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REIT can exclude income from two hedging transactions for purposes of income tests

PLR 201527013

IRS has privately ruled that income received by a real estate investment trust (REIT) from two sets of hedging transactions won’t constitute gross income for purposes of the income tests that a taxpayer must satisfy in order to qualify as a REIT. Income from the original set of transactions, which were entered in order to hedge against the risk of interest rate changes on borrowings related to the REIT’s ownership and acquisition of mortgages, met the requirements for exclusion under Code Sec. 856(c)(5)(G)(i); and income from the second set, intended to “counteract” all or part of the original hedging transactions in order to maintain a desirable level of hedging exposure, was excluded under IRS’s discretionary authority provided in Code Sec. 856(c)(5)(J).

Background. To qualify as a REIT for a tax year, a taxpayer must, among other things, pass two income tests—a 95% test and a 75% test.

Under the 95% test, at least 95% of the corporation’s gross income must be derived from sources that include dividends, interest, rents from real property, and gain from the sale or other disposition of stock, securities, and real property, abatements and refunds of taxes on real property, income and gain derived from foreclosure property, commitment fees, and gain from certain sales or other dispositions of real estate assets. (Code Sec. 856(c)(2))

Under the 75% test, at least 75% of the corporation’s gross income must be derived from rents from real property, interest on obligations secured by real property, gain from the sale or other disposition of real property, dividends from REIT stock and gain from the sale of REIT stock, abatements and refunds of taxes on real property, income and gain derived from foreclosure property, commitment fees to make loans secured by mortgages on real property or to purchase or lease real property, gain from certain sales or other dispositions of real estate assets, and qualified temporary investment income. (Code Sec. 856(c)(3))

Code Sec. 856(c)(5)(G)(i) provides that income from a hedging transaction, as defined in Code Sec. 1221(b)(2)(A)(ii) or Code Sec. 1221(b)(2)(A)(iii), including gain from the sale or disposition of such a transaction, isn’t gross income for purposes of the 75% or 95% tests to the extent that the transaction hedges any indebtedness incurred or to be incurred by the REIT to acquire or carry real estate assets, provided that such hedging transaction is properly identified under Code Sec. 1221(a)(7). Code Sec. 1221(b)(2)(A) defines a hedging transaction as any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily (i) to manage risk of price changes or currency fluctuations with respect to ordinary property held by the taxpayer, (ii) to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or ordinary obligations incurred by the taxpayer, or (iii) to manage such other risks identified in regs, including a transaction entered into primarily to offset all or any part of the risk management effected by one or more hedging transactions. (Reg. § 1.1221-2(d)(3))

In addition, IRS is authorized to determine whether any item of income or gain which does not otherwise qualify under Code Sec. 856(c)(2) or Code Sec. 856(c)(3) should be considered as not constituting gross income for purposes of the 75% or 95% tests. (Code Sec. 856(c)(5)(J))

Facts. Taxpayer is a residential mortgage REIT that invests primarily in instruments classified as mortgages on real property within the meaning of Code Sec. 856(c)(5)(B) (“Mortgages”), including mortgage-backed securities issued by U.S. Government agencies or Government-sponsored entities.

Taxpayer typically finances its Mortgages with short-term borrowings, including repurchase agreements (“repos”). Under a repo, Taxpayer nominally sells certain of its Mortgages to a counterparty, simultaneously agrees to repurchase those Mortgages at a fixed date in the future for a fixed price, and pays interest based on LIBOR (or a similar interest rate index) at the time it is entered. At maturity, Taxpayer must either repay the repo or enter into a new one, the proceeds of which are used to repay the old one. The PLR noted that a series of back-to-back repos resemble a loan with a variable (or “floating”) interest rate. In addition, Taxpayer uses other types of financial that actually or effectively bear a floating interest rate (collectively, with repos, the “Borrowings”).

Because Taxpayer finances its acquisition and ownership of Mortgages with floating rate Borrowings or short-term, current Borrowings (that, in turn, are anticipated to be repaid using the proceeds of short-term, future Borrowings), Taxpayer effectively must pay a floating interest rate on its indebtedness—and as such is subject to the risk of changing interest rates with respect to debt incurred (or to be incurred) to acquire or carry such real estate assets. To hedge that risk, Taxpayer enters into various hedging transactions, including, among others, “Pay-Fixed Swamps” (interest rate swaps under which Taxpayer pays a fixed rate of interest and receives payments based on a floating rate of interest) and “Pay-Fixed Swaptions” (options entitling Taxpayer to enter into a Pay-Fixed Swap). These are referred to collectively as the “Original Hedges.”

Based on its business goals and other factors, Taxpayer may decide to decrease the notional amount of its Original Hedges. Rather than terminating certain of its Original Hedges to achieve the desired level of hedging exposure, Taxpayer may find it commercially or economically desirable to enter into one or more additional hedges that have the effect of counteracting or offsetting all or part of such Original Hedges. These “Counteracting Hedges” take the form of swaps requiring Taxpayer to pay a floating rate of interest and receive a fixed rate of interest (“Receive-Fixed Swaps”) or options to enter into such swaps (“Receive-Fixed Swaptions”).

Representations. Taxpayer represents that, on the date into which each Original and Counteracting Hedge to be covered by the requested ruling is entered, each will be a “hedging transaction” within the meaning of Code Sec. 1221(a)(7) and Reg. § 1.1221-2(b) , with respect to which the identification requirements described in Code Sec. 1221(a)(7), Reg. § 1.1221-2, and Code Sec. 856(c)(5)(G) will be satisfied.

Hedging income isn’t gross income for income tests. Based on Taxpayer’s representations, the private letter ruling (PLR) concluded that neither Taxpayer’s gross income from the Original Hedges, nor Taxpayer’s gross income from the Counteracting Hedges, will constitute gross income for purposes of the 75% and 95% tests.

The PLR found that the income from the Original Hedges qualified for exclusion from gross income for purposes of the 75% and 95% tests under Code Sec. 856(c)(5)(G). The legislative history underlying amendments made to that section in 2004, which provided for the exclusion of such income (as opposed to prior treatment as qualifying income), made it clear that the REIT hedging rules were to generally follow rules in Code Sec. 1221—which the representations indicated were satisfied in this case.

The PLR also concluded that, under IRS’s discretionary authority in Code Sec. 856(c)(5)(J)(i), income from a Counteracting Hedge that qualifies as a hedging transaction similarly doesn’t constitute gross income for purposes of the 75% and 95% tests.

References: For REITs generally, see FTC 2d/FIN ¶  E-6500  ; United States Tax Reporter ¶  8564  ; TG ¶  20560  . For the REIT income tests, see FTC 2d/FIN ¶  E-6521  ; United States Tax Reporter ¶  8564.03  ; TG ¶  20576  .

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