In Private Letter Ruling 202424011, the Internal Revenue Service ruled that the taxpayer’s hypothecation loan is secured by mortgages on real property for purposes of Section 856(c) of the Internal Revenue Code and also that the taxpayer’s hypothecation loan is an interest in mortgages on real property for purposes of Section 856(c).

The “Hypothecation Loan” described in the ruling is a loan by a REIT to a construction lender. The construction lender made a loan (“Construction Loan”) to a developer that was secured by recorded mortgages on certain real property (“Construction Mortgages”). Simultaneously, the REIT made a loan to the construction lender. The construction lender assigned the Construction Mortgages to the REIT as collateral for the Hypothecation Loan. The collateral assignment of the Construction Mortgages was recorded in the county real estate records. Other Construction Loan documents were also assigned and used as collateral for the Hypothecation Loan, including an absolute assignment in blank to transfer full ownership of the collateral to the REIT. Upon an event of default under the Hypothecation Loan, the REIT could unilaterally complete, execute and record the absolute assignment of the collateral to itself. The entire collateral file was delivered to a custodian acting as the REIT’s agent, and the taxpayer represented that the possession of the collateral file by the custodian perfected the REIT’s security interest for purposes of Article 9 of the UCC. It appears that prior to an event of default on the Hypothecation Loan the borrower under the Construction Loan was to make any required interest payments to the construction lender, rather than to the REIT.

The Internal Revenue Service relied on Revenue Ruling 80-280 to conclude that the Hypothecation Loan is secured by mortgages on real property for purposes of Section 856(c) of the Internal Revenue Code and also that the Hypothecation Loan is an interest in mortgages on real property for purposes of Section 856(c). The ruling is similar to earlier hypothecation loan Private Letter Rulings 200705001, 200513002, 9431005, and 8640018. Interestingly, this ruling states with specificity what kind of real estate asset the Hypothecation Loan is, rather than merely concluding that it is a “real estate asset.” Although only binding for the taxpayer to whom they are issued, these private letter rulings give an indication of the Internal Revenue Service’s view on hypothecation loans. Importantly, in each ruling, the hypothecation lender itself or its agent was in possession of the underlying mortgage, either physically or through a perfected UCC security interest, and had the ability to foreclose in the hypothecation lender’s name on the underlying mortgage.

Emily Benedict and Zachary Roop contributed to this article