Rev. Rul. 76-356

Advice has been requested whether, under the circumstances described below, a real estate investment trust that makes an assignment of a note and mortgage is 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, invests in construction loans that are secured by first mortgages on the land and the buildings constructed thereon. The construction loans finance the cost of construction and mature on the date construction is completed. The loan proceeds used to finance the construction are advanced as the construction progresses. The principal amount of the loan, and the interest accrued thereon, is payable in full upon maturity of the loan at the time the construction is completed. During the existence of the loan, the trust is subject to all risks relating to the possible default of the borrower. The trust has the right upon default to enter into possession and cause the performance of all work necessary to complete construction.

In connection with making the loan the trust requires the borrower to obtain a commitment from a permanent mortgagee to lend money to the borrower upon the maturity of the construction loan. To assure the trust that the funds will be available to discharge the construction loan upon its maturity, the borrower assigns the commitment to the trust. The trust, the borrower, and the permanent mortgagee then enter into an agreement providing for the closing of the long-term loan. The agreement refers to the commitment made by the permanent mortgagee and provides for the trust to receive the principal amount outstanding on the construction note at the completion of the construction, plus accrued interest thereon. As a matter of mechanics, rather than making the payment to the borrower, who would pay off the construction loan to the trust upon cancellation of the construction note and mortgage, the permanent mortgagee makes the payment directly to the trust. The trust then assigns the construction note and the mortgage to the permanent mortgagee (without recourse to the trust). Upon assignment, the construction note is modified by an agreement between the permanent mortgagee and the borrower to provide that the note will bear the terms and conditions of the permanent loan. The construction loan obligation of the borrower is satisfied and a debtor-creditor relationship is established between the permanent mortgagee and the borrower that did not previously exist.

Section 856(a) of the Code provides, in part, that the term "real estate investment trust" means an unincorporated trust or association that, among other things, does 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 Income Tax 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, there exists a debtor-creditor relationship between the trust and the borrower. The borrower remains primarily obligated to satisfy the construction loan until the trust is paid the outstanding principal and interest accrued thereon by the permanent mortgagee at the time of the maturity of the construction loan. This payment and the corresponding assignment of the note and mortgage by the trust to the permanent mortgagee extinguishes the prior indebtedness of the borrower to the trust and creates a new debtor-creditor relationship between the borrower and the permanent mortgagee. Thus, the assignment of the note is not a sale.

Accordingly, in the instant case, the trust is not 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 merely by reason of the assignment.