IRS excludes REIT hedge and offsetting hedge income from gross income tests
PLR 202601013. Released January 2, 2026.
A mortgage REIT can exclude income from interest rate swaps, swaptions, and offsetting hedge positions from its 75% and 95% gross income tests when the hedges manage borrowing risk tied to real estate assets and are correctly identified.
Holding
The IRS issued a private letter ruling (PLR) that income from both primary interest rate hedges and offsetting counteracting hedges does not count as gross income for purposes of the §856(c)(2) and §856(c)(3) REIT income tests.
Why It Matters
Confirms that REITs can manage interest rate risk without jeopardizing income tests.
Treats counteracting hedges as part of the same risk management framework as the original hedges.
Aligns REIT hedging treatment with general §1221 hedging rules.
Reduces pressure to terminate swaps when breakage costs are prohibitive.
Key Facts
The taxpayer is a mortgage REIT holding long-term, fixed-rate mortgage assets.
Financing comes from short-term repurchase agreements tied to SOFR.
The duration mismatch creates interest rate risk.
The REIT uses pay-fixed interest rate swaps and swaptions to hedge that risk.
When hedges become misaligned with borrowing levels, the REIT enters into offsetting swaps or swaptions rather than terminating existing swaps.
The REIT never over-hedges. Hedge notional amounts remain below related borrowings.
Statutory and Regulatory Framework
§856(c)(2) and §856(c)(3) set the 95 percent and 75 percent REIT gross income tests.
§856(c)(5)(G) excludes income from qualifying hedging transactions tied to real estate debt.
§856(c)(5)(J) authorizes the IRS to exclude income when needed to carry out REIT policy.
§1221(b)(2) defines hedging transactions, including interest rate risk management.
Reg. §1.1221-2(d)(3) treats offsetting transactions as hedges if they manage prior hedge risk.
§1221(a)(7) requires timely identification of hedging transactions.
IRS Analysis
The primary swaps and swaptions hedge borrowings used to acquire or carry real estate assets.
Properly identified interest rate hedges qualify for exclusion under §856(c)(5)(G).
Counteracting hedges offset existing hedges and meet the regulatory definition of hedging transactions.
Congress intended REIT hedging rules to conform to §1221 principles.
Excluding income from offsetting hedges is consistent with REIT policy because the transactions do not create active business income.
The absence of over-hedging was critical to the analysis.
Result
Income from both the original hedges and the counteracting hedges is excluded from gross income for the REIT income tests.
The Takeaway
Mortgage REITs can rebalance hedge positions using offsetting swaps or swaptions without triggering income test problems, as long as the hedges track real estate borrowings, are properly identified, and do not exceed the underlying exposure.
Brilliant breakdown on how §856(c)(5)(J) basically saves mREITs from operational nightmares. The part about Reg §1.1221-2(d)(3) treating offsetting swaps as hedges rather than specualtive instruments is critical, because in practice exiting positions with prohibitive breakage costs can destroy returns. I've seen firms struggle with this exact issue when trying to rebalance duration exposure without triggering the income tests. The no over-hedging rule being crucial to the analysis makes total sense tho.