Taxation and Reporting of Excess Real Estate Investment Trust (REIT)

Taxation and Reporting of
Excess Inclusion Income
by REITs, RICs, and Other
Pass-Through Entities
Notice 2006–97
SECTION 1. PURPOSE
This notice provides interim guidance
relating to excess inclusion income of
pass-through entities, particularly real estate investment trusts (REITs). A growing
number of REITs are generating excess
inclusion income by engaging in mortgage
securitization transactions that cause the
REIT to be a taxable mortgage pool (TMP)
or have a qualified REIT subsidiary that
is a TMP. The interim guidance applies
to excess inclusion income both from
REMIC residual interests and from REIT
TMPs, whether received directly or allocated from another pass-through entity.
This notice also requests comments
and suggestions for further guidance, especially guidance regarding the tax and
reporting obligations of regulated investment companies (RICs) and other entities
that hold stock of REIT TMPs or that
receive excess inclusion income in other
ways.
SECTION 2. BACKGROUND
Enacted by the Tax Reform Act of 1986
(the 1986 Act), the real estate mortgage
investment conduit (REMIC) provisions
of the Internal Revenue Code permit a
qualifying entity or arrangement, which
finances mortgages by issuing multiple
classes of interests, to elect REMIC status.
In general, a REMIC is not treated as a
taxable entity. Instead, the holders of the
residual interests in a REMIC take into
account the REMIC’s net income or net
loss.
A REMIC issues regular interests and
a single class of residual interests. Regular interests in a REMIC are treated as
debt, and holders of these interests must
include interest income from the regular
interests under an accrual method. The
REMIC deducts interest accruals on the
regular interests in computing its net income or net loss. The holders of the residual interests in a REMIC take into account
the net income or net loss of the REMIC. A
portion of the net income allocated to the

2006–46 I.R.B.

residual interest holders may be an excess
inclusion within the meaning of section
860E(c). An excess inclusion may not be
offset by net operating losses, is treated as
unrelated business taxable income (UBTI)
by certain tax-exempt organizations, and is
not eligible for any reduction in withholding tax (by treaty or otherwise) in the case
of a nonresident.
In addition, the REMIC provisions
seek to ensure that excess inclusion income does not escape current taxation.
Some of these provisions are designed to
prevent certain tax-exempt entities (disqualified organizations) from being direct
holders of a REMIC residual interest.
Others impose tax on certain pass-through
entities that have excess inclusion income
allocable to a record owner that is a disqualified organization. For this purpose,
pass-through entities (as defined in section 860E(e)(6)(B)) include REITs, RICs,
and nominees; and disqualified organizations (as defined in section 860E(e)(5)(B))
include tax exempt entities that are not
subject to unrelated business income tax
under section 511. For example, a REIT
that owns REMIC residual interests must
pay any tax imposed by section 860E(e)(6)
with respect to excess inclusion income
allocable to a shareholder that is a disqualified organization. Rev. Rul. 2006–58,
2006–46 I.R.B. 876 (November 13, 2006),
illustrates the application of these provisions to a REIT (or a partnership) that has
a charitable remainder trust as a shareholder (or a partner).
Section 860E(d) addresses the tax consequences to a REIT’s shareholders when
the REIT holds a REMIC residual interest. The section provides that, if a REIT
holds one or more REMIC residual interests, then, under regulations prescribed
by the Secretary, the excess of the aggregate excess inclusions determined with respect to those interests over the REIT’s
taxable income shall be allocated among
the shareholders of the REIT in proportion
to the dividends received from the REIT.
Any such amounts allocated to a shareholder shall be treated as an excess inclusion with respect to a residual interest
held by the shareholder. Section 860E(d)
further provides that similar rules apply
to RICs, common trust funds, and certain cooperative organizations. Regulations issued under section 860E reserve
the portion of the regulations dealing with

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the application of section 860E(d). See
§ 1.860E–1(b).
Congress intended the REMIC regime
to be the exclusive vehicle for securitizations issuing multiple-maturity mortgagebacked debt securities. Accordingly, the
1986 Act also enacted TMP provisions,
which require an entity that issues such securities without making the REMIC election to be taxed as a separate corporation.
Section 7701(i) defines a taxable mortgage pool as any entity (other than a
REMIC) if—
(i) Substantially all of the assets of the
entity consist of debt obligations or interests in debt obligations, and more than
50% of these debt obligations or interests
are real estate mortgages or interests in real
estate mortgages;
(ii) The entity is the obligor under debt
obligations that have two or more maturities; and
(iii) The required payments on the debt
obligations that the entity issued bear a relationship to the payments to be received
by the entity on the debt obligations that it
holds as assets.
A portion of an entity may also be a
TMP under this definition.
Section 7701(i)(3) provides a special
rule for a REIT that is a TMP. Congress
generally intended for equity interests in
REIT TMPs to be subject to rules similar
to those that apply to residual interests in
REMICs. Accordingly, section 7701(i)(3)
provides that if a REIT, or a qualified
REIT subsidiary, is a TMP, then, under
regulations prescribed by the Secretary,
adjustments similar to the adjustments
provided in section 860E(d) are to apply
to the shareholders of the REIT. Regulations under section 7701(i) have been
issued, but these regulations specifically
reserve on the treatment of REIT TMPs.
See § 1.7701(i)–4(b).
The Treasury Department and the Service have been advised that a growing
number of REITs have recently begun
securitizing mortgages by issuing debt
obligations that cause the REITs to be
TMPs. These securitizations may be effected through a qualified REIT subsidiary
or a disregarded entity, such as a securitization trust. In these arrangements, not all
of the REIT’s income is attributable to a
TMP.
The Treasury Department and the Service have also been advised that, in the

