Loan-on-loan financing qualified as a REIT real estate asset

Plain-English summary

A REIT subsidiary made a loan to a lender that had originated a construction loan secured by real-property mortgages. The REIT subsidiary received a perfected collateral assignment of the construction loan documents and could enforce or take ownership of them after default. The arrangement also required a replacement mortgage if the original lender took title to the development property. Based on those protections and Revenue Ruling 80-280, the IRS ruled that the loan-on-loan financing was secured by mortgages on real property and was itself an interest in mortgages on real property for Section 856 purposes.

Ruling snapshot

• Question: Did the hypothecation loan qualify as an interest in mortgages on real property for the REIT asset rules?
• Outcome: approved
• Key authorities: IRC § 856(c); Treas. Reg. §§ 1.856-3, 1.856-10; Rev. Rul. 80-280

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 202424011                                              Third Party Communication: None
Release Date: 6/14/2024                                        Date of Communication: Not Applicable
Index Number: 856.00-00, 856.01-00,
              856.02-00                                        Person To Contact:
                                                               ----------------, ID No. ------------
-----------------------------------                            Telephone Number:
-------------------------------------------------              -------------------
------------------                                             Refer Reply To:
--------------------------------------------                   CC:FIP:B02
-----------------------------                                  PLR-118239-23
-------------------------------                                Date:
                                                               March 15, 2024




Legend:

Taxpayer          =         --------------------------------------------------------------------
----------------------------------------------------

Subsidiary        =        ----------------------------------------------

State             =        -------------

County            =        -----------------------------

Date 1            =        -----------------------

Date 2            =        --------------------------

a                 =        --

b                 =        ---

c                 =        --

d                 =        ---

PLR-118239-23                                2


Dear ----------------:

  This ruling responds to a letter dated September 6, 2023, and subsequent
correspondence, requesting the following rulings with respect to the Hypothecation
Loan described below:

   (1.) The Hypothecation Loan is secured by mortgages on real property within the
       meaning of section 856(c) of the Internal Revenue Code (the “Code”); and

   (2.) The Hypothecation Loan is an interest in mortgages on real property within the
       meaning of section 856(c).

                                       FACTS:

      Taxpayer is a State limited liability company which elected to be treated as a real
estate investment trust (a "REIT") by filing Form 1120-REIT, U.S. Income Tax Return for
Real Estate Investment Trusts, for its initial tax year beginning Date 1 and ended Date

2. Subsidiary is a State limited liability company disregarded as separate from Taxpayer
for federal income tax purposes.

      A third-party lender ("Borrower") originated and made the initial advance on a
loan (the "Construction Loan") to another party ("Construction Borrower") secured by
mortgages on certain real property within the meaning of section 1.856-10 of the
Income Tax Regulations (the "Development Property"). The Construction Loan is
evidenced by a separate promissory notes (the "Underlying Notes") and secured by a
separate mortgages (the "Underlying Mortgages") on the Development Property.

      Concurrently, and in order to finance Borrower’s making of the Construction
Loan, Subsidiary originated and made the initial advance on a loan to Borrower (the
“Hypothecation Loan"). The Hypothecation Loan is a "loan-on-loan" financing, in which
the Hypothecation Loan is secured by all of Borrower's rights under the Construction
Loan. This is accomplished through the collateral assignment of all of the documents
evidencing and securing the Construction Loan, including, without limitation, the
Underlying Notes and the Underlying Mortgages (the "Construction Loan Documents").
A Uniform Commercial Code (“UCC”) financing statement with respect to the collateral
assignment of the Construction Loan Documents has been filed in State, where
Borrower is organized. The collateral assignments of the Underlying Mortgages were
recorded in the real estate records of County, where the Development Property is
located.

      The initial stated maturity date of the Hypothecation Loan is the same as the
stated maturity date of the Construction Loan, although the maturity date of the
Hypothecation Loan may be accelerated upon an event of default (described in further

PLR-118239-23                                       3

detail below). 1 The Hypothecation Loan and the Construction Loan were originated on
the same date (the “Origination Date”).

