TAX NOTES FEDERAL, VOLUME 179, JUNE 19, 2023 1993
tax notes federal
VIEWPOINT
Do Phantom Income Concerns Stop
Shared Appreciation Home Loans?
by Marshall D. Feiring and Ryan J. Zucchetto
Shared appreciation home mortgages
(HSAMs) are intended to facilitate individual
homeownership by allowing borrowers to pay
current interest at below-market rates in exchange
for sharing some of the home appreciation
occurring between the time the mortgage loan is
originated and an identifiable event or a definitive
future time. Under ordinary circumstances, the
lender and borrower are unrelated, independent
parties, and it can be presumed that the lender
expects the value of the shared appreciation
payment to make up for, or even exceed, the
difference in value between the payments
received at below-market rates and the value of
the payments had they been received at regular
rates. Despite the economic benefit of this deferral
for mortgage borrowers and the expectation of
market (or better) returns for mortgage lenders,
the latter are often unwilling to make HSAMs.
The IRS and Treasury can and should change
this situation so borrowers can once again take
advantage of HSAMs, especially in the current
environment.
One reason that lenders may be reluctant to
make HSAMs could be the concern that HSAM
federal income taxation is governed by the rules
that apply to other types of contingent payment
debt instruments (CPDIs).
1
As a matter of cash
flow, the HSAM lender receives below-market
current interest payments and a single lump sum
(if any) after several years. Under the CPDI
regulations, however, the HSAM lender must
accrue and pay tax currently on interest computed
at a “comparable yield,” which can be expected to
exceed the actual interest payable at a below-
market rate. After accruing income and paying the
tax on it before the income is received, the HSAM
lender then gets the shared appreciation payment.
At that time, the HSAM lender either (1) receives
an amount equal to the previously accrued and
taxed income, which means the HSAM lender has
paid tax on an accelerated basis, (2) receives an
amount less than the previously accrued and
taxed income, which means the HSAM lender has
paid tax on an accelerated basis and can claim an
offsetting deduction on a deferred basis, or (3)
receives an amount greater than the previously
accrued and taxed income, which, depending on
Marshall D. Feiring and Ryan J. Zucchetto are
tax partners with Dentons’s New York capital
markets group. They thank Lawrence Salva,
William Cejudo, Sarah Nelson, James Gouwar,
and Salama Almahayni for their help with this
article.
In this article, Feiring and Zucchetto argue
that Treasury and the IRS should make shared
appreciation home mortgages exempt from
contingent payment debt instrument rules to
encourage lenders and improve the interest rate
environment.
1
See Andrew Caplin, Noel B. Cunningham, and Mitchell Engler,
“Rectifying the Tax Treatment of Shared Appreciation Mortgages,” 62
Tax L. Rev. 505 (2009).
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VIEWPOINT
1994 TAX NOTES FEDERAL, VOLUME 179, JUNE 19, 2023
the amount of the shared appreciation payment in
excess of the income previously accrued and
taxed based on the comparable yield, may
provide some deferral of tax.
2
The CPDI rules can, therefore, create the risk
of negative tax arbitrage to an HSAM lender. It is
possible that this risk of negative tax arbitrage has
turned lenders subject to the regular original issue
discount rules away from making HSAMs. Also,
the risk of negative tax arbitrage to lenders is not
balanced by any tax benefit to borrowers. Because
most home borrowers are cash-basis taxpayers,
and an HSAM, by definition, is used to carry or
acquire personal property, they cannot deduct
contingent interest (the shared appreciation
amount) until paid. Presumably, the difference
between interest actually paid and interest
computed at the comparable yield is never paid
and never deductible.
3
Given the potential benefit of HSAMs to
homebuyers and the unbalanced income tax
treatment between borrowers and lenders, it
would seem difficult to persist in applying the
CPDI rules to HSAMs. It is believed that not
subjecting HSAMs to the CPDI rules, even if only
temporarily, or clarifying that HSAMs are not
intended to be subject to the CPDI rules, would
encourage more home mortgage lending, which
could be helpful in the current interest rate
environment. That targeted temporary
suspension of the CPDI rules, or their clarification
in the case of HSAMs, could be justified by policy
considerations (the current pressure on
borrowers) but it could also be justified for
technical reasons, including the CPDI rules
themselves and their potential adverse effect on
real estate investment trusts and real estate
mortgage investment conduits. Finally, as a
historic matter, the CPDI treatment of HSAMs
does not reflect the government’s original
approach to HSAMs. That approach changed over
time, which again would suggest that a different
treatment is possible.
