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Sale of mortgage loans with retained servicing rights.

Before Rev. Rul. 91-46 and Rev. Procs. 91-49, 91-50 and 91-51 were issued, most financial institutions did not currently recognize taxable income when they mortgages with retained servicing rights. The mortgages were considered to be sold at par (face value) which equaled their basis; thus, there was no gain or loss. Ordinary servicing fee income was recognized in future years as payments were collected.

However, Rev. Rul. 91-46 drastically changed the way financial institutions must report these types of loan sales. Under this ruling, when a loan is sold and the servicing rights are retained, the loan must be treated as a "stripped bond" under Sec. 1286(e)(2) and the "excess" servicing rights as "stripped coupons" under Sec. 1286(e)(3).

A portion of the loan's basis must be allocated to the "excess" servicing rights (the "stripped coupons"), based on relative fair market values. Consequently, the loan's basis is reduced, causing a taxable gain in the year of sale.

The basis allocated to the excess servicing rights is treated under Sec. 1286(a) as the purchase price of an original issue discount (OID) obligation. Accordingly, the difference between the total excess servicing rights ("the redemption price") and the allocated basis is OID.

Generally, the holder of an obligation must currently include in income the sum of the daily portions of any OID pursuant to Sec. 1272(a)(1). A corresponding deduction is allowed to the issuer under Sec. 163(e)(1).

OID is deemed to be zero if it is less than 0.25% of the obligation's stated redemption price at maturity multiplied by the number of complete years to maturity (Sec. 1273(a)(3)). This de minimis rule does not specifically apply to stripped bonds and stripped coupons that have OID because of Sec. 1286(a); nevertheless, Temp. Regs. Sec. 1.1286-1T(a) makes it clear that this de minimis rule applies.

For purposes of these calculations, "excess" servicing is defined as the amount received in excess of "normal" servicing. Rev. Proc. 91-50 provided "normal" servicing safe harbors that generally equal the industry's standards. For servicing one- to four-unit residential mortgages, the safe harbors are

--0.25% for a conventional fixed rate mortgage;

--0.44% for a mortgage less than one year old insured or guaranteed by the Federal Housing Administration, Veterans Administration or Farmers Home Administration; and

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

However, if the original principal balance of any mortgage was $50,000 or less, the safe harbor rate for servicing that mortgage is 0.44%.

If the safe harbors are not elected, the seller must provide evidence of some other "normal" servicing cost.

Rev. Proc. 91-49 provided a simplified method of reporting gain for loan sales when the annual stated rate of interest payable on the stripped bond is no more than 100 basis points lower than the annual stated rate of interest payable on the original loan. For this purpose the annual stated rate of interest payable includes amounts treated as "normal" servicing.

The change required by these new rules is effective for the first tax year ending after Aug. 7, 1991 and constitutes an accounting method change. Accordingly, Form 3115 must be filed with the tax return for that year. The following statement must be typed or legibly printed at the top of page 1 of this form: "FILED UNDER REV. PROC. 91-51."

This new method applies only to mortgages sold on or after the first day of the year of change. The accounting method for mortgages sold before that first day need not be changed. Therefore, there is no transitional adjustment under Sec. 481.

Estimated taxes due after Sept. 22, 1991 that are not based on the preceding year's tax must be computed as if this new accounting method were used for the entire tax year. The first installment due after that date, which was based on the current year's income, must have been increased by any excess of the prior installments using the new accounting method over the prior installments paid using the old accounting method. See Rev. Proc. 91-41, Section 4.03.

See also "IRS" New Position on Excess Mortgage Servicing Affects Both Lenders and Investors," The Journal of Taxation (Jan. 1992), at 38.
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Author:Willis, James B.
Publication:The Tax Adviser
Date:May 1, 1992
Words:709
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