Rev. Rul. 65-95

Advice has been requested whether so-called `points' allowed to a lending institution (mortgagee) by a builder-seller for making mortgage loans insured by the Federal Housing Administration or guaranteed by the Veterans' Administration (FHA and VA), under the circumstances described below, are includible in the mortgagee's income in the year the mortgage is originated. Advice has also been requested whether the mortgagee may inventory its mortgage notes.

X , a mortgage corporation which uses an accrual method of accounting, is in the business of originating and (to a lesser extent) purchasing FHA insured and VA guaranteed mortgage loans for purposes of sale or resale to permanent investors for whom it services the mortgages. It derives its principal income from such servicing and the 1-percent origination fee (maximum allowed by the FHA and VA) it charges the mortgagor for processing the mortgage loan. `Servicing' means collecting the monthly payments, collecting for taxes and insurance, paying the taxes and insurance, and protecting against delinquencies. Although X may realize gains upon the sale or resale of the mortgages, it originates or purchases the mortgages for the purpose of obtaining the servicing contracts from which a major part of its income is derived.

The term `points' is commonly used in the business community. In a typical transaction involving `points,' a house builder arranges with X to finance the houses in a particular subdivision. Under X's closing procedure, a home buyer pays the builder-seller the down payment at closing and signs, as mortgagor, a mortgage note and mortgage in favor of X , as mortgagee, encumbering his home in, for example, the amount of 10,000 dollars. The home buyer pays X a 100 dollar origination fee. He also signs at the closing a direction to X to pay to the builder-seller the 10,000 dollars proceeds of the mortgage. If similar mortgages are selling on the market at that time at a discount of 500 dollars, X charges the builder-seller five `points' and pays him only 9,500 dollars instead of 10,000 dollars, the actual face amount of the mortgage note.

At a later date, X sells the mortgage which it originated to a permanent investor. X may realize either gain or loss upon this disposition depending upon whether the amount at which it is able to sell the mortgage is more or less than the amount which it paid the builder-seller. In most cases, X reserves the right to service the mortgage sold during its remaining life. For these services X receives a servicing fee from the permanent investor which is usually determined by reference to the amount of the outstanding principal balance of the mortgage note.

The `points' constitute a discount in the amount of the difference between the face amount of the mortgage note and the amount X could sell it for on the open market on the origination date. This enables X in effect to compensate a permanent investor for the interest income it will lose by investing in the FHA or VA mortgages instead of some other investment yielding a higher current money market interest rate.

In view of the foregoing, it is held that the `points' allowed to X for making loans insured by the FHA or VA do not constitute items of gross income when `received' by X within the meaning of section 451(a) of the Internal Revenue Code of 1954.

If X receives a mortgage installment payment from the mortgagor, however, a proper amount applicable to interest should be subtracted from the payment and be treated as income, a ratable part of the remainder treated as partial repayment of the principal, and a ratable part, computed on the basis of the entire discount, as income. Upon sale of the mortgage and note, ordinary gain or loss will be realized by X to the extent of the difference between the selling price and the originating price (face amount of the note minus discount), properly adjusted for any amounts treated as partial repayments of principal as described above.

Section 1236(c) of the Code provides, in part, that the term `security' means any note, bond, debenture, or other evidence of indebtedness.

Section 471 of the Code provides, in effect, that whenever the use of inventories is necessary in order to determine income clearly, they shall be taken by the taxpayer on such basis as the Secretary of the Treasury or his delegate may prescribe. Section 1.471-5 of the Income Tax Regulations, relating to inventories by dealers in securities, is the sole provision applicable to the inventorying of the mortgage notes under consideration here.

Since section 1.471-5 of the regulations is the exclusive section to be used when securities are involved, X must qualify as a dealer in securities in order to inventory such mortgages. See Mim. 3990, C.B. XII-1, 97 (1933): Harriman National Bank v. Commissioner , 43 Fed.(2d) 950 (1930); Helvering v. Albert Fried et al. , 229 U.S. 175 (1936), Ct. D. 1184, C.B. XV-2, 199 (1936); and Algernon S. Schafer et al. v. Helvering , 299 U.S. 171 (1936), Ct. D. 1183, C.B. XV-2, 197 (1936).

Section 1.471-5 of the regulations provides, in part, as follows:

* * * For the purposes of this section, a dealer in securities is a merchant of securities, * * * regularly engaged in the purchase of securities and their resale to customers: that is, one who as a merchant buys securities and sells them to customers with a view to the gains and profits that may be derived there-from. * * * Emphasis supplied.

With respect to those mortgages which X originates, it does not qualify as a dealer in securities because such mortgages are not acquired by `purchase'. With respect to those mortgages X purchases, it also does not qualify as a dealer in securities because, under the facts presented, X does not purchase and sell the mortgages with a view to the gains or profits to be derived from the sale itself, but for the profit from the fees it will collect from servicing the mortgages once sold.

Accordingly, it is further held that X may not inventory either the mortgages it originates or those it purchases.