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EXHIBIT 8
[COOPERS & LYBRAND LETTERHEAD]
March 31, 1997
D&N Bank
400 Quincy St.
Hancock, Michigan 49930
To D&N Bank:
In accordance with your request, we provide this opinion on the ability of D&N
Capital Corporation (the "Company") to qualify as a real estate investment
trust ("REIT") for federal income tax purposes.
The facts as we understand them as provided in the Offering Memorandum dated
February 27, 1997 are as follows:
The Company is a new corporation formed for the purpose of acquiring, holding,
and managing real estate mortgage assets. The Company has been formed by D&N
Bank, a federally chartered and insured savings bank (the "Bank"), in order to
raise capital for regulatory purposes. D&N Bank is a wholly owned subsidiary
of D&N Financial Corporation. D&N Financial Corporation's stock is widely
held.
The Company is to be financed through the issuance of preferred and common
securities. The Company will issue 1,000,000 shares of noncumulative
exchangeable preferred stock with a par value of $25 per share. Dividends on
the preferred shares are not cumulative, and if declared, are payable quarterly
in arrears. The preferred shares are not redeemable prior to the anniversary
date of the stocks issuance in 2002 except on the occurrence of a Tax Event.
In general, the Tax Event is triggered by the Company receiving a opinion of
law that (a) the dividends paid or to be paid by the Company are not, or will
not be fully deductible by the Company for United States federal income tax
purposes, or (b) the Company is, or will be, subject to more than a de minimis
amount of other taxes, duties or other governmental charges. After the Tax
Event is triggered or after 2002, the preferred shares may be redeemed at the
option of D&N Capital for cash at a redemption price of $25.00 per share. In
addition to the Tax Event, the preferred securities are subject to an Automatic
Exchange provision if a decline occurs in the performance and capital levels of
the Bank or placement of the Bank into conservatorship or receivership. The
Automatic Exchange provision would require holders of the Company preferred to
exchange such stock for Bank preferred stock.
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Simultaneously with the offering of the Company's preferred securities, the
Bank will purchase shares of common Stock for $25 million. The Company will
use the aggregate proceeds of $50 million from the offering of the preferred
stock and the Bank's acquisition of common stock to purchase a portfolio of
mortgage loans from the Bank. The Bank will purchase additional shares of
common stock for a price equal to the aggregate amount of underwriting
discounts and expenses incurred by the Company in connection with its offering
and formation. An estimate of the underwriting discounts, offering expenses,
and formation expenses was not provided. The comparative value of the
Company's preferred stock to the common stock is expected to remain constant
subsequent to the initial offering.
Pursuant to the Offering Memorandum, it is understood that the Company
contemplates ownership of property consisting of mortgage assets and mortgage
backed securities. The mortgage assets of the Company will be comprised of
approximately 90% of residential mortgage loans and approximately 10% of
commercial mortgage loans. The Company expects that subsequent to the initial
acquisition of mortgage assets that it will acquire additional assets in
similar form and terms to the original purchase. The Company may dispose of
any mortgage assets at anytime for any reason. However, the Company has not
indicated an intent to securitize its mortgage assets or otherwise participate
in the "trade or business" of selling mortgage assets. The Company may also
acquire mortgage backed securities representing interests in or obligations
backed by pools of mortgage loans. It is not currently anticipated that the
Company will hold a significant amount of mortgage backed securities.
The Company's day-to-day activities will be managed by the Bank through a
service agreement. In administering the Company's mortgage assets, the Bank
has been given a high degree of autonomy. The Company's Board of Directors has
established certain policies for the Bank including a prohibition against the
purchase of (1) a commercial mortgage loan constituting more than five percent
of the total book value of the mortgage assets of the Company, and (2) certain
loans in default.
With respect to the income expected to be realized on an annual basis, the
Company anticipates that greater than 75 percent of its gross income will be
generated from interest on mortgage assets. In addition, the Company expects
that at least 95% of its annual income will be derived from interests in
mortgage assets, dividends, interest, or gain or loss from the sale or other
disposition of capital assets. The Company further anticipates that less than
30% of its gross income will arise from the sale or other disposition of real
estate assets (including interests in mortgage assets) held for less than four
years and mortgage backed securities. The Company will not receive income from
servicing loans.
The Company expects to pay dividends on its outstanding capital stock equal to
approximately 100% of its REIT taxable income (excluding capital gains). In
the event the Company has insufficient cash flow to meet the 95% distribution
requirement, as provided in the Internal Revenue Code, it may find it necessary
to arrange borrowings or to pay dividends in the form of taxable stock
dividends.
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DISCUSSION:
The requirements for qualifying as a REIT for federal income tax purposes are
four-fold. First, the entity must meet certain organizational requirements.
Second, the entity must satisfy four interacting asset tests under IRC Section
856(c)(5). Third, the entity must satisfy three separate income tests each
year it operates under IRC Sections 856(c)(2), (3) and (4). Finally, the
entity must meet certain distribution requirements under IRC 857(a)(1).
