Rev. Rul. 71-399

Advice has been requested as to certain of the Federal income tax consequences associated with mortgage participations under the facts and circumstances set forth below.

The Federal Home Loan Mortgage Corporation (FHLMC) purchased from N, an insured savings and loan association, five mortgage participation certificates. The mortgage participation certificates represent fractional undivided interests aggregating 85 percent in each mortgage contained on a list of mortgages ("List"). All of the mortgages on the List are loans within the meaning of section 7701(a)(19)(C)(v) of the Internal Revenue Code of 1954 and are qualifying real property loans as defined in section 593(e) of the Code. The mortgage participation certificates are in denominations of approximately $100,000 and are purchased by FHLMC at face value.

FHLMC issues a certificate corresponding to each mortgage participation certificate it purchases from N, endorses thereon its guarantee of principal and interest payment by the mortgagor, and sells these certificates at face value to other savings and loan associations and exempt employees' pension and profit sharing trusts (certificate holders). The FHLMC guarantee to the certificate holders is a guarantee of timely payment of interest and collection of principal by N.

The mortgage participation certificates acquired by FHLMC from N and those certificates sold to certificate holders are transferable only upon the books of FHLMC.

FHLMC has the power within two years after it purchases mortgage participation certificates to require N to repurchase any mortgage on the List. In lieu of repurchase, N may, with FHLMC's consent, substitute other mortgages in substantially similar amounts and of a quality acceptable to FHLMC. FHLMC's replacement power is only applicable with respect to defective mortgages, i.e., mortgages which are not of the quality established for the particular List prior to the date of sale of the mortgage participation certificates by N to FHLMC. The two year period provides FHLMC sufficient time to ascertain whether the quality of the mortgages conforms to representations made by N at the time the mortgage participation certificates are sold to FHLMC. After the expiration of the two year period, no substitution of mortgage loans may be required by FHLMC. At no time will N have the power to substitute mortgage loans for the original mortgage on the List on its own initiative. There will be no change in the criteria applied to a particular List of mortgages after the sale of the mortgage participation certificates to FHLMC.

N is permitted by FHLMC to make "open-end" advances to the mortgagor on any given mortgage up to the original amount of the loan. Such advances will be subordinated to the rights of the certificate holders in the event of default by the mortgagor(s) on the loan or loans with respect to which open-end advances were made. In other words, neither FHLMC nor the certificate holders will have any interest, right, or obligation in the open-end advances or any income earned thereon.

N is required to service the mortgages on the List and pass through to FHLMC payments of principal and interest thereon to the extent necessary to produce the yield specified on each certificate (certificate yield). To the extent that the certificate yield rate exceeds any specific mortgage interest rate, N makes up the difference to FHLMC from the interest it (N) receives on its 15 percent participation in such mortgage.

The use of a certificate yield computation amounts to a sale of each individual mortgage at a premium or discount depending upon the relationship of the certificate yield to the mortgage interest rate. For example, if the certificate yield is 71/2 percent, mortgages on the List with an interest rate of exactly 71/2 percent are sold at par. Mortgages on the List with an interest rate of less than 71/2 percent are sold at a discount, and mortgages on the List with an interest rate of more than 71/2 percent are sold at a premium. The amount of the interest payable (at the mortgage interest rate) on any specific mortgage on the List will never be less than the amount of the interest payable (at the certificate yield rate) on the certificate holders' participations in that mortgage.

In the month following the month of receipt by FHLMC from N, FHLMC passes through to the certificate holders the principal and interest payments received by FHLMC from N after deducting a specified amount therefrom to discharge the certificate holders' obligations to pay FHLMC's guarantee and management fees.

With the exception of any late charges collected by N, all receipts of principal and interest, prepayment premiums, net proceeds from the sale of foreclosed properties, income from property management, and any costs incident to protection and preservation of the real property security for the mortgage loans will be shared by each certificate holder in direct proportion to each certificate holders' pro rata interest in the mortgage loans.

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

(1) The arrangement described does not create an association taxable as a corporation, but constitutes a trust.

(2) The certificate holders are owners of the trust under Subpart E of Subchapter J of the Code. 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 Income Tax Regulations.

(3) FHLMC is a fiduciary and will be required to file Form 1041. See section 1.671-4 of the regulations.

(4) N will recognize ordinary income or loss upon the sale of the 85 percent undivided interest in each of the mortgages on the List measured by the differences between the proportionate proceeds realized with respect to the sale of the 85 percent undivided interest in each of the mortgages on the List and the appropriate portion of its adjusted basis in those mortgages.

(5) The sale of certificates by FHLMC to the certificate holders transfers to the certificate holders 85 percent equitable ownership in each of the mortgages on the List.

(6) Each certificate holder using the cash receipts and disbursements method of accounting shall take into account its pro rata share of the mortgage interest and other items of income as and when they are collected by FHLMC.

(7) Each certificate holder using an accrual method of accounting shall take into account its pro rata share of the entire interest on each mortgage and other items of income as they become due to FHLMC.

(8) The special rules of section 1232 of the Code will be applicable to the certificate holders' proportionate shares of any mortgages 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 the section are met. With respect to any interest in a mortgage purchased at a discount, and not subject to section 1232, the excess of the ratable portion of the certificate yield over the ratable portion of the entire interest income on the mortgages constitutes ordinary income to the certificate holders.

(9) With respect to any undivided interest in a mortgage purchased at a premium, the certificate holder may be entitled to a deduction for amortization in accordance with applicable rules.

(10) The certificate holders may deduct FHLMC's guarantee and management fees under section 162 of the Code consistent with their method of accounting.

(11) A certificate held by a savings and loan association (certificate holder) 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.

(12) A certificate held by a domestic building and loan association (certificate holder) within the meaning of section 7701(a)(19) of the Code is considered as representing "qualifying real property loans" within the meaning of section 593(e) of the Code.

(13) The qualification of an employees' pension or profit-sharing trust (certificate holder) under section 401 of the Code and its exemption under section 501(a) will not be adversely affected by the purchase of certificates, provided that the purchase meets the applicable investment requisites set forth in Revenue Ruling 69-494, C.B. 1969-2, 88.

¹ Also released as News Release IR-1157, dated August 10, 1971.