Accounting for originated mortgage servicing rights.

A commercial bank often sells mortgages it originated, while retaining the servicing rights. The bank continues to collect the mortgage payment, and provides statements and other services to and from the borrower for a prearranged fee.

For financial reporting purposes, the bank records originated mortgage servicing rights in accordance with Statement of Financial Accounting Standards No. 140 (FAS 140). Under FAS 140, the bank recognizes a servicing fee (i.e., income) at the time of the sale for the right to service mortgages or other loans it sold. The servicing fee is normally expressed as a percentage of the principal balance of the outstanding loans and is collected over the life of the loans as payments are received. The income recognition creates an asset, amortized as an expense, over the life of the loans for which the bank retains the servicing rights. This method shifts income to the time of sale; the future cashflow from servicing the loans that constitutes income to the bank is offset by amortization of the originated mortgage servicing asset that had been created when the loans were sold.

In Rev. Rul. 91-46, the IRS described the manner in which the amounts received under a mortgage-servicing contract should be reported for tax purposes. The Service also issued Rev. Proc. 91-51, containing rules that require taxpayers to change their accounting method to comply with Rev. Rul. 91-46 and Rev. Proc. 91-50, to provide safe harbors for applying Sec. 1286 to taxpayers who sell mortgages and contract to service them.

Rev. Rul. 91-46 indicated that amounts received under a mortgage-servicing contract were interest payments for stripped bonds if (1) the amounts exceeded reasonable compensation for services and (2) the mortgages were sold at the time the mortgage-servicing contract was entered into. Mortgage lenders that sell mortgage loans and at the same time enter into contracts to service the mortgages for the buyer would be subject to the "stripped bond" rules described in Sec. 1286, if their fee exceeds reasonable compensation for servicing. The excess amount retained over reasonable compensation that the bank has the right to receive from interest payments collected on the mortgages would be treated as a "stripped coupon" under Sec. 1286. Sec. 1286 requires the purchaser to treat the purchased mortgages as a bond with an original issue discount equal to the excess of the stated redemption price at maturity over the bond's ratable share of the purchase price.

The safe-harbor rule in Rev. Proc. 91-50 determines the extent to which amounts that a taxpayer is entitled under a mortgage-servicing contract represent normal servicing. The safe-harbor limits for reasonable compensation for servicing one-to-four-unit residential mortgages are based on a percentage of the principal balance of the loans sold, as follows:

1. 0.25% for a conventional, fixed-rate mortgage;

2. 0.44% for a mortgage less than one year old insured or guaranteed by the Federal Housing Administration, Veterans Administration or Farmers Home Administration, or if the original principal balance of any mortgage was $50,000 or less; and

3. 0.375% for any other one-to-four-unit residential mortgage.

If the compensation falls within the safe harbor, the servicing contract is treated separately from the sale of the loan, and the reasonable compensation for servicing the loans is included in the bank's taxable income in accordance with its overall accounting method.

The Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation (FHLMC) are examples of government agencies that routinely buy residential mortgages and sell derivative interests therein to investors. A typical sales agreement between these agencies and a bank, selling mortgages with retained originated mortgage-servicing rights, meets the safe-harbor rules outlined in Rev. Proc. 91-50. As such, the typical bank selling mortgages (with retained servicing rights) is covered under the safe-harbor rule for reasonable compensation and does not have stripped coupons as described in Sec. 1286.

What if a bank had failed to apply the safe-harbor provisions? Recently, a taxpayer requested permission to change its accounting method for sales of mortgage loans when servicing rights had been retained. The taxpayer filed Form 3115, Application for Change in Accounting Method, under Rev. Proc. 91-51, indicating that it reported income from retained servicing rights in a manner inconsistent with Rev. Rul. 91-46 and was required to change its accounting method to a method consistent with Rev. Rul. 9146 and Sec. 1286.

The taxpayer was a calendar-year taxpayer employing an overall accrual method of accounting. Since 1996, the taxpayer regularly originated mortgages and then sold them to FHLMC while retaining the servicing rights. The taxpayer adopted FAS 122 in 1996 for financial statement reporting purposes. FAS 122 has since been superseded by FAS 125 and FAS 140. The treatment of originated mortgage-servicing rights is substantially identical in all three documents. Under FAS 122, the taxpayer computed the present value of all future payments to be received from the servicing contract, to determine the originated mortgage servicing asset to be recorded.

Example: Bank R sells mortgages (with servicing rights retained) having a principal balance of $10,000,000 and an expected 10-year life. R determined the present value of the servicing rights to be $100,000. It records the following entry:

                         Debit      Credit

Originated mortgage
  servicing rights
  (OMSR) (Asset)        $100,000
Gain on sale of loans
  (Income)                         $100,000

It amortizes the servicing asset, for book purposes, over the expected life of the loans for which R determined the originated mortgage-servicing asset. The yearly amortization expense is:

                        Debit     Credit

Amortization -- OMSR
  (Expense)            $10,000
OMSR (Asset)                     $10,000

For Federal income tax purposes, R would not be required to establish a separate originated mortgage-servicing asset, because the compensation it received under the contract satisfied the safe-harbor limits. R's book entries would have been reversed when calculating taxable income. However, R failed to apply the safe-harbor provisions outlined in Rev. Rul. 91-46 and did not reverse the book entries. By following the book treatment, R adopted an impermissible accounting method that resulted in recognizing a gain for tax purposes equal to the value of the servicing rights retained. This gain was recognized even though the retained servicing rights met the safe-harbor provisions of Rev. Proc. 91-50 and were not stripped coupons under Sec. 1286. The gain recognition created an asset that R amortized for tax purposes over the expected life of the loans for which it retained the servicing rights.

Under the proposed accounting method for originated mortgage-servicing rights, R would no longer recognize a gain equal to the value of servicing rights that represent reasonable compensation and are not stripped coupons under Sec. 1286. The amounts that R receives for servicing the mortgages constitutes reasonable compensation, because the servicing contract provides for compensation that meets the safe-harbor rules outlined in Rev. Proc. 91-50. Additionally, R no longer records amortization expenses for the mortgage-servicing asset. This change will allow R to defer the gain recognized at the time of the sale for book purposes to a later tax year when the income for servicing loans is collected.

R was granted a change in its accounting method for sales of mortgage loans when servicing rights were retained. The change is on the cut-off basis, as described in Rev. Proc. 91-51, and covers mortgages sold on or after the first day of the year of change. R will continue to apply the current (albeit impermissible) accounting method for mortgages sold before the year of change. The cut-off method in Rev. Proc. 91-51 relieves taxpayers from recalculating servicing income previously recognized for tax purposes. The IRS recognizes that it would be time-consuming to apply the safe-harbor rules retroactively to all mortgages sold before the cut-off date. Because the change is to be implemented on a cut-off basis, there is no Sec. 481 adjustment.

When a bank fails to apply the safe-harbor provisions for the treatment of amounts received under a mortgage-servicing contract published in Rev. Rul. 91-46, it must change its accounting method by filing Form 3115 in accordance with Rev. Proc. 91-51. The Service presently grants a change in accounting method for originated mortgage-servicing rights on a cut-off basis with no Sec. 481 adjustment.

FROM MARGARET PAJAK, CPA, AND KEVIN F. POWERS, CPA, OAK BROOK, IL

Editor:
Frank J. O'Connell, Jr., CPA, J.D.
Crowe Chizek
Oak Brook, IL