I. ORGANIZATIONAL REQUIREMENTS:
In order for an entity to qualify as a REIT, IRC Section 856(a) and the
corresponding Regulations provide that an entity must:
(1) be managed by one or more trustees or directors;
(2) have transferable shares or certificates relating to beneficial
ownership;
(3) be taxable as a domestic corporation if not for the provisions of
Sections 856-859;
(4) not be an IRC Section 582(c)(2) financial institution or an insurance
company;
(5) be owned by 100 or more persons;
(6) not be closely held;
(7) elect to be taxed as a REIT; and
(8) be organized as a corporation, trust, or association.
IRC Code Section 856(b) provides that the conditions described in items (1) to
(4) must be met during the entire taxable year whereas condition (5) must exist
during at least 335 days of a taxable year, or during a proportionate part of a
taxable year of less than 12 months. Condition (6) must be met by during the
last half of the taxable year. Conditions (7) and (8) are organizational
requirements for the entity. Each of the above listed factors is discussed in
detail below:
1. Management: In order to qualify as a REIT, the Company must be managed by
one or more trustees or directors. Reg. Sec. 1.856-1(d)(1) defines a trustee
[director] as a person who holds legal title to the property of the REIT. The
Regulations explain that the trustee [director] will be considered to hold
legal title to the property, for purposes of the requirement, when the title is
held in the trust's [corporation's] name. In the present case, the Company
(i.e. the "REIT") will hold title to the mortgage assets.
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The Regulations further provide that the trustee [director] must have rights
and powers that would meet the requirements of centralized management under IRC
Section 301.7701-2. An organization has centralized management if any person
(or group of any persons which does not include all members) has continuing
exclusive authority to make the decisions necessary to conduct the business.
Reg. Sec. 301.7701-2(c)(1). In other words, the directors must not be required
to obtain shareholder ratification for their day-to-day business decisions.
Reg. Sec. 301.7701-2(c).
In the present case, the Bank administers the day-to-day activities of the
Company through a service agreement. The Bank will be responsible for (i)
monitoring the credit quality of mortgage assets held by the Company, and (ii)
advising the Company with respect to the acquisition, management, financing and
disposition of the Company's mortgage assets. The Bank is allowed to
subcontract its obligations to one or more of its affiliates. In Rev. Rul.
72-254, the Commissioner held that a trustee's delegation of duties within
certain perimeters to an advisory company was not a violation of the
centralized management requirement. In Rev. Rul. 72-254 the trustees of a REIT
entered into an agreement with an advisory company to manage the trust with
respect to investments and administer the day-to-day operation of the trust,
subject to the supervision of the trust. The advisory company was authorized
to make investments on behalf of the trust up to a specific amount, subject to
the policies and guidelines set forth in the declaration of trust. In the
instant case, the Offering Memorandum provides that the Bank has been given a
high degree of autonomy in managing the Company's mortgage assets. The Bank's
management authority is only restricted to the purchase of (1) a commercial
mortgage loan constituting more than five percent of the total book value of
the mortgage assets of the Company, and (2) certain loans in default.
2. Transferable Shares: In order to qualify as a REIT the Company's
beneficial ownership must be transferable. The preferred stock will be listed
on the NASDAQ System and therefore will be fully transferable. The Company's
common stock held by the Bank is not intended to be listed on the exchange.
The Company's Certificate of Incorporation does contain specific restrictions
on the number of shares an individual stockholder may own. This restriction
was established in order to prevent the termination of REIT status. PLR
9627017; PLR 9621032; PLR 8921067. In these Private Letter Rulings, an excess
share provision within the governing instrument of a REIT, which is designed to
prevent the violation of the closely held prohibition, does not result in the
shares being deemed nontransferable. IRC Section 6110(j)(3) provides that
PLR's may not be cited as precedent. However, PLR holdings may provide insight
on how the IRS may rule in a similar instance.
3. Corporate Status: The Company must be taxable as a corporation
notwithstanding the REIT provisions. This determination is made under the
provisions and Regulations of Sections 7701(a)(3) and (4). Treasury Regulation
301.7701-3(c)(v)(B) provides that, "an eligible entity that files an election
under section 856(c)(1) to be treated as a real estate investment trust is
treated as having made an election under this section to be classified as an
association." Therefore, for purposes of the recently finalized
"check-the-box" regulations, an entity is deemed to be taxable as a corporation
upon the election to be treated as a REIT.
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Previous regulations promulgated under IRC Sec. 7701(a)(3)( and (4) set forth
the following characteristics to distinguish a corporate entity from other
organizations including (i) associates, (ii) an objective to carry on a
business and divide the gains, (iii) continuity of life, (iv) centralized
management, (v) liability for corporate debts limited to corporate property,
and (vi) free transferability of interests. The Company has many of the
corporate characteristics. First, as noted above, the Company has both
centralized management and free transferability of shares. Second, the
Offering Memorandum provides that "the Company's principle business objective
is to acquire, hold and manage mortgage assets that will generate net income
for distribution to stockholders. Clearly, the intent of the Company is to
generate profits and distribute such gains to its shareholders. Third, an
organization has continuity of life if the death, insanity, bankruptcy,
retirement, resignation, or expulsion of any member will not result in the
termination of such organization. Reg. Sec. 301.7701-2(b)(1). In the present
case, no provisions within the Offering Memorandum suggest that the actions or
fate of any one shareholder or group of shareholders would result in the
termination of the Company. Finally, the Offering Memorandum does not contain
any provisions that require the shareholder's to assume the debt obligations of
the Company.
