IRS Revenue Ruling
1998-34

Code Sec. 7872

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26 CFR 1.7872-5T: Exempted Loans (temporary).

Below-market loans; exempted loans; second mortgage loans under the
MAHRA Act. A below-market second mortgage loan made under the Multifamily
Assisted Housing Reform and Affordability Act of 1997, by the Department
of Housing and Urban Development (HUD) to the owner of a multifamily
low-income rental property in connection with restructuring the existing
first mortgage on the property, is exempted from section 7872 of the Code.


REV. RUL. 98-34

ISSUE

If the Department of Housing and Urban Development ("HUD") makes a
below-market second mortgage loan in accordance with the Multifamily
Assisted Housing Reform and Affordability Act of 1997, 111 Stat. 1384
("MAHRA Act"), is that loan exempt from section 7872 of the Internal
Revenue Code?


FACTS

Limited partnership PRS owns a multifamily low-income rental property
subject to a first mortgage that secures a nonrecourse first mortgage note
with an outstanding principal balance of $100x (the "Existing Mortgage
loan"). The Existing Mortgage loan is insured by the Federal Housing
Administration ("FHA"). PRS, as owner of the property, receives both
rental payments from the property's tenants and, under a project-based
assistance contract, certain additional payments from HUD. (Collectively,
the payments are referred to as "Contract Rents.") The Contract Rents
exceed the rents that would be received with respect to comparable
unassisted rental properties in the same housing market ("Street Rents").
If the project-based assistance from HUD were reduced so that Contract
Rents reflected Street Rents, PRS would not be able to satisfy its debt
service obligation on the Existing Mortgage loan.

Congress enacted the MAHRA Act to reduce the federal government's cost
of rental subsidies, to minimize FHA mortgage insurance risks, and to
ensure the continued viability of multifamily rental housing projects. See
section 511(b) of the MAHRA Act; H.R. Conf. Rep. No. 297, 105th Cong., 1st
Sess. 137-39 (1997). To achieve these goals, the MAHRA Act permits owners
of eligible multifamily housing projects with expiring project-based
assistance contracts to enter into mortgage restructuring and rental
assistance sufficiency plans with HUD or a participating administrative
entity acting on behalf of HUD.

In accordance with the MAHRA Act, the following actions occur:

(1) Project-based assistance payments to PRS are reduced so that the
Contract Rents received by PRS reflect Street Rents.

(2) HUD makes a $35x cash payment to the holder of the Existing
Mortgage loan on behalf of PRS to reduce the outstanding principal balance
of the Existing Mortgage loan to $65x.

(3) The terms of the Existing Mortgage loan are modified, resulting in
a new first mortgage loan with an outstanding principal balance of $65x
("New First Mortgage loan"). The New First Mortgage loan provides for
interest above the applicable Federal rate under section 1274(d) ("AFR").
Debt service on the New First Mortgage loan is supportable by the reduced
Contract Rents.

(4) In consideration for the payment in step (2), PRS executes a
nonrecourse note to HUD (the "Second Mortgage loan") secured by a second
mortgage. The Second Mortgage loan has a principal balance of $35x,
provides for interest below the AFR, and qualifies as indebtedness under
general principles of federal income tax law. The Second Mortgage loan is
made in accordance with section 517(a)(1)(B) of the MAHRA Act.


LAW AND ANALYSIS

In general, section 7872 defines a below-market loan as any loan on
which the interest rate charged is less than the AFR. Section 7872(b)
provides that the borrower of a below-market term loan is treated as
having received from the lender, on the date the loan is made, cash in an
amount equal to the excess of the amount loaned over the present value of
all payments required under the loan (the "imputed transfer"). Section
7872(b) further provides that a below-market term loan is treated as
having original issue discount ("OID") in an amount equal to the imputed
transfer, which is in addition to any other OID on the loan determined
without regard to section 7872(b).

Section 1.7872-5T(a)(1) of the temporary Income Tax Regulations
provides that, notwithstanding any other provision of section 7872 and the
regulations thereunder, section 7872 does not apply to the loans listed in
section 1.7872-5T(b) because the interest arrangements of those loans do
not have a significant effect on the federal tax liability of the borrower
or the lender. Section 1.7872-5T(a)(2) provides, however, that if a
taxpayer structures a transaction as a loan exempt under section
1.7872-5T(b) and one of the principal purposes of so structuring the
transaction is the avoidance of federal tax, then the transaction will be
recharacterized as a tax avoidance loan under section 7872(c)(1)(D).

Section 1.7872-5T(b)(5) provides an exemption for loans that are
subsidized by a federal, state, or municipal government (or any agency or
instrumentality thereof), and that are made available under a program of
general application to the public.

Under section 1.7872-5T(b)(15), other loans described in revenue
rulings or revenue procedures may be exempted from section 7872 if the
Commissioner finds that the factors justifying the exemption for those
loans are sufficiently similar to the factors justifying the other
exemptions listed in section 1.7872-5T.

The legislative history of section 7872 indicates that most
government-subsidized loans, such as government-insured residential
mortgage loans, were intended to be exempt from section 7872. See 1 Senate
Comm. on Finance, 98th Cong., 2d Sess., Deficit Reduction Act of 1984:
Explanation of Provisions Approved by the Committee on March 21, 1984, at
482 (S. Prt. 169).

The factors justifying exemption of the Second Mortgage loan from
section 7872 are similar to the factors justifying the exemption for
government subsidized loans made available under a program of general
application to the public, which are exempt from section 7872 under
section 1.7872-5T(b)(5).

The MAHRA Act was enacted as a reform measure to reduce HUD's cost of
renewing project-based assistance contracts on multifamily low-income
rental properties while ensuring the continued viability of these
multifamily rental housing projects. The interest arrangements of the
Second Mortgage loan to PRS are, therefore, not structured with a
principal purpose of avoiding federal tax.


HOLDING

The Second Mortgage loan is exempt from section 7872.


DRAFTING INFORMATION

The principal authors of this revenue ruling are David B. Silber and
Tina Jannotta of the Office of Assistant Chief Counsel (Financial
Institutions and Products). However, other personnel from the IRS and
Treasury Department participated in its development. For further
information regarding this notice, contact Tina Jannotta on (202) 622-3940
(not a toll-free call).

<<END RULING>>

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