Rev. Rul. 70-544

Advice has been requested as to certain of the Federal income tax consequences associated with "straight pass-through" mortgage-backed certificates to various parties under the facts and circumstances set forth below.

N, a savings and loan association engaged in the financing of residential mortgages, established a "pool" of mortgages, all of which are insured by the Federal Housing Administration, the Farmers Home Administration, or are insured or guaranteed by the Veterans Administration.

Some of the mortgages were originated by N and same were acquired by it. The amount of the "pool" was for $2 million, which represented the unpaid balances on the mortgages. The average cost of the mortgages in the "pool" was 94 percent of par or $1,880,000 for the entire "pool". All of the mortgages in the "pool" bear interest at the rate of 81/2 percent per annum and were issued during the month prior to the establishment of the "pool". Once the "pool" is established no additional mortgages may be added to the "pool".

N after application to the Government National Mortgage Association (GNMA), received a commitment from GNMA to guarantee an issue of "straight pass-through" mortgage-backed certificates (certificates). The certificates represent a proportionate interest in each of the mortgages in the above described "pool". After obtaining the GNMA commitment N, pursuant to a separate agreement, delivered the mortgages to a custodian (a commercial bank). The custodian's sole function is to hold the mortgages and it has no power of reinvestment.

In addition neither N nor GNMA will ever have the power to reinvest any of the proceeds attributable to the mortgages in the "pool". Within four months after GNMA issues its guarantee, GNMA may require N to replace defective mortgages included in the "pool". Thereafter, no substitution of mortgages may be required by GNMA. At no time will N have the power to substitute mortgages for the initial mortgages in the "pool" on its own initiative.

After the custodian verified to GNMA that it had the mortgages in its custody, N arranged for the sale of the entire issue of mortgage-backed certificates to various investors for 94.75 percent of par or a total of $1,895,000.

The certificate holders included other savings and loan associations, real estate investment trusts, individuals, and exempt employees' pension and profit-sharing trusts. The certificates called for payments by N to the certificate holders of specified monthly installments. These installments were based on the amortization schedules of each of the mortgages in the "pool". If a default or late payment on any mortgage occurs, N may advance funds to keep up the payments to the certificate holders until the deficiency is corrected by the mortgagor or foreclosure occurs. In addition, the certificates provide for payment of each of the certificate holders of its proportionate share of prepayments or other early recoveries of principal including foreclosure proceeds. An amount equal to 1/24 of one percent of the outstanding principal amount on the mortgages is withheld by N each month, which amount is used by N to discharge the certificate holders' obligations to pay N's servicing fee, the custodian's fee, and the GNMA guarantee fee.

When N notified GNMA of the sales agreement, GNMA prepared the certificates in the total amount of $2 million. GNMA guaranteed to the certificate holders only the proper performance of the mortgage servicing by N, with the certificate holders entitled only to interest and principal actually collected or collectable through due diligence. The sale of the certificates was consummated by delivery of the certificates to the certificate holders. The certificates were issued in minimum denominations of $50,000. The GNMA regulations provide, in part, that the certificates are transferable, but the share of the proceeds collected on account of the "pool" of mortgages may not be payable to more than one holder with respect to any certificate.

When all the mortgages in the "pool" are paid, and the final payments on the certificates are made to the certificate holders, the "pool" will be terminated.

Based solely on the foregoing facts certain of the Federal income tax consequences are as follows:

(1) The "pool" will not be considered an association taxable as a corporation, but is classified as a trust of which the certificate holders are the owners under Subpart E of Subchapter J of the Internal Revenue Code of 1954.

(2) N is a fiduciary and will be required to file Form 1041. See section 1.671-4 of the Income Tax Regulations.

(3) Each certificate holder is treated as the owner of an undivided interest in the entire trust (corpus as well as ordinary income). See section 1.671-3(a)(1) of the regulations.

(4) The sale of the mortgage-backed certificates transfers to the certificate holders the equitable ownership in each of the mortgages in the "pool". Thereafter, N has only a contractual right to service the mortgages for a specified fee.

(5) N will recognize ordinary income or loss upon the sale of its interest in each of the mortgages in the "pool" measured by the differences between the proportionate amount of the proceeds realized with respect to the sale of each of the mortgages and its adjusted basis in each of such mortgages.

(6) The certificate holders must report their ratable share of the entire interest income on each of the mortgages as ordinary income consistent with their method of accounting and may deduct the servicing, custodian, and guarantee fees under section 162 or section 212 of the Code.

(7) The certificate holders must also report their ratable share of the discount income realized on the purchase of each of the mortgages as ordinary income, consistent with their methods of accounting. The special rules of section 1232 of the Code will be applicable to the certificate holders' proportionate shares of the discount on any mortgages in the "pool" which are obligations of corporations, or of governments or their political subdivisions if, and to the extent that, the other conditions for the application of that section are met.

(8) The interest income is considered "interest on obligations secured by mortgages on real property" as that phrase is used in section 856(c)(3)(B) of the Code.

(9) A real estate investment trust which owns a certificate is considered as owning "real estate assets" as that phrase is used in section 856(c)(5)(A) of the Code.

(10) A certificate owned by a savings and loan association is considered as representing "loans secured by an interest in real property" within the meaning of section 7701(a)(19)(C)(v) of the Code, provided the real property is (or from the proceeds of the loan will become) the type of real property described in that section of the Code.

(11) The exempt status of an employees' pension and profit-sharing trust under section 501(a) of the Code is not adversely affected by the purchase of certificates.

¹ Also released as Technical Information Release 1045, dated October 1, 1970.