4. Financial Institution/Insurance Company: The Company must not be a
financial institution or an insurance company in order to qualify as a REIT.
IRC Section 582(c) defines a financial institution to be (i) any bank, mutual
savings bank, cooperative bank, domestic building and loan, and other savings
institutions chartered under Federal or State law (ii) any small business
investment company, and (iii) any business development corporation. IRC
Section 581 defines a bank as a business in which a substantial part of its
transactions include receiving deposits and making loans and discounts. In
accordance with the Offering Memorandum, the Company is only expected to
maintain a portfolio of mortgage assets. The Company is not expected to
receive deposits, make loans, or to discount debt obligations.
IRC Reg. Sec. 1.801-3(a) defines an insurance company as an entity engaged in
the business of issuing insurance contracts and annuity contracts. The
Offering Memorandum does not provide that the Company is contemplating entering
into any other activity outside of holding mortgage assets.
5. One Hundred Shareholders: The Company must have 100 shareholders for 335
days of a 12 month taxable year or a proportionally smaller number of days for
a shorter year in order to qualify as a REIT. The days are not required to be
consecutive. Reg. Sec. 1.856-1(c). In addition, IRC Section 856(h)(2) waives
the 100 shareholder requirement in the first year an entity elects to be
treated as a REIT. In the present case, the Company is offering its preferred
securities on the NASDAQ market. Based on this type of offering, the Offering
Memorandum provides that the Company will have more than 100 preferred stock
shareholders. The Company should be able to rely on the fact that it meets the
100 shareholder test through ownership of the preferred stock (i.e. the sole
common stock holder is the Bank). In PLR 8342016, Company A formed a
subsidiary corporation, Company B, intending to qualify it as a REIT. Company
A retained 100 percent of Company B's common stock and sold one share of
Company B's preferred stock to each of its 125 employees. Company B was held
to meet the 100 shareholder
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test. The facts in PLR 8342016 parallel the present case. At hand, the
Company will have one common stockholder and over 100 preferred stockholders.
Under certain circumstances, the Company's preferred stock could be converted
into Bank preferred stock. The conditions which would result in the conversion
of the Company's preferred stock are not expected to arise. However, such an
event could result in the termination of the Company's REIT status. This
opinion does not address this issue as the Company is expected to have more
than 100 shareholders as of the offering date.
6. Closely Held Provision: The Company will not qualify as a REIT if more
than 50% of the value of its outstanding stock is owned, directly or
indirectly, by or for not more than 5 individuals during the last half of the
year. The Offering Memorandum provides that at no time will five or fewer
shareholders who are individuals, private foundations, pension trusts or other
relevant entities in aggregate own more than 50% of the value of the stock in
either the Company or the Bank. In addition, the Offering Memorandum provides
that no holder of preferred stock is permitted to own (including attributed
shares) more than 9.9% of any issued and outstanding class or series of
preferred stock. In this manner, no more than 9.9% of the preferred stock
could be held by one individual; thus, by definition the 50% test should be
met.
The Company's common stock is held 100% by the Bank. However, for purposes of
applying the 50% test, each shareholder of D&N Financial Corporation counts as
a beneficial owner of the Company. IRC Section 544(a)(1). D&N Financial
Corporation is widely held.
The Offering Memorandum provides that the comparative value of the Company's
preferred stock to the common stock is expected to remain constant subsequent
to the initial offering. Under these circumstances, the relative value of the
common stock to the preferred stock should not affect the Company's compliance
with the closely held provision.
IRC Reg. Sec. 1.857-8 provides that a REIT is required to keep records that
will disclose the actual ownership of its outstanding stock. Specifically,
under Reg. Secs. 1.857-8(b) and (c) the REIT must demand written statements
from the shareholders disclosing the actual ownership of the stock. These
statements shall be demanded from shareholders of record based on the number of
shareholders within the REIT as follows:
(a) 2,000 Plus Shareholders: Each record holder of five percent or more
of its stock.
(b) Less than 2,000 but more than 200 Shareholders: Each record holder of
one percent or more of its stock.
(c) 200 or less Shareholders: Each record holder of one-half of one
percent or more of its stock.
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The written statements must be demanded within 30 days after the close of the
REIT's taxable year. Reg. Sec. 1.857-8(e). A REIT that fails to comply with
the demand statement requirements shall be taxed as an ordinary corporation.
Reg. Sec. 1.857-8(e).
