PLR 202601013

REITs Get Green Light on Offsetting Hedges

The IRS has given the green light to a real estate investment trust (REIT) to use 'Counteracting Hedges' – essentially offsetting swap positions – instead of terminating original hedges. This strategy allows the REIT to avoid potentially expensive 'breakage costs' associated with terminating the initial hedge. The IRS ruled that income from these counteracting hedges will not jeopardize the REIT's qualification under Section 856(c)(2) and (c)(3), which outline the 95% and 75% gross income tests for REITs.

The Financial Dilemma: Breakage Costs vs. Risk

The recent private letter ruling (PLR) addresses a common financial challenge faced by REITs: managing interest rate risk while minimizing costs associated with hedging instruments. The taxpayer in this case, a REIT, held substantial mortgage assets financed through sale-repurchase agreements, known as REPOs. These REPOs carried variable interest rates tied to the Secured Overnight Financing Rate (SOFR), creating a duration mismatch: long-term, fixed-rate mortgages funded by short-term, floating-rate debt.

To mitigate the risk that rising interest rates on the REPOs could erode or eliminate the spread between their financing costs and the income from their mortgage assets, the REIT entered into interest rate swaps, referred to as "Swap Hedges." These are colloquially known as pay-fixed swaps. Under each Swap Hedge, the REIT paid a fixed rate of interest on a notional amount and received a floating rate tied to an objective interest rate index, as defined under Section 1.1275-5(b) of the Income Tax Regulations. The REIT also planned to use swaptions – options to enter into swaps – to further manage interest rate exposure.

The REIT maintained a desired "Hedging Ratio," representing the ratio of the notional principal amount of its outstanding hedges to the principal amount of its borrowings. When the REIT wanted to decrease the notional amount of its hedges due to changes in its desired Hedging Ratio or a decrease in the amount of REPOs used to finance the mortgage assets, terminating the existing Swap Hedges was problematic. The counterparties, typically established financial institutions, imposed substantial "breakage costs" for early termination. These costs, representing the counterparty's expenses in unwinding their side of the hedge, outweighed the benefits of terminating the hedge. Although cleared swaps offered easier terminations, their higher margin requirements made them costly.

To address this, the REIT proposed using "Counteracting Hedges." Rather than terminating an existing swap, it would enter into an offsetting swap position, achieving the same economic effect as termination without incurring breakage costs. The REIT represented that both the Hedges and the Counteracting Hedges qualified as hedging transactions under Section 1221, which defines capital assets and excludes hedging transactions from that definition, and Section 1.1221-2(b), which provides rules for hedging transactions. Furthermore, the REIT confirmed it would identify these transactions under Section 1221(a)(7) and Section 1.1221-2. Critically, the REIT also represented that its Hedging Ratio would always be less than 1, ensuring that the notional amounts of the Hedges and Counteracting Hedges would never exceed the principal amount of the Mortgage Assets, preventing "over-hedging."

IRS Analysis: Expanding the Safety Zone

The IRS first addressed the treatment of standard hedging income. Section 856(c)(5)(G)(i), concerning REIT qualifications, states that income from a hedging transaction, as defined in Section 1221(b)(2)(A), is excluded from gross income under the 95% and 75% income tests of Sections 856(c)(2) and 856(c)(3), respectively, to the extent the transaction hedges indebtedness incurred to acquire or carry real estate assets. To qualify for this exclusion, Section 856(c)(5)(G)(iv) requires that the hedging transaction satisfy the identification requirement described in Section 1221(a)(7), which mandates clear identification of the hedge on the day it was acquired.

The issue at hand, however, involved "Counteracting Hedges." The IRS acknowledged that these might not strictly fit the standard hedging definition in isolation. To resolve this, the IRS turned to its authority under Section 856(c)(5)(J). This section grants the Secretary of the Treasury the power to determine whether an item of income that doesn't otherwise qualify under the REIT income tests can be considered as not constituting gross income for purposes of those tests. The IRS exercised this authority to rule that income from these offsetting positions also is excluded from gross income, provided they offset the risk of the original hedge and are properly identified under Section 1221(a)(7). The IRS reasoned that excluding income from Counteracting Hedges is consistent with the intent of Congress, which sought to encourage REITs to manage interest rate risk without inadvertently jeopardizing their qualification.

Implications for the Industry

The IRS ruled that the REIT's gross income from both the original Hedges and the Counteracting Hedges does not constitute gross income for purposes of Section 856(c)(2) and (3). Section 856(c)(2) contains the 95% income test, requiring that at least 95% of a REIT's gross income comes from dividends, interest, rents, and similar passive sources. Section 856(c)(3) contains the 75% income test, requiring that at least 75% of a REIT's gross income is derived from real estate related sources. This provides a roadmap for other REITs seeking to manage their hedge portfolios more cost-effectively by using offsetting hedges instead of terminating existing ones and incurring breakage fees. By implementing counteracting hedges, REITs can avoid generating non-qualifying income while still managing interest rate risk. As with all Private Letter Rulings, it's important to remember that this ruling is directed only to the taxpayer who requested it, and per Section 6110(k)(3), cannot be used or cited as precedent.