November 13, 2006

absence of regulations or other guidance under section 7701(i)(3), taxpayers
are uncertain about how to apply section 7701(i)(3) to REIT TMPs and to
shareholders of REIT TMPs. Taxpayers
are similarly uncertain about how to apply section 860E(d) to RICs (and other
pass-through entities) that receive excess
inclusion income (for example, a RIC
holding shares of a REIT that is required
by sections 7701(i)(3) and 860E(d) to
allocate excess inclusion income to its
shareholders).
SECTION 3. REQUESTS FOR
GUIDANCE AND RELIEF
Representatives of REITs and RICs
have requested guidance on the tax treatment of excess inclusion income of a
REIT that either is a TMP or has a qualified REIT subsidiary that is a TMP. Some
of the questions and issues they have
raised are:

•

The proper computation of excess inclusion income of a REIT (or qualified
REIT subsidiary) that is a TMP under
section 7701(i)(3);

•

The proper method for allocating excess inclusion income among the dividends paid by REITs and RICs during
the taxable year;

•

The reporting obligations of REITs,
RICs, and their shareholders with respect to excess inclusion income;

•

•

If excess inclusion income is allocated
to, or otherwise recognized by, an organization that is subject to tax under
section 511, whether the $1,000 deduction provided by section 512(b)(12) is
available;
Whether there is or will be, a de minimis exception that applies to REITs,
RICs, and other pass-through entities
that have only small amounts of excess
inclusion income.

Taxpayers have requested the Treasury Department and the Service to issue
an announcement providing that sections
860E(d) and 7701(i)(3) do not apply before the issuance of the regulations authorized by those sections. Taxpayers have
also requested that any such regulations

November 13, 2006

apply only to REIT distributions made
some period after the issuance of regulations or other guidance.

•

Allocate its excess inclusion income to its shareholders in proportion to dividends paid (determined
without regard to any special allocation of the expense for any
tax paid under section 860E(e)(6))
and inform the shareholders that
are not disqualified organizations
of the amount and character of the
excess inclusion income allocated
to them.

•

Pay the tax imposed by section
860E(e)(6) on the excess inclusion income that is allocable to its
shareholders that are disqualified
organizations.

•

As
provided
by
section
860G(b)(2), apply the withholding
tax provisions with respect to
the excess inclusion portion of
dividends paid to foreign persons
without regard to any treaty exception or reduction in tax rate.

SECTION 4. REQUEST FOR
COMMENTS
The Treasury Department and the Service are concerned that the purposes of the
REMIC excess inclusion provisions may
be avoided through the use of REIT TMPs
if the resulting excess inclusion income is
not properly reported to, and accounted for
by, direct and indirect shareholders of the
REITs that create TMPs. At the same time,
the Treasury Department and the Service
are mindful that many RICs and other investors hold stock in REITs that do not own
REMIC residual interests or create TMPs.
Accordingly, in developing further
guidance dealing with the excess inclusion
income of pass-through entities (especially
that of REIT TMPs), it is appropriate to
weigh the potential administrative burden
and complexity for all direct and indirect
investors in these entities. The Treasury Department and the Service invite
comments and suggestions on the issues
summarized in Section 3 above and on
any other matters that may be relevant
in achieving the purposes of the REMIC
provisions without imposing undesirable
administrative burdens on investors.

•

With respect to its excess inclusion income, a pass-through entity, other than
a REIT, RIC, or nominee, must—

•

Allocate its excess inclusion income to its partners, participants,
beneficiaries, or patrons (collectively, “owners”) in accordance
with applicable provisions (section
702, section 584, subchapter J, or
part I of subchapter T) and inform
any owners that are not disqualified organizations of the amount
and character of the excess inclusion income that has been allocated
to them.

•

Pay the tax imposed by section
860E(e)(6) on excess inclusion income that is allocable to disqualified organizations.

•

As
provided
by
section
860G(b)(2), apply the withholding
tax provisions with respect to the
excess inclusion portion of the
payments made to foreign persons
without regard to any treaty exception or reduction in tax rate.

