7894. When will a loan qualify as a real estate asset?Alexis Longrcline212014-09-18T14:48:00Z2014-09-18T14:48:00Z35503137Summit Business Media2673680147894. When will a loan qualify as a real estate asset?In order to qualify as a REIT, at least 75 percent of a REIT’s assets must consist of cash, cash items (including receivables), real estate assets and government securities at the end of each quarter of a REIT’s tax year.IRC Sec. 856(c)(4)(A), Treas. Reg. 1.856-2. Interests derived from mortgage loans typically qualify as real estate assets because the mortgage interest is really an interest in the underlying real property that secures the loan.If a mortgage loan covers both interests in real property and other non-real estate assets, the regulations require that the interest income on the loan must be apportioned between the two types of property. If the loan value of the property equals or exceeds the amount of the loan, all of the interest can be attributed to real property. If the amount of the loan is greater than the loan value of the property, the interest income apportioned to the real property portion is determined by multiplying the interest income by a fraction, the numerator of which is the loan value of the real property and the dominator of which is the amount of the loan.Treas. Reg. §1.856-5(c)(1).The loan value of the real property is equal to the fair market value of the property on the date the loan is made.Treas. Reg. §1.856-5(c)(2). Many REITs invest in real estate by making loans that are secured by real property. In certain cases because of financing arrangements and restrictive covenants, REITs make loans to the owners of the entities that hold real property instead of making loans that are secured directly by real property. These loans are secured by a pledge of the borrowers’ ownership interests in the property-owning entities. Rev. Proc. 2003-65, 2003-65 IRB 336. The IRS has set forth a safe harbor in Revenue Procedure 2003-65 that allows a REIT to make a loan to a partnership or other disregarded entity where the loan is secured by interests in the entity that owns the real property, rather than directly by the real property, and still count the loan as a real estate asset.Rev. Proc. 2003-65, ibid. In order to qualify for the safe harbor, the loan transaction must satisfy all of the following criteria:The borrower must be a partner in a partnership or sole member of another type of disregarded entity for tax purposes (e.g., the entity cannot have elected to be taxed as a corporation).The loan must be nonrecourse.The REIT must be granted a first priority security interest in the pledged property (meaning that the REIT’s interest must be superior to that of all other creditors of the partner or LLC member).The terms of the transaction must provide that if the borrower defaults, the REIT will replace the borrower as partner in the partnership or sole member of the disregarded entity.The borrower must own real property and the terms of the transaction must provide that if the real property is subsequently sold, the loan will immediately become due and payable.The value of the real property owned by the borrower must constitute 85 percent or more of the total value of the entity’s assets at each testing date(the close of the first quarter of the lender’s taxable year following the date on which the lender’s loan commitment becomes binding, and the close of each subsequent quarter in which the partnership or disregarded entity acquires certain other assets).The loan value of the real property owned by the borrower must equal or exceed the amount of the loan made by the REIT (the loan value of the property is reduced by any encumbrances on the real property and any other liabilities of the borrower).The interest on the loan must only constitute compensation for the use of money and the determination of interest cannot depend upon the income or profits of any person.