IRS RULES ON DETERMINATION THAT A BOND IS A 'STRIPPED BOND'; IMPLEMENTATION GUIDANCE ISSUED.

Rev. Rul. 91-46

ISSUES

(1) If a taxpayer sells mortgage loans (mortgages) and at the same time enters into a contract to service the mortgages for amounts received from interest payments on the mortgages, under what circumstances are the mortgages "stripped bonds" and the taxpayer's rights to receive interest "stripped coupons" within the meaning of section 1286 of the Internal Revenue Code?

(2) How are the respective fair market values of the stripped bonds and stripped coupons determined?

FACTS

Mortgage company M is in the business of originating and servicing residential mortgages. Agency A is in the business of purchasing residential mortgages and selling interests in those mortgages to investors. M originated a pool of mortgages with a total principal amount of $100,000,000 and an annual interest rate equal to the then-current market interest rate. Later, when the market interest rate had declined, M transferred the $100,000,000 pool of mortgages to A in exchange for $100,000,000.

At the time of the transfer, M and A entered into a contract for M to service the mortgages transferred. Under this contract, M is obligated to perform various services. For example, M is required to collect the monthly mortgage payments from the mortgagors and remit these payments to A. M also is required to accumulate escrows for the payment of insurance and taxes, to disburse these funds as the payments come due, to maintain records relating to the mortgages, and to handle delinquency problems.

The mortgage servicing contract provides that M is entitled to receive amounts from interest payments collected on the mortgages. The annual amount to be received is equal to 1.25 percent of the outstanding principal balance of the mortgages. In addition, M is entitled to retain certain income that it receives in the course of servicing the mortgages. This other income includes the income earned on principal and interest payments between the time they are collected and the time they are remitted to A, income from sources such as fees for late payments, bad checks, insurance, and assumptions with respect to the mortgages, and income earned through the maintenance of escrow accounts.

The minimum annual amount allowed by A for servicing mortgages of the type sold by M is equal to 0.25 percent of the outstanding principal balance of the mortgages. This amount is commonly referred to as "normal" servicing. Thus, of the annual amount that M is entitled to receive from interest payments collected on the mortgages, the portion that exceeds the normal servicing is equal to 1 percent of the outstanding principal balance of the mortgages. This portion is commonly referred to as "excess" servicing.

With the estimated prepayment rate on the mortgages taken into account, the present value of amounts that represent reasonable compensation for performing services under the contract is less than the sum of the present value of the amounts that M is entitled to receive as normal servicing and the present value of the income from other sources. M does not elect to use the safe harbor provided by Rev. Proc. 91-50, page ___, this Bulletin, for determining the extent to which amounts that a taxpayer is entitled to receive under a mortgage servicing contract represent reasonable compensation for the services provided.

LAW AND ANALYSIS

ISSUE 1

Section 1286(e)(1) of the Code defines the term "bond" to include a certificate or other evidence of indebtedness. In the present situation, the mortgages sold by M to A are evidences of indebtedness and, therefore, are "bonds" within the meaning of section 1286(e)(1).

Section 1286(e)(5) of the Code defines the term "coupon" to include any right to receive interest on a bond (whether or not evidenced by a coupon). To some extent, M's rights to receive amounts under the mortgage servicing contract are rights to receive reasonable compensation for the services that the contract requires M to perform. Because of the nature of these services, it is traditional in the mortgage servicing industry to compensate servicers with amounts of interest collected on the mortgages serviced. Therefore, to the extent that M's rights to receive amounts under the mortgage servicing contract represent rights to receive reasonable compensation for services to be performed under the contract, they will be treated as rights to receive compensation from A. However, to the extent that the contract entitles M to receive amounts in excess of reasonable compensation for services, M's rights to receive amounts from interest payments collected on the mortgages will be treated as "coupons" under section 1286(e)(5).

Section 1286(e)(2) of the Code defines the term "stripped bond" as a bond issued with interest coupons where there is a separation in ownership between the bond and any coupon that has not yet become payable. Section 1286(e)(3) defines a "stripped coupon" as any coupon relating to a stripped bond. When M sells the mortgages to A and enters into the mortgage servicing contract, the transaction results in a separation in ownership between the mortgages (bonds) and rights to receive some of the interest payable in the future (coupons) on those mortgages. Thus, the transaction causes the mortgages purchased by A to become "stripped bonds" and the coupons held by M to become "stripped coupons" within the meaning of section 1286(e)(2) and (3).

