • 60 percent of the interest will be treated as real estate interest
             • 40 percent of the interest will be treated as other interest
             • Similar allocation for purposes of the REIT asset tests
                 – Must ensure compliance with the five, 10 and 25 percent asset tests


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Is the “loan amount” $60 or $100?
•   Why should the “loan amount” in the prior example be treated as $60?
       –     Market discount rules
               •    Section 1276(a)(4) states that gain from the sale of a market discount bond shall be treated
                    as interest.
               •    Section 1276(b)(2) states that accrued market discount it treated as OID, which also is
                    interest.
       –     The excess of the $100 face amount of Mortgage X over the REIT’s $60 purchase
             price is a market discount.
       –     That excess, one way or another, is treated as interest.
       –     If that excess is treated as interest, then the “principal amount” of Mortgage X
             must be $60.
•   Why should the “loan amount” be treated as $100?
       –     From the issuer’s perspective, the loan principal is still $100.
       –     The regulations under Section 856 contemplate secondary acquisitions
             of mortgage debt.




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What happens to the REIT if Mortgage X
is modified?
•   Significant modification is treated as a transfer of “old” Mortgage X to the
    issuer in exchange for “new” Mortgage X.
       –     REIT recognizes gain or loss equal to the difference between its basis in old Mortgage
             X and the “issue price” of “new” Mortgage X.
       –     The issue price of “new” mortgage X will be its face amount if Mortgage X is not
             “traded.”
       –     The issue price of “new” mortgage X will be its FMV if Mortgage X is “traded.”


•   Potential REIT Issues
       –     Potential gain recognition
               •    REIT income test compliance
               •    REIT distribution requirement
               •    Prohibited transaction tax compliance
       –     Deemed acquisition of “new” Mortgage X requires retesting for asset test purposes




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When is a debt “traded”?
       •       A debt instrument is treated as “traded” under Treas. Reg 1.1273-2(f) if the debt:
                          •    is listed on a securities exchange or interdealer quotation system (e.g., NYSE, AMEX,
Exchange                       NASDAQ, London Stock Exchange, Tokyo Stock Exchange, etc.)
 Traded
                          •    is traded on an “interbank” market
                          •    “appears on a system of general circulation (including a computer listing disseminated
Interbank
                               to subscribing brokers, dealers or traders) that provides a reasonable basis to determine
 Market
                               fair market value by disseminating either recent price quotations (including rates, yields
                               or other pricing information) of one or more identified brokers, dealers, or traders or
System of                      actual prices (including rates, yields or other pricing information) of recent sales
 General                       transactions (a quotation medium),” or
Quotation                 •    is an instrument price quotations for which are “readily available” from dealers,
                               brokers, or traders
                                 – A limited safe harbor excludes an instrument from the “readily available” category
                                 if:
 Readily
Available                                  » No other outstanding instrument of the issuer (or a guarantor) is “traded,”
 Quotes                                    » The original stated principal amount of the issue that includes the instrument
                                             does not exceed $25 million,
                                           » The instrument is economically significantly subordinated to the issuer’s other
                                             traded debt, or
                                           » The maturity date of the instrument is more than three years after the latest
                                             maturity date of the issuer’s other traded debt.


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    What is an “interbank market”?
    •     The law is unclear.

    •     Field Service Advice 200025020 (Jun. 23, 2000), issued in the context of foreign currency forward contracts,
          described an interbank market —
            – “The interbank market is not a formal market, but rather a group of banks holding themselves out to
                 the general public as being willing to purchase, sell, or otherwise enter into certain transactions. The
                 Service broadly interprets the interbank market to include all banks and investment banks (as the terms
                 are generally used in the market place).”

    •     Commentators such as the NYSBA have suggested that this definition could not apply to debt instruments
          sensibly, because conceivably a willing bank could always be found to purchase a debt instrument.

    •     If the regulation is to have any meaning, the definition of “interbank market,” at least in the debt instrument
          context, should be narrower than this FSA suggests.




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    The Scope of “Trading”
•       A debt may be “traded” even if the borrower did not participate in, consent to, or have knowledge of, the
        trading activity.
          – Not all transfers result in debt being “traded.”

•       Trading platforms for 144A debt may result in debt being “traded.”
         – PORTAL/TRACE and EuroMTF

•       Electronic trading platforms or Internet-based information systems may result in debt being “traded.”
         – Bloomberg; Reuters; InvestingInBonds.com; LoanLocator.com

•       Networks of banks, dealers, traders and hedge funds that provide “readily available” price quotations may
        result in “traded” debt.

•       Treatment of participation interests in bank debt is unclear.




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    The Scope of “Trading” (continued)

    •    The “traded” rules seem to rely on public trading prices of debt instruments as reliable indications of the
         fair market values of the instruments.
           –     Is an instrument’s trading price a fair proxy for fair market value in today’s turbulent and often-
                 times illiquid markets?
           –     Is a thinly traded instrument’s “trading price,” which may reflect a very large bid-ask spread, really
                 a useful guide to fair market value?
                   •    How should the limited liquidity of a thinly traded instrument affect the determination of the
                        instrument’s “trading price”?




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Example of the Impact of a
“Significant Modification”
•   If Mortgage X is “traded,” the REIT is deemed to have exchanged a loan with a tax basis of $60 for a new loan with
    an issue price of $60.
       –     The REIT has no gain on the deemed exchange.
       –     The deemed exchange should establish a new loan with a “loan amount” and “loan value” of $60.
       –     Even if the old Mortgage X was a bifurcated instrument, the new Mortgage X might not be.


•   If Mortgage X is not “traded,” the REIT is deemed to have received a new loan with an issue price of $100 in
    exchange for an “old” loan with a tax basis of $60.
       –     REIT recognizes gain of $40.
       –     The deemed exchange should establish a new loan with a “loan amount” that is greater than the “loan value”
             of the real estate. If bifurcation was not required for the old Mortgage X, it will be required for the New
             Mortgage X.
       –     REIT compliance issues
               •    Treatment of $40 of gain for purposes of the REIT income tests
                      –     Was the old Mortgage X bifurcated?
               •    Impact of bifurcation on income and asset tests
               •    Distribution requirement
               •    Prohibited transaction concerns




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Considerations

•   PLR?
•   TRS?
       – What does a TRS have to do in order to use mark-to-market
         accounting?
       – Can the REIT leverage the TRS?




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NAREIT Proposals
•   August 2009 request for guidance for transactions involving
    distressed debt
•   Proposals:
       – REITs should not have to retest the qualification of a mortgage loan under
         Treas. Reg. 1.856-5(c) if the loan undergoes a “significant modification”
         for reasons outside of the REIT’s control.
       – Codifying the apportionment method of Treas. Reg. § 1.856-5(c) into the
         current REIT income and asset tests.
       – Amending the definition of the “amount of the loan” under Treas. Reg.
         1.856-5(c) for a mortgage loan with market discount so that the “amount of
         the loan” is based on the REIT’s highest adjusted tax basis in the mortgage
         loan during the REIT’s taxable year.




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U.S. Treasury Department Circular
230 Notice
To ensure compliance with Treasury Department regulations, we
advise you that, unless otherwise expressly indicated, any federal
tax advice contained in this presentation was not intended or
written to be used, and cannot be used, for the purpose of
avoiding tax-related penalties under the Internal Revenue Code
or promoting, marketing or recommending to another party any
tax-related matters addressed herein.




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