     Taxpayer represents that on the Origination Date, the amount of the Construction
Loan exceeded the amount of the Hypothecation Loan, and the value of the
Development Property securing the Construction Loan was greater than the amount of
the Hypothecation Loan.

      A file containing the Construction Loan Documents, the collateral assignments of
the Construction Loan Documents, as well as other documents securing the
Hypothecation Loan (the "Collateral File") was delivered to an institutional custodian
("Custodian") to hold on behalf of Subsidiary. Taxpayer represents that the possession
of the Collateral File by Custodian (as Subsidiary’s agent) perfects Subsidiary’s security
interest for purposes of Article 9 of the UCC.

      The Collateral File also contains a set of documents in blank for the possible
absolute assignment of the Construction Loan Documents to Subsidiary under the
circumstances described below (the "Absolute Assignment Documents"). In connection
with delivery of the Absolute Assignment Documents, Borrower granted to Subsidiary a
power of attorney to unilaterally complete, execute and record the Absolute Assignment
Documents assigning to itself the Construction Loan Documents in the event that
Borrower defaults on the Hypothecation Loan.

      Upon the occurrence of an event of default under the aforementioned agreement
between Subsidiary and Borrower (a “Hypothecation Loan EOD”), Subsidiary is
permitted to instruct Construction Borrower to pay all amounts due under the
Construction Loan directly to Subsidiary. Borrower has the initial right to foreclose in the
event of a default by Construction Borrower under the Construction Loan Documents (a
“Construction Loan EOD”). However, in the event that Borrower forecloses on or
otherwise takes title to the Development Property, Borrower is required to grant
Subsidiary a new mortgage on the Development Property (a “Replacement Mortgage”)
to secure the Hypothecation Loan. Taxpayer represents that once the collateral
assignments of the Underlying Mortgages are recorded, Borrower may not foreclose on
the Underlying Mortgages without granting a Replacement Mortgage to Subsidiary.
Similarly, because the collateral assignments of the Underlying Mortgages are
recorded, Borrower may not impermissibly release the Underlying Mortgages on its own
accord.



1
 Borrower has an option to extend the maturity date of the Hypothecation Loan by b months, but only if
the maturity date of the Construction Loan has also been extended to at least the same date. Borrower
has two further successive options to extend the maturity date of the Hypothecation Loan by c months. To
exercise any c-month successive option, Borrower must commit in writing to diligently pursue a
foreclosure action against the Development Property and must actually commence and diligently pursue
such foreclosure action within d days after the maturity date as extended by the first c-month option.

PLR-118239-23                                        4

      Upon the occurrence of a Construction Loan EOD, Borrower is required to
ensure protection of the collateral by either (i) curing the Construction Loan EOD or (ii)
paying down a portion of the Hypothecation Loan and enforcing the Construction Loan.
Borrower’s failure to take such required actions upon a Construction Loan EOD
constitutes a Hypothecation Loan EOD, and Subsidiary would thereafter be permitted to
enforce the Construction Loan directly. 2

      Upon a Hypothecation Loan EOD, Subsidiary may either (i) complete the
Absolute Assignment Documents and take full ownership of the collaterally assigned
Construction Loan Documents, or (ii) resort to the remedies provided in Part 5 of Article
9 of the UCC, which, in essence, lead to either a sale of the collateral (i.e., the
Construction Loan Documents) or the retention of the collateral by Subsidiary in
satisfaction of the debt.

       Taxpayer represents that due to Subsidiary’s perfected security interest with
respect to the Construction Loan through Custodian's possession of the Collateral File,
Subsidiary has priority with respect to any future purchaser or assignee of the
Construction Loan Documents. Therefore, if Borrower were to impermissibly sell the
Construction Loan Documents to another purchaser or pledge the Construction Loan
Documents as collateral to another Lender, such sale or assignment would not be
effective with respect to Subsidiary.