Before the current CPDI rules were issued,
HSAMs were subject to income tax accounting
rules that did not require any HSAM appreciation
payment (or comparable yield) to be projected
and taken into income annually as OID. To the
contrary, under a 1983 revenue ruling on HSAMs
(Rev. Rul. 83-51, 1983-1 C.B. 48) the REIT
provisions concerning shared appreciation
mortgages (SAMs) added by the 1986 Tax Reform
Act
4
and the first two sets of OID regulations for
CPDI,
5
HSAM payments would not be projected
or accrued currently based on a comparable yield
or taken into account before being fixed.
Although it is arguable that the current CPDI
regulations have changed that treatment for
HSAMs, the mechanics of those rules (especially
the definition of “comparable yield”) and their
failure to address the treatment of HSAMs under
the REIT statute and REMIC regulations indicate
that HSAMs were not intended to be CPDIs.
Initially, the IRS and Treasury addressed the
borrower side of HSAMs in Rev. Rul. 83-51, which
was issued at a time when home mortgage
interest rates were hitting historic highs. As
contemplated by the facts of the revenue ruling,
regular interest rates were as high as 18 percent
annually. The revenue ruling explains that by
borrowing under an HSAM, a homebuyer could
pay interest regularly (monthly) at a below-
market rate, such as 12 percent annually. In
return, the homeowner would pay a share of the
home’s appreciation occurring between the loan
origination and the earliest of (1) the loan payoff,
(2) the sale of the home, or (3) 10 years from the
origination. The revenue ruling concludes that the
regular interest payments and the shared
appreciation payment could be deducted as
interest in the year paid.
Rev. Rul. 83-51 did not address the lender’s tax
consequences of an HSAM, but the first set of
proposed CPDI rules does. Under the first set of
proposed rules for CPDIs (LR-189-84), published
in the Federal Register for April 8, 1986, a SAM
issued for cash or publicly traded property would
be split into two components: the non-contingent
payments and the contingent payments. The non-
contingent payments would be treated as a
separate, non-contingent debt instrument, having
an issue price equal to the issue price of the overall
2
Reg. section 1.1275-4.
3
Reg. section 1.163-7 and section 1275(b)(2).
4
Section 856(j).
5
T.D. 8517 and T.D. 8674.
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VIEWPOINT
TAX NOTES FEDERAL, VOLUME 179, JUNE 19, 2023 1995
debt. The contingent payments would be treated
entirely as interest deductible by the issuer and
includable by the holder for the tax year in which
the payment became fixed. Under these
regulations, the HSAM described in Rev. Rul. 83-
51 would be split into two components: a straight
debt component having a principal balance equal
to the initial loan principal balance of the entire
loan, paying interest at 12 percent annually, and a
contingent shared appreciation component which
would be treated as additional interest paid when
due under the contract (the earlier of: payoff, sale,
or the end of 10 years). Inclusion and deduction of
the HSAM appreciation component was deferred
and essentially mirrored the timing of the
deduction for the borrower in Rev. Rul. 83-51.
The next set of proposed rules for CPDIs (FI-
189-84), published in the Federal Register for
February 28, 1991, revised the initial rules. CPDIs
were again split into two separate components
except that the issue price of the non-contingent
component was determined under the investment
unit rules. More importantly, the contingent
payment component would no longer be
automatically characterized as interest but
instead in accordance with its economic
substance. Under this second set of proposed
regulations, entitlement to a SAM payment could
be treated as an option or some other kind of
property right.
An example in these revised, proposed
regulations posited a five-year debt instrument
issued for a cash payment of $1 million. Until
maturity, the debt instrument was to make non-
contingent, semiannual interest payments based
on a 9 percent annual rate, which rate was based
on the midterm applicable federal rate. At
maturity, the debt instrument was to make a non-
contingent payment of $1 million and a
contingent payment equal to $1 million
multiplied by the percentage increase in a public
stock index over the five-year term of the
instrument.