ISSUE 2

Section 1286(b) of the Code provides that, for purposes of subtitle A of the Internal Revenue Code, if any person strips one or more coupons from a bond and, after July 1, 1982, disposes of the bond or the coupon, the basis of the bond and coupons immediately before the disposition is allocated among the items retained and the items disposed of on the basis of their respective fair market values.

Since the transaction between M and A results in stripped bonds and stripped coupons, section 1286(b) requires M to allocate its total basis in the mortgages immediately before their sale to A between (1) the items sold (i.e., the stripped bonds) and (2) the items retained (i.e., the stripped coupons). This allocation must be made on the basis of the respective fair market values of the stripped bonds and stripped coupons at the time of the transaction between M and A.

The fair market value of the stripped bonds, which are the mortgages held by A, is the purchase price that A paid for the mortgages. This amount is $100,000,000.

The fair market value of the stripped coupons, which are M's rights to receive interest other than as compensation for services, is determined on the basis of all of the relevant facts and circumstances. Facts to be considered in determining this amount include, but are not necessarily limited to, recent sale prices of comparable rights.

In the present situation, no portion of the excess servicing is reasonable compensation for services. Therefore, the full value of M's right to receive the excess servicing is included in the fair market value of the stripped coupons.

A portion of the value of M's right to receive the normal servicing of 0.25 percent also is included in the fair market value of the stripped coupons. This portion is the excess of (1) the value of M's right to receive the normal servicing, over (2) the excess, if any, of (i) the value of amounts that represent reasonable compensation for providing services under the mortgage servicing contract, over (ii) the value of the other income that M is expected to receive.

HOLDINGS

(1) If a taxpayer sells mortgages and at the same time enters into a contract to service the mortgages for amounts received from interest payments on the mortgages, and if the contract entitles the taxpayer to receive amounts that exceed reasonable compensation for the services to be performed, the mortgages are "stripped bonds" within the meaning of section 1286(e)(2). The taxpayer's rights to receive amounts under the contract are "stripped coupons" within the meaning of section 1286(e)(3) to the extent that they are rights to receive mortgage interest other than as reasonable compensation for the services to be performed.

(2) The fair market value of the stripped bonds is their sale price in the transaction. The fair market value of the stripped coupons is determined on the basis of all of the relevant facts and circumstances.

APPLICATION

As a consequence of these holdings:

(1) To the extent that the amounts received by M from interest payments are treated as compensation for services, they are treated as received by A from mortgagors and paid by A to M as compensation. To the extent that the amounts received by M are treated as payments with respect to stripped coupons held by M, they are treated as received directly by M from the mortgagors.

(2) M's ownership of the mortgage servicing rights is not an interest in either an entity that owns the related stripped bonds or the assets of such an entity. Thus, if the holder of these stripped bonds otherwise qualified as a REMIC within the meaning of section 860D of the Code, the fact that M stripped coupons from the bonds would not cause the stripped coupons to be treated as interests in the REMIC for purposes of sections 860A through 860G. Similarly, if the holder of these stripped bonds otherwise qualified as a trust for federal income tax purposes, the fact that M stripped coupons from the bonds would not cause the stripped coupons to be treated as a separate class of ownership interest in the assets of the trust within the meaning of section 301.7701-4(c) of the Regulations on Procedure and Administration.

Three revenue procedures accompany this revenue ruling. Rev. Proc. 91-51, page ___, this Bulletin, provides expeditious consent for a taxpayer to change its method of accounting for sales of mortgages to comply with section 1286 of the Code. Rev. Proc. 91-50, page ___, this Bulletin, provides an elective safe harbor for determining the extent to which amounts that a taxpayer is entitled to receive under a mortgage servicing contract represent reasonable compensation for the services provided. Rev. Proc. 91-49, page ___, this Bulletin, provides simplified tax treatment for certain mortgages that are stripped bonds.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 66-314, 1966-2 C.B. 296, is obsoleted.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Mark S. Smith of the Office of Assistant Chief Counsel (Financial Institutions and Products) and Christopher T. Rogers, formerly of that office. For further information regarding this revenue ruling contact Mr. Smith on (202) 566-3297 (not a toll-free call).