7. Elect REIT Status: The Company must elect to be treated as a REIT. IRC
Section 859 provides that in order for the Company to elect REIT status it must
adopt a calendar year accounting period. The election to be treated as a REIT
is made by computing taxable income as a real estate investment trust in its
return for the first taxable year for which it desires the election to apply.
It is presumed that the Company will adopt a calendar year period and elect to
be taxed as a REIT.
8. Organized as a Corporation: Reg. Sec. 1.856-1(a) provides in part that the
term REIT means a corporation that meets certain requirements. In the instant
case, the Company was formed as a corporation in the State of Delaware.
II. ASSET TESTS:
The Company must satisfy certain asset tests in order to maintain its
qualification as a REIT. Pursuant to IRC Section 856(c)(5), an entity is not
considered to be a REIT unless at the close of each quarter of the taxable year
the following tests are satisfied:
(A) at least 75 percent of the value of its total assets is
represented by real estate assets, cash and cash items (including
receivables), and Government securities; and
(B) not more than 25 percent of the value of its total assets is
represented by securities (other than those included under
subparagraph (A)).
In addition, IRC Section 856(c)(5)(B) imposes the following two
sub-requirements in order to satisfy the 25 percent test:
(1) not more than 5 percent of the value of the total assets of
the trust may consist of securities of any one issuer, other than
the securities included under the 75% test; and
(2) not more than 10 percent of the outstanding voting securities
of any one issuer may be held, other than those securities
included under the 75 percent test.
A REIT must satisfy each of the four asset tests noted above at the end of each
quarter of the REIT's taxable year. IRC Section 856(c)(5)(B). Failure to
satisfy any one of the four asset tests may result in disqualification of REIT
status. However, certain mitigation provisions within the Internal Revenue
Code (Code) may prevent the disqualification of the REIT if a violation of one
of the asset tests occurs. Under Rev. Rul. 72-83, the mitigation provisions
can only be applied once the tests have actually been met for at least one
quarter. The mitigation tests are not
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provided herein in that the purpose of this letter is only to address whether
or not the Company initially qualifies as a REIT.
Pursuant to the Offering Memorandum, the Company intends to maintain adequate
records of the value of its assets to ensure compliance with the asset tests,
and to take the necessary action within 30 days after the close of any quarter
as may be required to cure any noncompliance with the asset tests.
1. 75 Percent Asset Test: IRC Section 856(c)(5)(A) requires that at least 75
percent of the value of the total assets of the trust must be represented by
one or more of either (1) real estate assets, (2) Government securities, and
(3) cash and cash items (including receivables). For purposes of applying the
75 percent "asset" test, IRC Section 856(c)(6)(B) defines the term "real estate
assets" as follows:
The term "real estate assets" means real property (including
interests in real property and interests in mortgages on real
property) and shares (or transferable certificates of beneficial
interest) in other real estate investment trusts which meet the
requirements of this part.
Several rulings make clear that the nature of the underlying asset secured by a
mortgage will determine whether a mortgage is secured by qualified "real estate
assets." In Rev. Rul. 70-544, 1970-2 C.B. 6, a federally insured mortgage pool
that was subsequently sold at a discount was considered to be a "real estate
asset." In Rev. Rul. 77-349, 1977-2 C.B. 2, the IRS considered whether a
mortgage pooling arrangement where "straight pass-through" mortgage
certificates in a "pool" of residential mortgage loans were sold to building
and loan associations, individuals and REITs qualified as "real estate assets."
The REIT's interest was secured by private mortgage insurance. The IRS ruled
that a REIT that owns mortgage certificates is considered as owning "real
estate assets" within IRC Section 856(c)(5)(A). As such, it is clear that the
nature of the underlying asset of a mortgage is determinative of whether such
mortgage is included for purposes of determining the trust's compliance with
the 75 percent asset test.
If a REIT asset constitutes an interest in a mortgage on both real and personal
property, an apportionment is necessary because only the value of the portion
of a mortgage secured by real property is included for purposes of the 75
percent asset test. IRC Sec. 856(c)(6)(B); Reg. Sec. 1.856-3(b), (c) and (d).
Although not specifically defined, IRC Section 856(c)(5)(A) also indicates that
cash, cash items, and Government securities are also considered for purposes of
determining a REIT's compliance with the 75 percent asset test.
In addition to the items identified above, IRC Section 856(c)(6)(B) states that
the term "real estate assets" shall also include property attributable to
"temporary investment of new capital." Section 856(c)(6)(B) provides in
pertinent part:
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any property (not otherwise a real estate asset) attributable to
the temporary investment of new capital, but only if such property
is stock or a debt instrument, and only for the one-year period
beginning on the date the REIT receives such capital.
As stated above, the Company contemplates ownership of property consisting
solely of mortgage assets and mortgage backed securities. The Offering
Memorandum indicates that the Company's business objective is to acquire, hold
and manage "mortgage loans" secured by first mortgages or deeds of trust on
single family residential or commercial real estate properties. Further, the
Offering Memorandum provides that from time to time the Company will acquire
mortgage securities that qualify as "real estate assets" under IRC Section
856(c)(6)(B). Such mortgage securities will consist of interests in or
obligations backed by pools of mortgage loans.