Under this second set of proposed regulations
the non-contingent payments were characterized
as a debt instrument with an issue price reflecting
the regular interest payments and a $1 million
redemption price. The contingent payments were
characterized as a cash-settled index option
issued for a premium equal to $1 million minus
the deemed issue price of the non-contingent
payments. Again, the inclusion and deduction of
something like an HSAM appreciation
component would be deferred even if it were not
necessarily characterized as the receipt of interest.
The REMIC regulations were modified in the
same year that this second set of CPDI regulations
was proposed.
6
Although they do not address the
treatment of HSAMs directly, they can be seen as
adopting the deferral model of HSAM income
taxation. Specifically, these REMIC regulations
explain that some rights that would ordinarily
prevent a mortgage loan from qualifying as a
REMIC asset could be retained by a sponsor. This
would allow the mortgage loan to then be
contributed to a REMIC so long as the mortgage
loan (without the rights retained by the sponsor)
would then pay interest at a REMIC-qualifying
fixed or variable rate. Specifically, reg. section
1.860D-1 says that:
If an obligation with a fixed principal
amount provides for interest at a fixed or
variable rate and for certain contingent
payment rights (e.g., a shared appreciation
provision or a percentage of mortgagor
profits provision), and the owner of the
obligation contributes the fixed payment
rights to a REMIC and retains the
contingent payment rights, the retained
contingent payment rights are not an
interest in the REMIC.
If a shared appreciation right can be stripped
and leave an ordinary fixed or variable rate
mortgage loan, the indication is that the
contingent payment right can be accounted for
separately and no longer affect the remaining
instrument. The indication is that the comparable
yield was no longer part of the mortgage loan held
by the REMIC and that the stripped right could go
untaxed until the shared appreciation payment, if
any, was made or at least fixed.
Section 856(j), which establishes rules for
REITs that make or acquire SAMs appears to take
a similar view: Appreciation payments should be
treated separately and taxable when paid or fixed.
It was added to the code by TRA 1986 because
6
T.D. 8366, amended by T.D. 8458.
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VIEWPOINT
1996 TAX NOTES FEDERAL, VOLUME 179, JUNE 19, 2023
Congress believed that the treatment of SAMs
should be clarified for purposes of the REIT
income requirements.
7
In general, Congress
believed that for these purposes it was
appropriate to treat the income from the shared
appreciation provision as gain from the sale of the
related real property, indicating, again, the
contingent payment right could be accounted for
separately in the future and without affecting the
remaining instrument.
Many comments on the second set of
proposed CPDI regulations convinced the IRS
and Treasury to propose a third set of CPDI
provisions.
8
The commentators were most
concerned that deferring the deduction and
inclusion of the contingent payment to the year in
which the contingent payment became fixed
allowed for substantial backloading of interest
income. In addition, the commentators doubted
how easy it would be to both calculate the size of
contingent payments and to characterize the
entitlement to contingent payments as definitive
types of financial instruments.
It is under this final set of regulations
9
that
OID is accrued and reported annually based on
the comparable yield, which for a debt instrument
is the yield at which the issuer would issue a
fixed-rate debt instrument with terms and
conditions similar to those of the contingent
payment debt instrument (the comparable fixed-
rate debt instrument), including the level of
subordination, term, timing of payments, and
general market conditions (but of course without
the contingent payment). Positive or negative
adjustments to the amounts included based on the
comparable fixed yield would be made when the
amount or amounts of the contingent payments
were known.
Presumably, if the current CPDI rules were
applied to the HSAM in Rev. Rul. 83-51, the lender
would have to annually accrue and report interest
at 18 percent (the comparable yield) while only
receiving interest at 12 percent and could adjust
these accruals only when the single contingent
payment was fixed.
There are reasons to doubt whether it is
appropriate to apply the CPDI comparable yield
rules to an appreciation right of an HSAM.
HSAMs are for individuals that cannot acquire a
home if compelled to pay interest at a regular
fixed rate, which is the entire reason for the
HSAM alternative. An HSAM appreciation right
does not measure general market movements of
residential real estate; an HSAM appreciation
right gives a lender an economic interest in the
value of the individual, financed property. The
concept of comparable yield makes the most sense
when applied to a commercial borrower that can
otherwise actually borrow at a fixed, comparable
rate under general markets and conditions. In that
context, the CPDI rules appropriately discourage
the significant backloading of interest. But unlike
other contingencies, shared appreciation rights
are key to the financing. HSAMs make a home
purchase possible. Depending on the referenced
contingency for a CPDI, commercial parties can
use hedging to reduce their exposure, especially
in the case of contingencies based on widely
published indices and commodity prices. HSAM
lenders can face an undiversified, financial risk
for extended periods.
