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Ryan Hirsch Mark Sutton
August 7, 2019 Article 1 min read
When attempting to mitigate interest rate risk on floating-rate debt, REITs often consider acquiring an interest rate hedge. But tread carefully, as this can result in a REIT qualification violation if the arrangement isn’t properly identified.

Water fountain in a city.

If a REIT exercises foresight and acquires an interest rate swap agreement that ultimately becomes “in the money,” a negative consequence is that the resulting income will be considered “bad income” for purposes of the 75 percent and 95 percent tests unless the REIT clearly identified the transaction before the close of the day on which it was entered into. If such required identification occurs, the resulting income can be excluded for both the 75 and 95 percent tests.

Although many experienced real estate professionals have used interest rate swap agreements throughout their careers, those who recently joined REITs may not be aware of this requirement and the time-sensitive nature of the designation. Those who are aware may still misstep by assuming that identifying the transaction for financial accounting purposes is sufficient. On the contrary, the identification requirement specifically provides that the identification is being made for tax purposes and reflected on the taxpayer’s books and records. Also, within the designation, the hedge transaction must be “clearly identified.” Guidance has evolved as to what specific information the identification of the hedge should include, but common details include the currency and dollar amount, rate, which index the hedge is tied to, effective date, and maturity date.

REITs seeking to avoid these concerns should seek appropriate guidance when considering an interest rate swap. Additionally, REITs that discover that a previous swap wasn’t appropriately identified for tax can potentially mitigate the negative impact on the 75 and 95 percent tests by contributing the agreement to a taxable REIT subsidiary.

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