2. 25-, 5- and 10 Percent Asset Tests: For purposes of applying the 25
percent asset test, the Regulations indicate that not more than 25 percent of
the value of the total assets of the trust may be represented by securities
other than those described in section 856(c)(5)(A) as defined above. Thus, the
25 percent limitation is necessarily satisfied by virtue of compliance with the
75 percent asset requirement. However, the Reg. Sec. 1.856-2(d)(2) indicates
that the trust must meet the 5 and 10 percent tests provided under IRC Section
856(c)(5)(B).
Pursuant to IRC Section 856(c)(5)(B), a trust may not own "securities" of any
one issuer in an amount greater in value than 5 percent of the value of the
total assets of the trust and not more than 10 percent of the outstanding
voting securities of such issuer. Reg. Sec. 1.856-3(e) provides that the term
"securities" does not include "interests in real property" or "real estate
assets" such as interests in mortgages on real property.
The Offering Memorandum indicates that the Company may acquire from time to
time solely securities which qualify as "real estate assets" under IRC Section
856(c)(6)(B). As indicated above, securities consisting of mortgages or
interests in mortgages are specifically excluded from the term "securities" for
purposes of the 5- and 10- percent asset tests.
With regard to "securities" included within the 5- and 10- percent limitations,
the Offering Memorandum specifically restricts ownership by the Company of
securities of any one issuer which are either (a) in an amount greater than 5
percent in value of the trust's asset; and (b) equal to or greater than 10
percent of the outstanding voting securities of the issuer.
3. Determination of "Value" for Purposes of Asset Tests: The various asset
tests are based on the value of the REIT's total assets as of the close of each
quarter. A revaluation of assets is not required at the end of any particular
quarter unless during that period the REIT acquired assets which do not meet
the 75% test (e.g. non-"real estate assets" as defined under IRC Sec.
856(c)(5)(A) above). IRC 856(c)(5). As such, the mere fluctuation in the
market value of the REIT's assets does not, in itself, require the REIT to
revalue the assets for purposes of determining the REIT's compliance with the
asset tests. Reg. Sec. 1.856-2(d)(3).
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For purposes of valuing the REIT's assets, securities (other than REIT shares)
for which market quotations are readily available must be valued at market
value. Reg. Sec. 1.1856-3(a). With respect to other securities and assets,
Reg. Sec. 1.856-3(a) provides that the trustees of the REIT are permitted to
determine the fair market value. The regulations require that such
determination by the trustee be made in good faith. Id.
Pursuant to the Offering Memorandum, the Company intends to maintain adequate
records of the value of its assets to ensure compliance with the asset tests,
and to take the necessary action within 30 days after the close of any quarter
as may be required to cure any noncompliance with the asset tests.
III. INCOME TESTS:
To qualify as a REIT, the corporation must meet three separate "income" tests
each year under IRC Section 856(c). The three requirements of this test, all
of which must be satisfied, are:
(1) At least 75% of gross income (other than income from
prohibited transactions) must be derived from the following
sources:
(a) rents from real property;
(b) interest on obligations secured by mortgages on real
property or on interests in mortgages on real property;
(c) gain from the sale or other disposition of real property
(including interests in real property and interests in
mortgages on real property other than property held primarily
for sale to customers in the ordinary course of a trade or
business;
(d) dividends or other distributions on, and gain (other than
gain from prohibited transactions) from the sale or other
disposition of, transferable shares (or certificates of
beneficial interest) in other qualifying REITs;
(e) abatements and refunds of taxes on real property;
(f) income and gain from foreclosure property;
(g) amounts (other than amounts determined by the income or
profits of another person) received as consideration for
entering into commitments to make mortgage loans or to purchase
or lease real property (including interests in real property
and interests in mortgages on real property);
(h) gain received from the sale or other disposition of a real
estate asset which is not a prohibited transaction solely by
reason of section 857(b)(6);
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(i) and qualified temporary investment income;
(2) At least 95 percent of gross income (excluding gross income
from prohibited transactions) must be derived from the following
sources:
(a) sources that satisfy the 75 percent income test;
(b) dividends;
(c) interest; and
(d) capital gains on the sale or other disposition of stocks
or securities;
(3) Less than 30% of gross income must be derived from the sale
or other dispositions of the following:
(a) any stock or securities held for less than one year;
(b) property in a transaction which is a prohibited
transaction; and
(c) real property (including interests in real property and
interests in mortgages on real property) held for less than
four years other than involuntarily converted property or
foreclosure property.
A REIT must satisfy the income tests on an annual basis. IRC Sec. 856(c). All
of the income tests are based on gross income. However, the 75- and 95-
percent income tests apply to gross income other than gross income from
prohibited transactions (discussed below). IRC Sec. 856(c)(2) and (c)(3). The
30 percent income limitation applies to gross income including income from
prohibited transactions. IRC Sec. 856(c)(4).
