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GT Alert

New Proposed Treasury Regulations Regarding Timing of Interest Accruals on REMIC Regular Interests

August 2004
By Jay Blaivas, Greenberg Traurig, New York Office

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On August 24, 2004, the Treasury Department and the Internal Revenue Service issued proposed regulations (the “Proposed Regulations”) relating to the proper method for including in income, for federal income tax purposes, interest earned on regular interests in a REMIC.1 Specifically, the Proposed Regulations provide that, where REMIC regular interests provide for a delay of 31 days or less between the record dates2 and payment dates, a holder of the REMIC regular interests must accrue interest in its taxable income for the period beginning on the issue date of the REMIC regular interests, through the final record date of such REMIC regular interests.

Jay Blaivas
"The Treasury Department and IRS believe that, generally, REMIC servicers have interpreted these rules to require or permit the accrual of interest earned on REMIC regular interests on a payment date to payment date basis."

Under the applicable provisions of the Internal Revenue Code and Treasury regulations, a holder of a REMIC regular interest generally must include in income all interest earned on the REMIC regular interest (whether characterized as original issue discount (“OID”) or “qualified stated interest”) as such interest accrues for federal income tax purposes, regardless of the holder's regular method of accounting for such purposes. The preamble to the Proposed Regulations (the “Preamble”) states that the Treasury Department and IRS believe that, generally, REMIC servicers have interpreted these rules to require or permit the accrual of interest earned on REMIC regular interests on a payment date to payment date basis. In order to remedy the fact that, in applying such an accrual method, interest continues to accrue for tax purposes between the final record and payment dates (for which period the holder is not contractually entitled to any interest accrual), these servicers treat no interest as accruing to the holder for such purposes for the same number of days elapsing from the record date to the payment date, beginning on the issue date of the REMIC regular interests. Consequently, under this accrual method, interest would only first begin to accrue a number of days after the issue date equal to the number of days between the record and payment dates, and would continue to accrue through the final payment date.

The Preamble raises a number of concerns regarding the application of such an interest accrual method by REMIC servicers. One such concern is that the tax accrual of interest will always lag the economic/legal accrual of interest by the number of days between the record and payment dates, essentially resulting in a tax deferral of the interest economically earned during this lag period beginning on the issue date, until it is finally included in income in the final accrual period ending on the final payment date. Another, related, concern is that if a REMIC regular interest for which this accrual method is employed is sold in the secondary market, the purchaser would accrue interest, for tax purposes, beginning on the purchase date, and through the final payment date. This would result in the seller never including in its taxable income the interest it economically earned during the original lag period beginning on the issue date, and, correspondingly, in the purchaser including such interest in its taxable income for the final accrual period, despite the fact that it is never economically entitled to receive it. Finally, the Preamble indicates that a secondary market purchaser of such an interest may have tax accruals in excess of its economic accruals of interest, even if it does not hold the interest through the final accrual period, since its tax accruals will be based on an artificially high principal balance, as a result of the deferral of accruals for tax purposes (and, hence, a deferral of the reduction of principal associated with such accruals).

To address these concerns, the Proposed Regulations require that REMIC regular interests providing for a delay of 31 days or less from record date to payment date, accrue interest, for federal income tax purposes, from the issue date through the final record date, with no allowance for an initial deferral period, and no accruals after the final record date (i.e., interest would accrue for tax purposes over the same period which it economically accrues).3 Additionally, the Proposed Regulations would clarify that all interest (whether OID or not) must be accrued over that same period, from issue date to final record date.4

The following example illustrates the different effect of accruing interest, for federal income tax purposes, from payment date to payment date, with the application of an initial deferral period, on the one hand, and, on the other hand, in accordance with the Proposed Regulations, from issue date to final record date, with no allowance for the application of an initial deferral period:

Assume, that on December 24, 2004, REMIC A issues regular interests with a principal amount of $100,000 and a fixed 3.6% coupon, with a record date of the last day of each month and a payment date of the 20th day of each month, with the final record and payment dates being December 31, 2023, and January 20, 2024, respectively.

If a payment date to payment date accrual method is employed, with an initial deferral period equal the number of days between record and payment dates, a holder of a regular interest would not accrue, for tax purposes, any interest from the issue date (December 24, 2004) through January 13, 2005 (corresponding to the 20-day period between record and payment dates), even though, economically, approximately $200 of interest has accrued during that period. The initial tax accrual period would encompass January 14, 2005, to January 20, 2005, for which period approximately $75 of interest would accrue, and each succeeding accrual period would run from the 20th of the month to the 20th of the following month, with $300 accruing in each such accrual period, with the final tax accrual period running from December 20, 2023, to January 20, 2024.

Under the Proposed Regulations, interest would accrue, for tax purposes, beginning on the issue date (December 24, 2004), and would continue to accrue only though the final record date (December 31, 2023), with no accrual following the final record date (i.e., January 1, 2024, to January 20, 2024). Consequently, under the Proposed Regulations, a holder of the REMIC A regular interest, having a calendar year taxable year, would include in income for its 2004 taxable year interest accrued from December 24, 2004, through December 31, 2004, in the amount of approximately $75, and would not accrue any interest in its taxable income for its 2024 taxable year. In contrast, applying the payment date to payment date accrual method described above, a holder of the REMIC A regular interests would include no interest in its taxable income for its 2004 taxable year, or through January 13 of its 2005 taxable year (despite an approximate $200 economic accrual), but would include approximately $200 in its income for its 2024 taxable year, representing interest accrued from January 1, 2024, to the final payment date of January 20, 2024, and equal to the interest not accrued in the initial tax deferral period beginning on the issue date. See the below charts for a time-line illustration of these two different methods for accruing interest for federal income tax purposes.

Two different methods for accruing interest for federal income tax purposes.


Footnotes

1 A REMIC, or real estate mortgage investment conduit, is an entity whose assets consist primarily of mortgages satisfying certain requirements, and which issues instruments, called “regular interests,” treated as debt for federal income tax purposes. In their present form, the Proposed Regulations would apply to any REMIC regular interests issued after the date on which the final regulations are published in the Federal Register.

2 The Proposed Regulations define a record date, as the date on which a holder becomes entitled to a payment (of interest or principal) that is to be made on a subsequent payment date.

3 The Proposed Regulations have reserved on the accrual of interest on REMIC regular interests with delays between record and payment dates of 32 days or more.

4 The Proposed Regulations would further provide that, solely for purposes of calculating the amount of OID in the final accrual period, any payments made after the final record date that are included in the stated redemption price at maturity of the REMIC regular interest (i.e., are not “qualified stated interest”), will be treated as made during the final accrual period ending on the final record date.

 

© 2004 Greenberg Traurig


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This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.