REIT PLR addresses the qualification of a hypothecation loan as an interest in mortgages on real property

In brief

What happened?

In Private Letter Ruling 202424011 (PLR), the IRS issued two rulings to a corporation (taxpayer), which elected to be taxed as a real estate investment trust (REIT). The IRS held that a hypothecation loan originated by the taxpayer’s subsidiary (hypothecation lender) was secured by mortgages on real property and qualified as an interest in mortgages on real property under the REIT rules.   

Why is it relevant?    

It has been over 17 years since the IRS has provided any guidance on REIT qualification of hypothecation loans. This PLR addresses the treatment of “loan-on-loan” financing structures, specifically hypothecation loans under the REIT rules. The ruling concludes that a hypothecation loan with a perfected security interest (through delivery of the collateral file to custodian) that is secured by all of a borrower’s rights under a construction loan, which is in turn secured by the underlying mortgages on the developing property, qualifies as an interest in mortgages on real property under the REIT rules.   

Action items to consider   

REITs or taxpayers considering making a REIT election may want to consider seeking guidance from the IRS or their tax advisors to determine whether any similar loans qualify as real estate assets under the REIT rules.

Factual background  

Taxpayer was a limited liability company that elected to be taxed as a REIT. The hypothecation lender was a limited liability company disregarded for federal income tax purposes.  

A third-party lender (construction lender) originated and made the initial advance on a loan (construction loan) to another party (construction borrower) that was secured by mortgages on certain real property (development property). Concurrently, and to finance the construction lender’s making of the construction loan, the hypothecation lender originated and made the initial advance on a loan to the construction lender (hypothecation loan). The hypothecation loan was a “loan-on-loan financing,” and secured by the collateral assignment of all the documents evidencing and securing the construction loan (construction loan documents), including all the underlying notes (underlying notes) and mortgages (underlying mortgages). Both the construction loan and the hypothecation loan were originated on the same date and had the same maturity date. The taxpayer represented that on the origination date, the amount of the construction loan, and the value of the development property securing the construction loan, were greater than the amount of the hypothecation loan.   

Additionally, the taxpayer represented that the security interest in the underlying mortgages had been perfected, for purposes of Article 9 of the Uniform Commercial Code (UCC), through delivery of a file containing all the documents securing the hypothecation loan, including the construction loan documents, (collateral file) to a custodian. The collateral file also contained blank documents for the possible absolute assignment of the construction loan documents to the hypothecation lender under certain circumstances. In connection with delivery of these documents, the construction lender granted to the hypothecation lender a power of attorney to unilaterally complete, execute, and record the absolute assignment documents assigning the construction loan documents to itself in the event of a default.  

In the event of a default under the hypothecation loan agreement (hypothecation loan EOD), the hypothecation lender could force the construction borrower to pay all amounts on the construction loan directly to the subsidiary.   

In the event of a default by the construction borrower under the construction loan documents (construction loan EOD), the construction lender had the initial right to foreclose. However, in such an event, the construction lender was required to grant the hypothecation lender a new mortgage on the development property (replacement mortgage) to secure the hypothecation loan. The taxpayer represented that once the collateral assignments of the underlying mortgages were recorded, the construction lender could not foreclose on the underlying mortgages without granting a replacement mortgage to the hypothecation lender, nor could it release the underlying mortgages on its own accord.  

Upon the occurrence of a construction loan EOD, the construction lender was required to ensure protection of the collateral by curing the default or paying down a portion of the hypothecation loan and enforcing the construction loan. The construction lender’s failure to take such required actions upon a construction loan EOD would constitute a hypothecation loan EOD.   

Upon a hypothecation loan EOD, the hypothecation lender could either execute the absolute assignment documents to take full ownership of the construction loan documents or resort to the remedies provided in Part 5 of Article 9 of the UCC (i.e., a sale of the collateral or the retention of the collateral by the subsidiary in satisfaction of the debt).  

The taxpayer also represented that due to the hypothecation lender’s perfected security interest with respect to the construction loan through the custodian's possession of the collateral file, the hypothecation lender had priority with respect to any future purchaser or assignee of the construction loan documents. Therefore, if the construction lender 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 the hypothecation lender.  

Observations  

The hypothecation loan in the PLR is analogous to the developer loans made by the REIT in Rev. Rul. 80-280. The requirement that the construction lender grant a replacement mortgage ensured that the hypothecation loan was always secured by the development property. In addition, the absolute assignment documents ensured that the hypothecation lender, like the REIT in Rev. Rul. 80-280, had the ability to safeguard its interest in the hypothecation loan by having the right to take possession of the development property if the construction lender defaulted on the hypothecation loan.   

However, while the facts in the PLR are similar to those in the revenue ruling, there are notable differences. For one, the mortgage loans securing the hypothecation loan in the revenue ruling were endorsed without recourse to the REIT in the revenue ruling, who collected all amounts payable by the original borrower, retained interest due from the construction lender, and remitted the net amount to the construction lender. This is a different flow of funds than with respect to the PLR, in which the construction lender collected the amounts due under the original loans.  

Another difference is that in the event of default by the original mortgagor, the REIT in the revenue ruling could enforce payment in its own name and had the same rights as the construction lender to force a sale of the mortgaged property, whereas the facts in the PLR state that the construction lender had the initial right to foreclose in the event of a construction loan default, although not without granting the hypothecation lender a replacement mortgage. Further, in the event of default, the construction lender in the PLR was required to ensure the protection of the collateral by either curing the default or paying down a portion of the hypothecation loan and enforcing the construction loan. Both the replacement mortgage construct and the ability of the construction lender to cure the default are new facts that were not discussed in the revenue ruling.  

Finally, the PLR references the value of the collateral securing the construction loan and the amount of the construction loan being “greater than” the amount of the hypothecation loan “on the origination date.” The PLR does not reference a percentage (the revenue ruling discussed a ratio of 80%), nor does it mention that the ratio should be preserved at all times.