SECTION 5. INTERIM GUIDANCE
The Treasury Department and the Service have concluded that, although the issuance of regulations may be appropriate to provide detailed guidance on certain issues identified by concerned parties, sections 860E(d) and 7701(i)(3) establish basic principles that are applicable
even in the absence of regulations. Pending the issuance of further guidance, in administering sections 860E(d), 860E(e)(6),
and 7701(i), the IRS will apply the following principles, which are applicable to
all excess inclusion income, whether from
TMPs or from REMIC residual interests:

•

A REIT must—

•

Determine whether it or its qualified REIT subsidiary (or a portion of either) is a TMP, and if so,
calculate the excess inclusion income of the TMP under a reasonable method.

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•

With respect to excess inclusion income, a nominee must—

2006–46 I.R.B.

•

•

Inform the beneficial owners that
are not disqualified organizations
of the amount and character of their
excess inclusion income.

•

Pay the tax imposed by section
860E(e)(6) on the excess inclusion
income of beneficial owners that
are disqualified organizations.

•

As
provided
by
section
860G(b)(2), apply the withholding tax provisions to the excess
inclusion portion of the payments
made to foreign persons without
regard to any treaty exemption or
reduction in tax rate.

•

Allocate its excess inclusion income to its shareholders in proportion to dividends paid (determined
without regard to any special allocation of the expense for any tax
paid under section 860E(e)(6)).

•

Inform shareholders who are nominees of the amount and character
of the excess inclusion income that
has been allocated to them.

•

Pay the tax imposed by section
860E(e)(6) on excess inclusion income that is allocable to record
shareholders that are disqualified
organizations.

A RIC must inform all of its shareholders that are not nominees re-

A RIC that is not subject to the
reporting requirement in the preceding bullet must inform all of its
shareholders that are not nominees
regarding the amount and character of excess inclusion income allocated to those shareholders, taking into account only excess inclusion income allocated to the RIC
from REITs described in the following sentence. A REIT is described in this sentence if it reported to its shareholders for the
most recent REIT taxable year ending not later than nine months before the first day of the RIC’s taxable year that—
1.

A portion of the REIT’s dividends for the year was excess
inclusion income, and

2.

This excess inclusion income
exceeded three percent of the
REIT’s total dividends for the
year.

As an example, the reporting obligation
described in this bullet applies to a fiscal year RIC for its taxable year beginning February 1, 2007, with respect to
excess inclusion income allocated to the
RIC by that REIT for the REIT’s taxable year ending December 31, 2007,
if the REIT had reported for its taxable
year ending December 31, 2005, that its
excess inclusion income exceeded three
percent of its total dividends for that
year.

As
provided
by
section
860G(b)(2), apply the withholding tax provisions to the
excess inclusion portion of dividends paid to foreign shareholders
without regard to any exemption
or reduction in tax rate.

Pending the issuance of further guidance, except as provided in this paragraph, a RIC is not required to report
the amount and character of the excess
inclusion income allocated to its shareholders who are not nominees. For
RIC taxable years beginning on or after January 1, 2007—

•
1

•

With respect to its excess inclusion income, a RIC must—

•

•

garding the amount and character
of the excess inclusion income allocated to those shareholders if the
excess inclusion income received
by the RIC from all sources (including investments in REMIC
residual interests) exceeds one percent of the gross income of the
RIC.

SECTION 6. PAPERWORK
REDUCTION ACT
The collection of information contained
in this notice has been reviewed and approved by the Office of Management and
Budget in accordance with the Paperwork

Reduction Act (44 U.S.C. 3507) under
control number 1545–2036.
An agency may not conduct or sponsor,
and a person is not required to respond
to, a collection of information unless the
collection of information displays a valid
OMB control number.
The collection of information in this notice is in sections 860E(d) and 7701(i)(3).
This information is required to allow the
recipients of the information to properly
report and pay taxes on excess inclusion
income allocable to them. The collection
of information is mandatory. The likely respondents are business or other for-profit
institutions.
The estimated total annual reporting
and/or recordkeeping burden is two hours.
The estimated annual burden per respondent/recordkeeper varies from one to three
hours, depending on individual circumstances, with an estimated average of two
hours. The estimated number of respondents and/or recordkeepers is 50.
The estimated annual frequency of responses (used for reporting requirements
only) is once.
Books or records relating to a collection
of information must be retained as long
as their contents may become material in
the administration of any internal revenue
law. Generally, tax returns and tax return
information are confidential, as required
by 26 U.S.C. 6103.
DRAFTING INFORMATION
The principal author of this revenue ruling is Anna Kim of the Office of the Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact
Anna Kim at (202) 622–3735.

2007 Limitations Adjusted As
Provided in Section 415(d),
etc.1
Notice 2006–98
Section 415 of the Internal Revenue
Code (the Code) provides for dollar limitations on benefits and contributions under qualified retirement plans. Section 415
also requires that the Commissioner annu-

Based on News Release IR–2006–162 dated October 18, 2006.

2006–46 I.R.B.

906

November 13, 2006