Rev. Rul. 70-545

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

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

The amount of the "pool" was $2 million, which represented the sum of the unpaid balances on the mortgages. Each of the mortgages in the "pool" bears interest at the rate of 81/2 percent per annum. Once the "pool" is established no additional mortgages may be added to the "pool".

M, after application to the Government National Mortgage Association (GNMA), received a commitment from GNMA to guarantee an issue of "fully-modified pass-through" mortgage-backed certificates (certificates). Each of the certificates represents a proportionate interest in each of the mortgages in the above described "pool" of mortgages. After obtaining the GNMA, commitment, pursuant to a separate agreement, M 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 M 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 M to replace defective mortgages included in the "pool". Thereafter, no substitution of mortgages may be required by GNMA. At no time will M 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, M arranged for the sale of the entire issue of certificates to various certificate holders at par or $2 million.

The certificate holders included savings and loan associations, real estate investment trusts, individuals, and exempt employees' pension and profit-sharing trusts. The certificates called for payment by M to the certificate holders of specified monthly installments. These installments were based on the amortization schedules of each of the mortgages in the "pool", but were to be made by M irrespective of whether the mortgagors actually make the payments due on their loans.

In addition, the certificates provided for payment to 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 was to be withheld by M each month, which amount is to be used by M to discharge the certificate holders' obligations to pay M's servicing fee, the custodian's fee, and the GNMA guarantee fee.

When M notified GNMA of the sales agreement, GNMA prepared the certificates in the total amount of $2 million with the full guarantee of GNMA to the certificate holders as to payment of principal and interest. The sale was consumated 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. Each certificate contains a statement that the full faith and credit of the United States is pledged to the payment of all amounts required by the certificates. 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) M 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, M has only a contractual right to service the mortgages for a specified fee.

(5) The certificate holders must report their ratable share of the entire interest income on the mortgages, including those amounts advanced by M, 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.

(6) 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.

(7) 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.

(8) 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.

(9) 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.