                                        LAW & ANALYSIS:

      Section 856(c)(4)(A) of the Code 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.

       Section 856(c)(5)(B) defines the term “real estate assets”, in part, to mean real
property (including interests in real property and interests in mortgages on real property
or on interests in real property). Section 1.856-3(b)(1) provides that the term “real estate
assets” means real property, interests in mortgages on real property (including interests
in mortgages on leaseholds of land or other improvements thereon) and shares in other
qualified REITs. Section 1.856-10(b) provides that local law definitions are not
controlling for purposes of determining the meaning of the term “real property” for these
purposes.

2
Construction Borrower may obtain a future mezzanine financing that is secured by a pledge of
Construction Borrower’s direct or indirect interests in its subsidiary that holds title to the Development
Property (a “Mezzanine Loan”). Any Mezzanine Loan would be subordinate to the Construction Loan. To
date, Construction Borrower has not obtained a Mezzanine Loan.

A holder of a Mezzanine Loan, instead of Borrower, may provide additional funds to Construction
Borrower (in the form of additional debt financing, which would be subordinate to the Construction Loan)
to cure a Construction Loan EOD. In such instance the Construction Loan EOD would not cause the
Hypothecation Loan to become immediately due and payable.

PLR-118239-23                                5

      Rev. Rul. 80-280, 1980-2 C.B. 207, concerned a REIT that made loans to
commercial real estate developers (the “developer loans”). The developer loans were
nonrecourse except for the security of commercial mortgage notes held by the
developers that were assigned and delivered to the REIT by the developers as collateral
(the “assigned mortgages”). The balances of the developer loans would never exceed
80 percent of the unpaid balance of the assigned mortgages. As holder of the assigned
mortgages, the REIT was able to enforce payment in its own name if an original
mortgagor defaulted. The REIT collected all amounts due from the original mortgagors.
From these amounts, the REIT retained the interest due on the developer loans and
remitted the balance to the developers. Rev. Rul. 80-280 held that the developer loans
(commonly referred to as hypothecation loans) qualified as real estate assets under
section 856, and the interest on the developer loans qualified as “interest on obligations
secured by mortgages on real property.”

      The Hypothecation Loan is analogous to the developer loans made by the REIT
in Rev. Rul. 80-280. Through the collateral assignment of the Construction Loan
Documents, the Hypothecation Loan is secured by the Construction Loan which is in
turn secured by the Underlying Notes and Underlying Mortgages (i.e., the mortgages on
the Development Property). Moreover, the value of the Development Property securing
the Construction Loan (and the amount of the Construction Loan) was greater than the
amount of the Hypothecation Loan on the Origination Date. In addition, Taxpayer
represents that the security interest in the Underlying Mortgages has been perfected
through delivery of the Collateral File to Custodian. The requirement that Borrower grant
a Replacement Mortgage ensures that the Hypothecation Loan is always secured by
the Development Property, and the Absolute Assignment Documents ensure that
Subsidiary is able to take possession of the Development Property if Borrower defaults
on the Hypothecation Loan. Therefore, Subsidiary has an equivalent ability to protect its
interests as in the case of Rev. Rul. 80-280.

                                   CONCLUSION

     Accordingly, based on the information submitted and representations made, we
conclude that:

  (1.) The Hypothecation Loan is secured by mortgages on real property within the
      meaning of section 856(c); and

  (2.) The Hypothecation Loan is an interest in mortgages on real property within the
      meaning of section 856(c).

      Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, no opinion is expressed or implied whether
Taxpayer otherwise qualifies as a REIT.

PLR-118239-23                                         6

     This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of
the Code provides that it may not be used or cited as precedent.

        In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representatives.

                                              Sincerely,


                                              ___________________________
                                              Bernard J. Audet, Jr
                                              Chief, Branch 2
                                              Office of Associate Chief Counsel
                                              (Financial Institutions & Products)




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