If a REIT fails to satisfy either the 75- or 95- percent income tests in any
year, and such failure is due to "reasonable cause" and not willful neglect,
the REIT will not lose its status as such, but instead the REIT will be subject
to 100% tax on its taxable income attributable to the amount by which it failed
to comply with such tests. IRC Secs. 856(c)(7) and 857(b)(5). If a REIT
violates either or both 75- or 95- percent income tests other than for
reasonable cause, or if it violates the 30 percent rule under any
circumstances, the REIT will be disqualified and taxable as a regular
corporation for the taxable year and the four succeeding years. IRC Sec.
856(g)(1), (3), and (4).
1. 75- and 95 Percent Income Tests
a. Qualified Sources of Income :
(1) Interest : Interest is qualified income for purposes of both the 75- and
95- percent income test. IRC Sec. 856(c)(2)(B). For interest to qualify as
"interest on obligations secured by mortgages on real property or on interests
in real property" for purposes of the 75 percent test,
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the obligation must be secured by real property having a fair market value at
the time of acquisition at least equal to the principal amount of the loan.
Reg. Sec. 1.856-5(c). The term "interest" includes only an amount that
constitutes compensation for the use or forbearance of money. Reg. Sec.
1.856-5(a); Rev. Rul. 76-413, 1976-2 C.B. 213. For purposes of both the 75-
and 95- percent income tests, income that a REIT derives from mortgages it
originates and holds as investments is "interest on obligations secured by
mortgages" within the meaning of IRC Sec. 856(c)(3)(B). Rev. Rul. 65-67.
1965-1 C.B. 269. In the present case, the Company's primary source of income
is from interest on its mortgage assets. No projections or facts were made
available that provided the specific amount of income that the Company would
recognize from the mortgage assets.
(2) Interest From Hypothecation Loans : Interest received on a hypothecation
loan is qualifying interest for purposes of the 75 percent income test as long
as the security for such loan consists of a first mortgage which is secured by
real property. Rev. Rul. 80-280, 1980-2 C.B. 207. In the present case, the
Offering Memorandum indicates that the Company's business objective is to
acquire, hold and manage "mortgage loans" which are secured by first mortgages
or deeds of trust on single family residential or commercial real estate
properties.
(3) Loans Purchased at Market Discount : Income from loans secured by
mortgages on real property purchased for an amount less than the face amount of
the loan ("market discount") qualify for purposes of the 75- and 95- percent
income tests. The difference between the face amount and the purchase price of
the loan is treated as a gain from the "disposition" of interests in mortgages
on real property as provided in IRC Secs. 1276 through 1278. As such, income
related to the disposition of mortgage assets will be qualified income for
purposes of the 75- and 95- percent income tests provided that the mortgage
assets are not property held in the ordinary course of the taxpayer's trade or
business and such notes are secured by real property. PLR 7412260550A; PLR
8202005; GCM 32491. In the present case, the Company is expected to purchase
$50 million of mortgage assets from the Bank. This acquisition of debt may
produce market discount providing that the amount paid is less than the face
value of such debt.
(4) Penalties and Prepayments on Loans : A REIT can provide for penalties on
the prepayment of all or a portion of a loan balance, loan assumption fees and
late payment charges. The IRS has ruled, in a non-REIT context, that penalties
received on prepayments of loans constitute interest. Rev. Rul 57-198, 1957-1
C.B. 94; Rev. Rul. 73-141, 1973-1 C.B. 331. The IRS has issued favorable
Private Letter Rulings to REITs in this regard. PLR 8640018; PLR 8545039. In
the instant case, the Company may receive income from prepayment penalties on
the mortgage assets it will hold.
(5) Interest on Loans Secured by Personal Property : Interest received from
loans secured by personal property is excluded for purposes of the 75 percent
income test. Reg. Sec. 1.856-5(c). Interest from mortgages secured by both
real and personal property must be apportioned for purposes of satisfying the
75- and 95 percent income tests. Id. In the case of a construction loan, the
portion of interest related to a mortgage secured by personal property must
also be apportioned. Reg. Sec. 1.856-5(c)(2).
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b. Other Income : In addition to the types of income discussed above, two
other kinds of income qualify for either the 75- or 95- percent income tests
including:
(1) Deed In Lieu of Foreclosure : If a REIT acquires property through a deed
in lieu of foreclosure and the fair market value of property exceeds the REIT's
basis in the mortgage note, the REIT realizes gain in the amount of the excess.
Rev. Rul. 80-56, 1980-1 C.B. 154. Similarly, if the REIT purchases property
at a foreclosure sale for less than its fair market value and if the REIT's
basis in its mortgage note is also less than the property's fair market value,
the REIT realizes ordinary income to the extent that the property's fair market
value exceeds the purchase price. Rev. Rul. 80-57, 1980-1 C.B. 157. In both
cases, the gain is qualified income for purposes of the 75- and 95- percent
tests.
(2) Commitment Fees : Commitment fees are qualifying income for purposes of
the 75- and 95- percent income tests. The Offering Memorandum does not
contemplate that the Company will receive commitment fees.
