Rev. Rul. 75-141

Advice has been requested whether, under the circumstances described below, the existence and exercise of options held by the owner of senior loans to acquire at book value junior loans held by a real estate investment trust will cause the trust to be considered to be holding property primarily for sale to customers in the ordinary course of its trade or business within the meaning of section 856(a)(4) of the Internal Revenue Code of 1954.

An unincorporated trust, otherwise qualifying as a real estate investment trust under section 856 of the Code, makes conventional residential mortgage loans (joint loans) in cooperation with a commercial bank. Because restrictions imposed upon the bank prohibit it from making home mortgage loans in excess of 75 percent of the residence value, the bank and the trust entered into an agreement whereby the bank furnishes funds equal to 75 percent of the value of the residence and the trust furnishes funds equal to 15 percent of such value. The purpose of the joint loans is to make available to home buyers mortgage loans equal to 90 percent of the value of the residence. Although a single first mortgage exists on the real property securing the entire joint loan, two separate notes are required, a senior note in favor of the bank and a junior note for the trust.

The bank originates and services the loan, controls all the rights of the mortgages throughout the term of the loan, and holds the junior note for the trust's benefit. Both the trust and the bank have all the rights and prerogatives of a first mortgagee, but the senior loan has priority in the security of the lien on the mortgaged real estate. For this reason, the yield to the trust on the junior loan is 1.5 percent per annum above the gross annual yield to the bank on the senior loan. The interest rate charged to the mortgagor on the joint loan is calculated to take into account this additional interest, all of which inures to the trust.

The agreement between the bank and the trust provides that the bank has an option to purchase the trust's junior loan on ninety days' notice upon payment of the outstanding principal and interest accrued to the date of purchase.

Section 856(a)(4) of the Code and section 1.856-1(b)(4) of the Income Tax Regulations provide that a real estate investment trust may not hold any property primarily for sale to customers in the ordinary course of its trade or business. Section 1.856-1(d)(4) of the regulations provides that whether property is held for sale to customers in the ordinary course of the trade or business of a real estate investment trust depends upon the facts and circumstances in each case.

In the instant case, the restrictions on the amount the bank can lend cause the options not to be readily exercisable. Thus, although appreciation or depreciation of the mortgaged property may accelerate or postpone the time when the options can be exercised, at the time joint loans are made and the option agreements are executed it is reasonable to assume that the trust will hold the junior loans for a substantial period.

The options are granted by the trust solely to induce the bank to provide the trust with opportunities to invest in the joint loans and are integral features of the joint loan agreements rather than separate transactions.

If the options are exercised in accordance with the agreement, an occurrence beyond the control of the trust, the trust recovers only the book value of the junior loan and realizes neither gain nor loss upon the disposition of such loan as a result of market fluctuation. The sole source of profit for the trust in holding the loans is the interest payable by the mortgagors. The interest yield is thus the trust's principal purpose for holding the loans. The options are granted merely to provide the trust with investment opportunities.

Accordingly, the existence and exercise of options held by the bank to acquire at book value junior loans held by the trust will not cause the trust to be considered to be holding property primarily for sale to customers in the ordinary course of its trade or business within the meaning of section 856(a)(4) of the Code.