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Taxable mortgage pool rules now in effect.

Newly formed mortgage-pool entities, and older pools that accept substantial new investment after 1991, need to be wary of the Sec. 7701(i) taxable mortgage pool (TMP) rules. Characterization of an entity as a TMP results in the pool being taxed as a corporation that cannot join in a consolidated return. Because the scope of these rules goes beyond entities that would otherwise be characterized as real estate mortgage investment conduits (REMICs) it is important to review them in any pooling of debt instruments.

Mortgage-backed securities (MBSs) are generally pools of mortgages that pass through the payments of principal and interest to investors, often in exotic arrangements that give different priorities to payment, and rates of return, to different classes. The so-called "Sears Regs" of Regs. Sec. 301.7701-4(c), finalized in 1986, would reclassify many multiple-class MBSs - nominally in trust form - as corporations unless (1) there is no power under the trust agreement to vary the investment of the MBS holders, (2) the trust is formed to facilitate direct investment in its assets and (3) the existence of multiple classes of ownership interests is incidental to that purpose.

The REMIC rules (Secs. 860A through 860G) were enacted in 1986 to provide a safe harbor for multiple-class MBSs from characterization as corporations, with the intention that REMICs would be the exclusive passthrough entity for issuing multiple-class MBSs. Electing REMIC status allows an entity to offer investments backed by real estate mortgages with different payout schedules, rates of return and cash flows, without being subject to entity-level tax.

Congress decided in 1986 that any entity formed after 1991 that offered real-estate mortgage debt-backed securities with two or more maturities and that did not elect REMIC status was to be taxed as a corporation and would not be eligible to join in filing a consolidated return. Under Sec. 7701(i), a TMP is an entity - "substantially all" of whose assets are debt obligations (or interests therein), more than 50% of which are real estate mortgages (or interests therein); - that is the obligor under debt obligations with two or more maturity dates (or with the same maturity but different rights relating to acceleration of maturity); and - whose payments on the debt obligations are required (or are arranged) to bear a relationship to payments on the underlying debt-obligation assets.

It appears that the two-class (or two-maturity) requirement will be interpreted with an eye to business reality. There is an example in the "Sears Regs" of a mortgage pool whose two investment classes are identical except that the rights to repayment of the class retained by the seller will be subordinated to the senior class on a default of the underlying mortgages. Literally, this appears to be a different right relating to acceleration of the maturity of the second class, which could result in the trust being a TMP. The "Sears Regs" specifically respect this entity as a trust, however, and a senior IRS National Office manager recently told an ABA group that any entity respected as a trust under those regulations should not be classified as a TMP.

The TMP rules will also apply to previously existing entities that receive "a substantial transfer of cash or other property" after 1991, beginning on the day of that substantial transfer. (The General Explanation of the Tax Reform Act of 1986 provided that a transfer of cash or property in payment of obligations held by the entity will not invoke TMP status.) Thus, an existing entity would be deemed to become a corporation at whatever point in its tax year at which a "substantial transfer" occurs, presumably terminating its tax year and starting a new one. IRS Letter Ruling 9138026 concluded that the assumption of a mortgage loan held by the entity by a new borrower, to avoid default, will not be treated as a transfer of cash or other property that would invoke TMP status. Beyond this limited guidance, however, the rules could be invoked in a number of unexpected situations.

These rules have a broad reach, and have been given scant attention by both practitioners and the IRS because they generally went into effect only for transactions or transfers occurring after 1991. Now, in 1992, TMP issues suddenly take on a greater urgency.
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Author:Culp, David P.
Publication:The Tax Adviser
Date:Jun 1, 1992
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