Rev. Rul. 80-57

1980-1 C.B. 157, 1980-9 I.R.B. 16.

                       Internal Revenue Service
                                 Revenue Ruling

   REAL ESTATE INVESTMENT TRUST; DEED IN LIEU OF FORECLOSURE; PROPERTY VALUE
                                EXCEEDING BASIS

                            Published: March 3, 1980

Section 857.--Taxation of Real Estate Investment Trusts and Their Beneficiaries, 26 CFR 1.857-2: Method of taxation of real estate investment trusts.

(Also Sections 61, 1221, 1232, 1.61-6, 1.1221-1, 1.1232-2.)

  Real estate investment trust; deed in lieu of foreclosure; property value exceeding basis. A real estate investment trust that engaged primarily in short term financing activities, such as making construction and development loans, made a construction loan to a borrower who later defaulted. The trust accepted a deed in lieu of foreclosure when the fair market value of the property exceeded the trust's basis in the mortgage note. The gain realized by the trust, the difference between its basis in the note and the value of the property, is ordinary income, and such income qualifies under section 856(c)(2)(D) and (3)(C) of the Code.

ISSUE

  What are the income tax consequences to a real estate investment trust of its acceptance of a deed to mortgaged property in lieu of foreclosing on the mortgage?

FACTS

  X, which qualifies as a real estate investment trust under section 856 of the Internal Revenue Code, engages primarily in short-term financing activities such as construction and development loans that are secured by mortgages on real property.  In addition to making construction and development loans, X frequently originates and services these loans.  In 1976, X made a construction loan to Y, a corporation.  The loan was secured by a first mortgage on the land and the building to be constructed on it.  In 1979, Y defaulted on the loan. In lieu of foreclosing on the mortgage, X accepted a deed to the real property in full satisfaction of the outstanding indebtedness.  At the time of the conveyance the fair market value of the real property exceeded the amount of X's basis in the mortgage note.

LAW AND ANALYSIS

  Section 61(a) of the Code and the Income Tax Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived, including gains derived from dealings in property.

  Section 1222 of the Code provides that capital gain means gain from the sale or exchange of a capital asset.

  Section 1232(a)(1) of the Code provides that any amount received by a holder of an evidence of indebtedness issued by a corporation, upon retirement of such evidence of indebtedness, is considered an amount received in an exchange if the underlying evidence of indebtedness is a capital asset.  In McClain v. Commissioner, 311 U.S. 527 (1941), 1941-1 C.B. 378, the Supreme Court of the United States stated that the term 'retirement' is construed broadly and in accordance with its ordinary meaning and includes a conveyance in lieu of foreclosure.

  Section 1221(4) of the Code excludes from the definition of a capital asset accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered.  In Burbank Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963), acq. sub. nom. United Associates Inc., 1965-1 C.B. 5, modified on other grounds, 335 F.2d 125 (9th Cir. 1964), the Tax Court of the United States held that one of the business activities of a savings and loan association could properly be described as 'rendering the service' of making loans and that, by reason of section 1221(4), the taxpayer's notes receivable, which were secured by real estate mortgages, were ordinary assets rather than capital assets.  Thus, the court concluded that the loss from the sale of such notes receivable was deductible as an ordinary loss.

  Rev. Rul. 72-238, 1972-1 C.B. 65, holds that when a bank purchases real property at a mortgage foreclosure sale and the bid price is less than the fair market value of the property, the gain realized is characterized as ordinary income because such gain results from the ordinary operation of the bank's business, which includes the rendering of the services of originating and making loans that are secured by mortgages.

  In this case, X is engaged primarily in originating, making, and servicing short-term construction and development loans.  Under the authorities cited above, such activities are normally considered an active trade or business. See also section 542(d) of the Code. The fact that the taxpayer in this case is a real estate investment trust and subject to certain restrictions with respect to

types and sources of income does not change the inherent nature of these activities.  The income from the activities is of the type permitted a real estate investment trust under section 856(c)(2) and (3) and is not income from prohibited transactions under section 857(b)(6).

  Because the loan to Y was made in the ordinary course of X's trade or business, the note held by X was not a capital asset.  Thus, section 1232 of the Code does not apply.

HOLDING

  The gain realized by X when it accepted the deed to the mortgaged property in lieu of foreclosure is ordinary income.  The amount of the gain is the difference between X's basis in the mortgage note and the fair market value of the mortgaged premises on the date of the conveyance to X.

  For purposes of the income requirements of section 856(c) of the Code, the income qualifies under section 856(c)(2)(D) and (3)(C) as gain from the sale or other disposition of real property (including interests in real property and interests in mortgages on real property) that is not property described in section 1221(1).

Rev. Rul. 80-57, 1980-1 C.B. 157, 1980-9 I.R.B. 16.