Internal Revenue Bulletin: 2007-21
May 21, 2007
Real estate investment trust (REIT) foreign currency. This ruling provides that section 988 gain that is recognized by a REIT will be qualifying income under section 856(c)(2) or (3) of the Code to the extent that the underlying income so qualifies.
If a real estate investment trust (REIT) recognizes foreign currency gain in a section 988 transaction, to what extent is that gain qualifying income for purposes of the REIT income tests under § 856(c) of the Internal Revenue Code?
R, a corporation with the U.S. dollar as its functional currency, has elected, and qualifies, to be treated as a REIT under subchapter M of Chapter 1 of the Code. R invests both in real property from which R derives rental income and in debt instruments that are partially or fully secured by mortgages on real property.
Some of the leases of the real estate that R owns provide for rents to be paid in euros. For some of these leases, R recognizes rental income for federal income tax purposes before receiving the corresponding rent payments. R’s rental income from these euro-denominated leases is described in § 856(c)(2)(C) and in § 856(c)(3)(A).
Some of the mortgage loans that R acquires are denominated in euros, and both principal and interest under these loans are payable in euros. R’s interest income from these euro-denominated loans is described in § 856(c)(2)(B) and in § 856(c)(3)(B).
R’s activities of investing in rent-producing real estate and in mortgage loans are not subject to § 987. Therefore, if the euro changes in value against the dollar, payments of rent under the leases of the real estate and periodic payments made under the mortgage loans may generate foreign currency gain or loss under § 988. See § 1.988-2(b).
During its taxable year, R recognized rental income on the euro-denominated leases, interest income on the euro-denominated mortgage loans, and section 988 gain on payments received under the leases and the mortgage loans.
To qualify as a REIT for a taxable year, at least 95 percent of an entity’s gross income must be “derived from” the types of income listed in § 856(c)(2), and at least 75 percent of its gross income must be “derived from” the types of income listed in § 856(c)(3). Gains from foreign currency are not specifically enumerated in § 856(c)(2) or (c)(3).
Section 988(c)(1) defines a “section 988 transaction” as any transaction described in § 988(c)(1)(B) if the amount which the taxpayer is entitled to receive (or is required to pay) by reason of such transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies. Under § 988(c)(1)(B)(i), a section 988 transaction includes the acquisition of a debt instrument or becoming the obligor under a debt instrument. Under § 988(c)(1)(B)(ii), a section 988 transaction also includes accruing (or otherwise taking into account) any item of gross income or receipts which is received after the date on which so accrued or taken into account.
Section 988(b)(1) provides that the term “foreign currency gain” means any gain from a section 988 transaction to the extent that such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date (as defined in § 988(c)(2)) and before the payment date (as defined in § 988(c)(3)).
Rev. Rul. 74-191, 1974-1 C.B. 170, holds that otherwise-qualifying assets do not fail to satisfy § 856(c)(4) merely because the assets are foreign:
Neither section 856 of the Code nor the regulations thereunder restrict the term “real estate assets” to those located within the United States. Accordingly, it is held that, for purposes of section 856(c), the term “real property” includes land or improvements thereon located outside the United States and the term “mortgages on real property” includes a security interest which, under the laws of the jurisdiction in which the property is located, is the legal equivalent of a mortgage or deed of trust in the United States.
1974-1 C.B. at 170. It follows from this holding both that rents on foreign real property qualify under § 856(c)(2)-(3) to the same extent that they would qualify if the property were located in the United States and that interest on foreign mortgage loans qualifies under § 856(c)(2)-(3) to the same extent that it would qualify if the loans were governed by United States law and the property were located in the United States. Thus, foreign situs of a REIT’s assets does not necessarily prevent the REIT from satisfying the income and asset tests of § 856(c), which must be met in order to qualify as a REIT. Rev. Rul. 74-191, however, does not address the treatment of foreign currency gain that may result from investing in real property or other assets that produce income denominated in a currency other than the taxpayer’s functional currency.
The legislative history describing the tax treatment of REITs indicates that the central concern behind the gross income restrictions in § 856(c) is that a REIT’s gross income should largely be composed of passive income. For example, H.R. Rep. No. 2020, 86th Cong., 2d Sess. 4 (1960) at 6, 1960-2 C.B. 819, 822-23 states, “One of the principal purposes of your committee in imposing restrictions on types of income of a qualifying real estate investment trust is to be sure the bulk of its income is from passive income sources and not from the active conduct of a trade or business.”
Although § 856(c) describes the sources of REIT qualifying income, neither the statute nor its legislative history describes what it means for income to be “derived from” those sources. Because of the close nexus, however, between section 988 gain on payments received by a REIT and the income from which that payment is derived, the section 988 gain qualifies under § 856(c)(2) or (3) to the extent that the underlying income does. Thus, for example, if interest income recognized by R qualifies under § 856(c)(2) or (3), then so does the 988 gain from that interest income. Similarly, if an item of income qualifies as rents from real property for purposes of § 856(c)(3)(C), then, for purposes of § 856(c)(3), section 988 gain with respect to that income is derived from a type of income listed in § 856(c)(3)(A)-(H). Cf. Rev. Rul. 92-56, 1992-2 C.B. 153 (concluding that a regulated investment company’s (RIC’s) receipt of a reimbursement of an investment advisory fee was “derived from” the RIC’s business of investing in stock, securities, or foreign currencies and was therefore qualifying income under the “other income” provision of § 851(b)(2)).
If section 988 gain is recognized with respect to income recognized by a REIT, the gain qualifies under § 856(c)(2) or (3) to the extent that the underlying income so qualifies.
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