Unfortunately, no version of the CPDI
regulations provides any specific example of how
to apply the CPDI method in the context of a
noncommercial transaction such as an HSAM,
most likely because home borrowers are cash-
basis taxpayers and can only deduct interest when
paid. In addition, the last set of CPDI rules did not
address or even discuss the treatment of HSAMs
in either the context of the REMIC regulations
discussed earlier, which allow an HSAM
provision to be stripped from a mortgage loan
before it is put in a REMIC or in the context of the
REIT SAM rules (which require payments based
on real estate appreciation to be characterized —
and presumably included in income — when
made). Either there was no intention to impose
the CPDI rules on REMIC-held or REIT-held
SAMs or the drafters of the CPDI regulations
made significant statute-like changes affecting the
REIT and REMIC rules without providing any
helpful guidance.
7
Joint Committee on Taxation, “General Explanation of the Tax
Reform Act of 1986,” JCS-10-87 (May 4, 1987); S. Rep. 99-313, p. 769-782,
H. Rep. 99-841, Vol. II, p. 214-221.
8
T.D. 8674.
9
Reg. section 1.1275-4.
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TAX NOTES FEDERAL, VOLUME 179, JUNE 19, 2023 1997
For example, under the REMIC regulations
discussed earlier, a home mortgage having both a
fixed rate (or variable rate) and a shared
appreciation component can be made into a
qualified REMIC asset by stripping the
appreciation component and leaving it in the
hands of the depositor (or another third party). If
the last set of CPDI rules were intended to apply
to an HSAM held by a REMIC, one would
anticipate that these REMIC regulations would
have been modified or the drafters would have
used the preamble to clarify how the new CPDI
rules affected a stripped HSAM in the REMIC
context. Would the difference between the actual
and comparable yield be included in income by
the REMIC as the owner of the mortgage loan or
in the income of the owner of the stripped
appreciation rights? If included in the income of
the holder of stripped appreciation rights, would
that owner be taxable on just the difference
between the comparable yield and the fixed rate
and then account for the settlement of the
appreciation rights as a regular net positive
adjustment or net negative adjustment?
Conversely, would the REMIC be compelled to
treat an HSAM as a mortgage bearing a fixed rate
equal to the comparable yield? In which case, how
would the REMIC offset the resulting phantom
income (that is, the difference between interest
accrued at a comparable yield and interest
collected on the loan)? It does not appear that a
REMIC could issue a regular interest accruing
(but not currently paying) interest at a rate equal
to the difference between the actual yield and the
comparable yield given (1) the rules against
contingencies
10
and (2) a regular interest paying
interest based on home appreciation (instead of
reflecting contemporaneous changes in interest
rates) would not be paying interest at a “qualified
floating rate.”
11
Or would the REMIC allow the
resulting phantom income to increase the excess
inclusions of the holder of the residual interest,
which would increase the inducement fee
demanded by that holder? None of these
questions appear to be answered.
As another example, if the CPDI rules were
intended to apply to a SAM held by a REIT, would
they override the statutory scheme of section
856(j) without furnishing some explanation? The
CPDI regulations are statutory regulations,
12
but
one supposes the drafters of the CPDI rules would
at least explain ways or provide rules for
navigating the apparent conflict between the REIT
code provisions and the CPDI regulations and the
complexities resulting from applying the CPDI
rules to the REIT SAM rules in section 856(j).
In particular, section 856(j)(1) characterizes
shared appreciation payments as gain recognized
on the sale of the secured property for purposes of
the annual REIT gross income tests under section
856(c). But the section seems to implicitly defer
that income until it is earned, providing that “any
income derived from a shared appreciation
provision shall be treated as gain recognized on
the sale of the secured property.” But under the
CPDI regulations, if the appreciation payment
exceeds the interest accrued based on the
“comparable yield,” the excess is most likely a
“net positive adjustment,” and characterized as
additional interest. Conversely, if the interest
accrued based on the comparable yield, exceeds
the appreciation payment, the excess is most
likely a net negative adjustment. A net negative
adjustment first reduces the amount of interest
that would otherwise be accounted for the year in
which the adjustments arise; the remainder is
then treated as an ordinary loss in that year up to
the amount of interest income accrued in prior
years, and the remainder after that is carried
forward and either reduces the amount realized
on the disposition of the instrument or is taken as
an ordinary loss.
