United States: IRS Rules That Interest In A Money Market Fund Is A Cash Item For REITS

The Internal Revenue Service (the "IRS") recently provided guidance to real estate investment trusts (a "REIT"), establishing that an interest in a money market fund qualifies as a cash item for purposes of the REIT asset test under Section 856(c)(4)(A) of the Internal Revenue Code of 1986, as amended (the "Code").¹

Background

A REIT must satisfy numerous requirements in order to maintain its qualification as a REIT. One requirement is that, at the close of each quarter of the REIT's taxable year, at least 75% of the value of the REIT's total assets must consist of real estate assets, cash and cash items (including receivables), and Government securities (the "75% Asset Test").² At the end of each quarter, not more than 25% of the value of the REIT's total assets may be represented by securities (other than securities that qualify for the 75% Asset Test) (the "25% Asset Test"), and, generally, not more than 5% of the REIT's total assets may be represented by securities of a single issuer (the "5% Asset Test"), and a REIT may not hold securities possessing more than 10% of the total voting power or value of the outstanding securities of a single issuer (the "10% Asset Test" and together with the 25% Asset Test, the 5% Asset Test and the 75% Asset, the "Asset Tests").³

Prior to the recent guidance provided in Rev. Rul. 2012-17, released on June 18, 2012, it was unclear whether an interest in a money market fund was a cash item. Some practitioners believed that bank money market funds were cash items, but there was no clear authority as the term cash item is not defined in the Code, the Treasury Regulations nor the legislative history of Code Section 856. If a money market fund was not a cash item, violations of the 75% Asset Test, the 25% Asset Test, the 5% Asset Test and the 10% Asset test could result. Commentators warned that if an interest in a money market fund was not a cash item, a violation of the 5% Asset Test could easily occur in connection with cash temporarily held in a money market fund as a result of a disposition of real property assets or in anticipation of other transactions.⁴

The Code states that those terms not defined for purposes of the REIT rules have the same meaning as when used in the Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 and following) (the "1940 Act").⁵ Although the term cash item is not defined in the 1940 Act or the regulations under the 1940 Act, the IRS has previously applied 1940 Act authorities in ruling that certificates of deposit are cash items for purposes of the 75% Asset Test.⁶

Under newly issued Rev. Rul. 2012-17, the IRS has relied upon 1940 Act authorities provided under a no-action letter issued by the staff of the Division of Investment Management of the Securities and Exchange Commission (the "SEC No-Action Letter") that directly addressed the question of whether an interest in a money market fund is a cash item for purposes of the 1940 Act.⁷ If investment securities comprise at least 40% of the value of an issuer's total assets (excluding Government securities and cash items) on an unconsolidated basis, the issuer will be an investment company.⁸ Under the SEC No-Action Letter, an issuer can calculate the amount of its investment securities without including money market fund shares.⁹ The SEC reasoned that the essential quality of a cash item is a high degree of liquidity and a relative safety of principal and that in its view money market fund shares have those same qualities.¹⁰ The SEC further noted that treating money market fund shares as a cash item provides operating companies with appropriate flexibility in managing their cash holdings.¹¹ In ruling that an interest in a money market fund is a cash item for purposes of the 75% Asset Test, Rev. Rul. 2012-17 noted that the conclusion reached by the SEC No-Action Letter is not inconsistent with the language of the 75% Asset Test or its underlying legislative history.

Impact

Rev. Rul. 2012-17 provides REITs with an expanded number of investment options. Money market funds may be preferable to traditional bank accounts as they generally offer higher yields, while providing a similar level of liquidity and security. Prior to Rev. Rul. 2012-17, REITs were constrained in their ability to invest in money market funds as a result of the uncertainty of whether it was a cash item for purposes of the 75% Asset Test. The impact of this uncertainty was compounded by the limitations imposed on a REIT's ability to hold securities. If an interest in a money market fund was not considered a cash item, a REIT's ability to invest in it would be subject to the same limitations as its investments in other securities. As a result of Rev. Rul. 2012-17, REITs no longer need to avoid large investments in a single money market issuer out of concern that such investment would cause a violation of one of the Asset Tests. REITs should continue to bear in mind, however, that the ruling did not discuss the treatment of income earned from such money markets funds; accordingly, income earned from such money market funds would presumably continue to produce income that qualifies for the broader 95% REIT income test under Code Section 856(c)(2) (as opposed to the 75% REIT income test under Code Section 856(c)(3)).¹²

Footnotes

1 Rev. Rul. 2012-17, 2012-25 I.R.B. 1018.

2 Code Section 856(c)(4)(A).

3 Code Section 856(c)(4)(B).

4 American Bar Association Section of Taxation Request for Guidance on Treatment of Investments in Money Market Mutual Funds as "Cash Items" for Purposes of Section 856(c)(4)(A) (April 22, 2009).

5 Code Section 856(c)(5)(F).

6 Rev. Rul. 77-199, 1977-1 C.B. 195. (relying on the holding in Securities and Exchange Commissioner v. Fifth Avenue Coach Lines, Inc., 289 F. Supp. 3 (S.D.N.Y. 1968) that certificates of deposit were cash items for purposes of the 1940 Act).

7 Willkie Farr & Gallagher, SEC No-Action Letter, IM Ref. No 2000 10 24 1124, File No. 132-3 (October 23, 2000) viewable at http://www.sec.gov/divisions/investment/noaction/2000willkie-farrgallagher102300.pdf

8 1940 Act Section 3(a)(1)(C).

9 SEC No-Action Letter at 6.

10 Id.

11 SEC No-Action Letter at 7.

12 Income from certain investments in money market funds may qualify for the for the 75% REIT income test as "qualified temporary investment income." Code Sections 856(c)(3)(I) and (c)(5)(D).