2. 30 Percent Income Test
IRC Section 856(c)(4) requires that a REIT satisfy a 30 percent income
limitation on an annual basis. Section 856(c)(4) requires that less than 30
percent of a REIT's gross income for the taxable year must be derived from the
sale or other dispositions of (i) any stock or securities held for less than
one year; (ii) property in a transaction which is a prohibited transaction; and
(iii) real property (including interests in real property and interests in
mortgages on real property) held for less than four years other than
involuntarily converted property or foreclosure property. The term "prohibited
transaction" is defined below.
The Offering Memorandum contemplates that the Company will own mortgage assets
and from time to time interests in mortgage backed securities. The Company has
not indicated an intent to securitize its mortgage assets or otherwise
participate in the "trade or business" of selling mortgage assets. However, in
the event of a sale or disposition of mortgage assets or mortgage backed
securities by the Company, any income derived from such sale will be considered
for purposes of determining the Company's compliance with the 30 percent income
limitation.
3. Prohibited Transactions: A "prohibited transaction" is any sale of dealer
property that is not foreclosure property. IRC Sec. 857(b)(6); See also, IRC
Sec. 1221(1). Transactions which constitute "prohibited transactions" do not
necessarily terminate REIT status. However, "prohibited transactions" are
taken into consideration for purposes of determining whether the Company
satisfies the 30 percent income limitation.
(a) Sale or Disposition in the Ordinary Course of Taxpayer's Trade or
Business: Real estate loans that are originated or acquired by a REIT for the
purpose of being packaged for sale may constitute "prohibited transactions" for
purposes of determining the Company's compliance with the 30 percent income
test. In Rev. Rul. 74-554, 1974-2 C.B. 199, a REIT that sold several mortgages
to two unrelated mortgage brokers in two separate transactions within one
taxable
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year as part of a single plan to reduce the REIT's long term investments was
deemed to have held the mortgages primarily for sale to customers in the
ordinary course of its trade or business.
(b) Sale of Mortgage in an Isolated Transaction: In Rev. Rul. 76-356, 1976-2
C.B. 213, a REIT that sold mortgage loans in a single, isolated transaction to
balance its loan portfolio was deemed not to have held the mortgages primarily
for sale to customers in the ordinary course of its business. Accordingly,
such sales qualified for the 75 percent income test. Id.
(c) Sale of Mortgage to Protect Investment: In Rev. Rul. 76-327, 1976-2 C.B.
212, a REIT, which financed construction of a townhouse development,
subsequently made mortgage loans to purchasers after the developer could not
arrange financing and then sold the mortgage loans to investors at no profit or
premium in order to protect its investment. The Service ruled that the REIT in
this instance was not a dealer.
(d) Foreclosure Property : "Foreclosure property" is property that a REIT
acquires through foreclosure or an action similar to foreclosure, such as deed
in lieu of foreclosure. When a REIT earns income from involuntarily acquired
foreclosure property, it runs the risk of receiving "trade or business" income
that could cause it to fail the income tests and possibly forfeit its REIT
status. However, the REIT may make an election that allows for a grace period
following the acquisition of property by foreclosure that provides time to
convert potentially disqualifying income into qualifying income without
consequence to REIT status. IRC Sec. 856(e)(5). During this grace period,
income from foreclosure property is taxed at the REIT level at the maximum
corporate income tax rate. IRC Sec. 857(b)(4).
Although Company's business strategy may not intend for the trust to engage in
rental real estate activities, it may nevertheless become the lessor of real
property upon a mortgage default. Due to the limitations imposed under the
Code on the activities of a REIT in connection with rental real estate,
ownership of real estate upon foreclosure may create nonqualifying income
issues.
(e) Safe Harbor Provisions: IRC Section 857(b)(6)(C) identifies certain safe
harbor provisions which permits a REIT to avoid entering into prohibited
transactions. Pursuant to these safe harbor rules, a sale of property which is
a "real estate asset" (including interests in mortgages secured by real
property as defined above), does not constitute a "prohibited transaction" if:
(i) the trust has held the property for not less than four years;
(ii) aggregate expenditures made by the trust, or any partner of
the trust during the four years prior to the date of sale which
are included in the basis of the property do not exceed 30 percent
of the net selling price of the property;
(iii) (I) during the taxable year the trust does not make more
than 7 sales of property (other than foreclosure property) or (II)
the aggregate adjusted bases of all such property does not exceed
10 percent of the aggregate bases of all of the assets of the
trust as of the beginning of the year;
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(iv) in the case of property, which consists of land or
improvements, not acquired through foreclosure (or deed in lieu of
foreclosure) or lease termination, the trust has held the property
for not less than four years for production of rental income, and
(v) if the requirement of clause (iii) (I) is not satisfied,
substantially all of the marketing and development expenditures
with respect to the property were made through an independent
contractor . . . from whom the trust itself does not derive or
receive any income.