If the CPDI rules were intended to apply to
REIT-held HSAMs, one would anticipate that
some additional guidance would have been
provided unless the intent was to prevent REITs
from holding HSAMs. Regarding the
characterization of interest accrued at the
comparable yield, it would have been helpful had
the CPDI regulations explained or affirmed that
interest accrued based on the comparable yield
still qualified under the REIT gross income tests as
10
Reg. section 1.860G-1(a)(5).
11
Reg. section 1.1275-5(b)(1) (requiring that variations in the value of
a qualified floating rate be reasonably expected to measure
contemporaneous variations in the cost of newly borrowed funds).
12
Section 1275(d) (specific reference to “contingent payments”).
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VIEWPOINT
1998 TAX NOTES FEDERAL, VOLUME 179, JUNE 19, 2023
interest from a mortgage loan. It would also have
been helpful had the regulations confirmed or
explained that characterizing net positive
adjustments as additional interest was intended
to override the statutory treatment of an
appreciation payment as gain from the sale of the
underlying property. If that override was
intended, it would alter the treatment of a SAM
secured by property that was held for sale to
customers within the meaning of section 1221(a).
Treating a net positive adjustment as additional
interest instead of gain from property held for sale
to customers could help a REIT avoid the
prohibited transactions tax, which could
otherwise apply under section 856(j)(3) of the
REIT SAM rules. If the CPDI rules were not
intended to override the REIT SAM assets tests,
the question would remain of how to treat a
shared appreciation provision regarding a loan
secured by inventory. If the appreciation payment
resulted in a negative adjustment or positive
adjustment, would the difference be treated as a
gain or loss from section 1221(a)(1)? In the case of
a positive adjustment, presumably (1) the amount
of interest income based on the comparable yield
in prior years would not be changed, and so the
treatment of that income as good REIT income
(interest on a mortgage secured by an interest in
real property) would not be disturbed, and (2) the
amount of income not qualifying under section
856(c) would be reduced by virtue of the netting.
In the case of a net negative adjustment,
presumably any reduction would be an offset or a
deduction, but more importantly, that adjustment
would not represent gross income, qualified or
not.
Whether one agrees with these technical
arguments and the inference that the failure of the
CPDI rules to address HSAMs held by REMICs
and REITs means the deferral rules were intended
to remain in place, and whether one believes these
arguments make a case for changing the SAM
rules applicable to both HSAMs and commercial
SAMs, they at least justify suspending application
of the CPDI rules to HSAMs for the present.
It is believed that changing the treatment of
HSAMs under the CPDI rules could be
accomplished, at least initially, by an
administrative notice jointly issued by the IRS and
Treasury. That notice could impose sufficient
restrictions to limit the benefits of HSAMs used as
alternative financing for acquisition of personal
residences
13
and might provide as follows:
(1) In the case of a shared appreciation
home mortgage loan described in section
(2) of this notice, the interest on that such
shared appreciation loan, and the amount
of any payment reflecting any
appreciation occurring between the time
the mortgage loan is originated and the
time such payment is due under the terms
of such mortgage, may at the election of
the lender, be included in income only
when paid.
(2) A shared appreciation mortgage loan is
described in this section (2) only if all of
the following are true:
(a) the indebtedness is incurred by an
individual taxpayer to (i) acquire,
construct, or substantially improve a
residence that secures such
indebtedness, which residence is
owned by such taxpayer and used as
the taxpayer’s principal residence, or
(ii) to refinance the unpaid principal
balance of a loan described in section
(2)(a)(i);
(b) the amount of interest currently
payable on the loan is less than the
amount that would be currently
payable if the loan did not require a
shared appreciation payment; and
(c) the indebtedness does not exceed
$1,000,000 ($500,000 in the case of a
married individual filing a separate
return).
13
Relief could also be limited to debts meeting certain additional
conditions such as (1) debts secured by, and providing a shared
appreciation interest in, homes of four units or less or (2) debts with a
minimum, annual coupon set at AFR or a percentage of AFR.
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