The IRS created a temporary safe harbor (Revenue Procedure 2020-34) to allow rental property trusts with mortgages and lease holders to make certain modifications and receive cash contributions to deal with the impact of the COVID-19 pandemic on their tenants without changing their tax status.

For the purpose of determining whether the arrangement is treated as a trust under Reg. Section 301.7701-4(c) and Revenue Ruling 2004-86, the safe harbor specifies that these modifications are not manifestations of a power to vary.

Background

An investment trust is not classified as a trust under Treas. Reg. Section 301.7701-4(c) if there is a power under the trust agreement to vary the investment of the certificate holders (power to vary), which may occur as a result of a significant modification of a debt instrument held by the trust.

In Revenue Ruling 2004-86, the IRS ruled that a trust formed to hold real property subject to a lease under the trust agreement is an arrangement that is classified as a trust for federal tax purposes under Treas. Reg. Section 301.7701-4(c). Each of the trust's owners is treated as an owner of a pro-rata portion of the trust and considered to own an undivided fractional interest in the rental real property held by the trust. Accordingly, under IRC Section 1031, a taxpayer may exchange an interest in real property for an interest in the trust without recognition of gain or loss.

The IRS noted in Revenue Ruling 2004-86 that the trust in question would have been treated as a business entity and not a trust if the trustee had a power under the trust agreement to, among other things, renegotiate the lease with its tenant, enter into leases with other tenants, or renegotiate or refinance the mortgage loan.

In response to the COVID-19 pandemic, on April 13, 2020, the IRS, granted safe harbors (Revenue Procedure 2020-26) for determining the federal income tax status of certain securitization vehicles that hold mortgage loans (see Tax Alert 2020-1007).

Revenue Procedure 2020-34 requirements

Revenue Procedure 2020-34 applies to arrangements that are trusts under Treas. Reg. Section 301.7701-4(c) and Revenue Ruling 2004-86 and hold real property.

The modifications of mortgage loans must be connected with the economic relief provided under the CARES Act or certain similar programs that are requested, or agreed to, from March 27, 2020, through December 31, 2020, and that are granted as a result of a borrower experiencing a financial hardship due to the COVID-19 emergency.

The modifications of leases (including to the specific allocations of fixed rent in the lease agreements under IRC Section 467) must have been for leases entered by the trust on or before March 13, 2020, to (1) coordinate the cash flow with the forbearances or (2) defer or waive one or more tenants' rental payments for any period from March 27, 2020, through December 31, 2020, because the tenants are experiencing financial hardship due to the effects of COVID-19.

In addition, cash contributions made from March 27, 2020, through December 31, 2020, due to the trust's financial hardship stemming from the effects of COVID-19 must be needed to increase permitted trust reserves, to maintain trust property, to fulfill obligations under mortgage loans or to fulfill obligations under real property leases.

Revenue Procedure 2020-34 also said that a "cash contribution from one or more new trust interest holders to acquire a trust interest or a non-pro rata cash contribution from one or more current trust interest holders must be treated as a purchase and sale under IRC Section 1001 of a portion of each non-contributing (or lesser contributing) trust interest holder's proportionate interest in the trust's assets."

Implications

This Revenue Procedure addresses situations in which historical IRS guidance is too rigid for extraordinary economic conditions, such as those produced by the COVID-19 crisis. Its approach is largely consistent with the approach taken in a 2010 Program Manager Technical Advice, which applied to syndicated tenant-in-common arrangements during the financial crisis, when the requirements of Revenue Procedure 2002-22 were found to be too rigid.

In general, this Revenue Procedure provides helpful clarification as to how particular activities that might otherwise be viewed as violating the safe harbor provisions in Revenue Procedure 2004-86 will be treated in light of the effects of COVID-19. Permitting some level of flexibility in loan modifications and lease modifications in the context of trust-owned property was appropriate in this context.

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