Sales or dispositions of "real estate assets" which do not satisfy the safe
harbor provisions may be considered for purposes of determining the Company's
compliance with the 30 percent income limitation.
IV. DISTRIBUTION REQUIREMENTS
In order to qualify as a REIT, the Company must satisfy certain distribution
requirements set forth in IRC Sec. 857(a)(1). Pursuant to Section 857(a)(1),
the REIT must distribute an amount equal to the following:
(A) The sum of:
(i) 95% of the REIT's tax income computed without regard to
distributions and excluding net capital gain, and
(ii) 95% of the excess of net income from foreclosure property
over the tax on such income, minus
(B) any excess "noncash income" as determined under IRC Sec.
857(e).
As a general rule, only dividends actually paid during a taxable year are taken
into account for purposes of satisfying the distribution requirements. IRC
Sec. 858(a) provides certain statutory exceptions which treat dividends paid in
one year as paid in the prior year for purposes of the distribution
requirements and for purposes of calculating REITTI.
For purposes of the distribution requirements, the term "real estate investment
trust taxable income" (REITTI") is defined as taxable income computed according
to the normal corporate rules with specific adjustments as set forth in IRC
Sec. 857(b)(2)(A) through (F).
The Offering Memorandum contemplates a plan to distribute an aggregate amount
of dividends with respect to the Company's outstanding shares of capital stock
equal to 100 percent of the Company's REITTI excluding capital gains.
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CONCLUSION
The Company should qualify as a REIT under the organizational provisions of
IRC Section 856(a). This conclusion is based upon the Company:
Organizational Requirements:
(1) retaining centralized management through its board of directors
by maintaining sufficient control over the Bank as its advisor;
(2) maintaining the free transferability of the preferred stock
and common stock;
(3) continuing to be taxable as a corporation notwithstanding the
REIT provisions pursuant to the check-the box entity classification
regulations and the fact that the Company possesses a majority of
the corporate characteristics as defined under former
Reg. Sec. 301.7701-2(a)(2) including (i) the objective of carrying on
a trade or business, (ii) continuity of life, (iii) centralized
management, (iv) liability for corporate debts limited to corporate
property, and (v) free transferability of interest;
(4) not being deemed a financial institution as long as it does
not receive deposits, make loans, or discount debt obligations
nor should the Company be deemed an insurance company as long as it
does not issue insurance or annuity contracts;
(5) continuing to have more than 100 preferred shareholders
through its public offering and the IRS will remain consistent
with its holding in PLR 8342016 that each class of stock need not
have 100 shareholders;
(6) insuring that it will never allow more than 50% of the value
of its outstanding stock to be owned, directly or indirectly,
by or for not more than 5 individuals during the last half of the
year.
(7) elects to be treated as a REIT; and
(8) was organized as a corporation.
Asset Test:
The Company should qualify as a REIT under the asset test of IRC Section
856(c)(5). This conclusion is based upon the Company:
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(1) maintaining an asset base which includes at least 75% of
property which consists of solely of mortgage assets, mortgage
backed securities or other property which qualifies as "real estate
assets" for purpose of IRC Sec. 856(c)(5)(A) or (c)(6)(B); and
(2) not owning "securities" of any one issuer in an amount greater
in value than 5 percent of the value of the total assets of the
trust and not more than 10 percent of the outstanding voting
securities of such issuer.
Income Test:
The income test under IRC Section 856(c) should be met by the Company as long
as it:
(1) continues to derive at least 75 percent of its gross income
(excluding income from prohibited transactions) from mortgage
assets and mortgage backed securities;
(2) continues to derive at least 95 percent of its gross income
(excluding income from prohibited transactions) from sources
that satisfy the 75 percent income test; dividends; interest; and
capital gains on the sale or other disposition of stocks or
securities;
(3) continues to realize less than 30 percent of its gross income
from the sale or other dispositions of (i) any stock or
securities held for less than one year; (ii) property in a
transaction which is a prohibited transaction; and (iii) real
property (including interests in real property and interests in
mortgages on real property) held for less than four years other than
involuntarily converted property or foreclosure property.
Distribution Test
The distribution test under IRC Section 857(a)(1) should be met by the Company
as long as it:
(1) distributes an aggregate amount of dividends with respect to the
Company's outstanding shares of capital stock equal to (i) 95
percent of the Company's REITTI excluding capital gains, (ii) 95
percent of the excess income from foreclosure property over the tax
imposed on such income, minus (iii) any excess noncash income.
The conclusions in this letter are based upon a review of the facts as of
February 27, 1997 and upon pertinent statutory, legislative and other relevant
tax authority as of such date. To confirm these conclusions with respect to
the actual transaction it will be necessary to review the final transaction
documents, other factual data as may be relevant and the tax authority as of
the date
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of implementation. It must be emphasized that all tax authority is subject to
modification at any time by legislation, judicial and/or administrative action.
Any such change in law could be applied retroactively. Further, it is
possible that the Internal Revenue Service may disagree with these conclusions
and argue toward a different, more adverse result.
Very truly yours,
Coopers & Lybrand, LLP
BAK