Internal Revenue Service
Revenue Ruling

TaxLinks.com   sm

 Rev. Rul. 75-98

1975-1 C.B. 196

Sec. 856

IRS Headnote

Real estate investment trust; unequal interest rates on joint loan. A real estate investment trust issued a joint mortgage loan commitment at a fixed interest rate of 9 percent under an agreement providing for 10 percent interest on the trust's portion of the loan and 8 percent on the unrelated other lender's portion. The interest on the trust's portion of the joint loan qualifies as interest within the meaning of section 856(c) of the Code provided the unequal rates are attributable to the lenders' differing costs of acquiring funds. However, if fund acquisition costs are the same for both and the unequal rates are due to the trust's locating and originating the loan, the amount in excess of 9 percent received by the trust does not qualify as interest.

Full Text

Rev. Rul. 75-98

Advice has been requested whether, under the circumstances described below, amounts received by a real estate investment trust qualify as interest within the meaning of section 856(c) of the Internal Revenue Code of 1954.

An unincorporated trust, otherwise qualifying as a real estate investment trust under section 856 of the Code, invests in first mortgage loans secured by income producing real estate. Because the trust desired to limit its investment in a particular loan, it entered into an agreement with another lender to make the loan jointly. The trust and the other joint lender were not related. The trust issued a joint loan commitment to the borrower stating a fixed rate of interest of 9 percent. The commitment was issued pursuant to an agreement between the trust and the other joint lender providing for a 10 percent rate of interest on the trust's portion of the loan and an 8 percent rate on the other lender's portion. The borrower issued a single note secured by a mortgage on real property. In the event of a default on the loan, neither lender had any obligation to or recourse against the other lender.

The trust received the payment on the loan and remitted to the other lender its portion of each principal and interest payment. The trust received no compensation for this function and incurred no expenses it would not otherwise have incurred.

The following two situations illustrate the income tax consequences to the trust as a result of the greater amount of interest received by the trust.

Situation 1. The trust's costs of acquiring the money to fund the loan were such that the trust required that the loan bear interest of at least 10 percent in order to provide the trust with a satisfactory investment yield. The other joint lender was willing to make the loan at an interest rate of 8 percent because its costs of acquiring funds were considerably less than the trust's.

Section 856(c) of the Code provides, in part, that for a trust to qualify as a real estate investment trust for Federal income tax purposes certain percentages of its gross income must be derived from specified sources, including interest.

Section 1.856-2(c)(2)(ii) of the Income Tax Regulations provides, in part, that fees imposed upon borrowers that are in fact a charge for services in addition to the charge for the use of borrowed money are not includible as interest.

For Federal income tax purposes, interest has been defined by the Supreme Court of the United States as the amount one has contracted to pay for the use of borrowed money and as the compensation paid for the use or forbearance of money. See Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), XI-1 C.B. 274 (1932), and Deputy v. Dupont, 308 U.S. 488 (1940), 1940-1 C.B. 118.

In this situation, the trust performed no services with respect to the loan. Thus, the entire amount earned by the trust with respect to its portion of the loan constituted compensation to the trust from the borrower for the use of the trust's money. The difference in the amount of interest earned by each joint lender with respect to its portion of the loan is attributable solely to independent investment decisions made by each lender regarding the rate of interest it must charge on the loan to produce a satisfactory investment yield.

Accordingly, in Situation 1, the interest earned by the trust on its portion of the joint loan at the rate of 10 percent (including the interest earned in excess of the 9 percent rate set forth in the first mortgage loan agreement) qualifies as interest within the meaning of section 856(c) of the Code.

Situation 2. The trust's and the other joint lender's costs of acquiring funds with which to make the loan were substantially the same. The unequal interest rates were agreed upon by the joint lenders because the trust located the investment opportunity and originated the loan.

In this situation, the difference in the amount of interest earned by each joint lender with respect to its portion of the loan is attributable to a service performed by the trust for the other joint lender. The difference between the 9 percent interest rate earned by the trust on its portion of the loan and the 10 percent retained by the trust under the agreement between the joint lenders is, therefore, compensation for services paid to the trust by the other joint lender in the form of the additional interest over the term of the loan.

Accordingly, in Situation 2, the interest earned by the trust on its portion of the joint loan at the 9 percent rate set forth in the first mortgage loan agreement is interest within the meaning of section 856(c) of the Code. However, the amount received by the trust in excess of the 9 percent rate earned on its portion of the joint loan does not qualify as interest within the meaning of section 856(c).