Taxable Mortgage Pools

DEPARTMENT OF THE TREASURY

26 CFR Part 301

[TD 8610]

RIN 1545-AP98

Taxable Mortgage Pools

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations relating to taxable

mortgage pools. This action is necessary because of changes made to the

law by the Tax Reform Act of 1986. The final regulations provide

guidance to entities for determining whether they are subject to the

taxable mortgage pool rules.

EFFECTIVE DATE: These regulations are effective September 6, 1995.

FOR FURTHER INFORMATION CONTACT: Arnold P. Golub or Marshall D.

Feiring, (202) 622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

A notice of proposed rulemaking (FI-55-91) under section 7701(i) of

the Internal Revenue Code was published in the Federal Register on

December 23, 1992 (57 FR 61029). Written comments relating to this

notice were received, but no public hearing was requested or held.

After consideration of the comments, the proposed regulations under

section 7701(i) are adopted as revised by this Treasury decision.

Explanation of Provisions

Section 301.7701(i)-1(c)(1)--Basis Used To Determine the Composition of

an Entity's Assets

Among other requirements, to be classified as a taxable mortgage

pool, substantially all of an entity's assets must consist of debt

obligations, and more than 50 percent of those debt obligations must

consist of real estate mortgages (or interests therein). Under the

proposed regulations, an entity must apply these tests using the tax

bases of its assets. One commentator, however, suggested that the

entity should have the choice of using either the tax bases of its

assets or the fair market value of its assets. The IRS and Treasury

believe that using fair market value for the asset composition tests

creates uncertainty and administrative difficulties. The final

regulations, therefore, retain the rule in the proposed regulations.

Section 301.7701(i)-1(c)(5)--Seriously Impaired Real Estate Mortgages

Not Treated as Debt Obligations

Under the proposed regulations, real estate mortgages that are

seriously impaired are not treated as debt obligations for purposes of

the asset composition tests. Whether real estate mortgages are

seriously impaired generally depends on all the facts and

circumstances. The proposed regulations, however, provide two safe

harbors. Under those provisions, whether mortgages are seriously

impaired depends only on the number of days the payments on the

mortgages are delinquent (more than 89 days for single family

residential real estate mortgages and more than 59 days for multi-

family residential and commercial real estate mortgages). The safe

harbors are not available, however, if an entity is receiving or

anticipates receiving certain payments on the mortgages such as

payments of principal and interest that are substantial and relatively

certain as to amount.

Several commentators have asked for additional safe harbors based

on factors other than the number of days a mortgage is delinquent. For

example, one suggested a safe harbor for mortgages having excessively

high loan to value ratios. Others suggested a safe harbor for mortgages

that are purchased at a substantial discount.

The final regulations retain, unchanged, the safe harbors of the

proposed regulations. The IRS and Treasury believe that no single

factor is as clear an indication that a mortgage is seriously impaired

as days delinquent. For example, a mortgage may be purchased at a

discount for a variety of reasons, some of which bear no relation to

the quality of the mortgage. To provide further guidance, however, the

final regulations list some of the facts and circumstances that should

be considered in determining whether a mortgage is seriously impaired.

Another commentator has criticized the safe harbors because they

are unavailable if an entity anticipates receiving certain payments on

a delinquent mortgage. The commentator is concerned that a test based

on whether an entity anticipates receiving payments on a mortgage is

both subjective and open-ended. To address this concern, the final

regulations create a new rule, under which if an entity makes

reasonable efforts to resolve a

[[Page 40087]]

mortgage and fails to do so within a designated time, then the entity

is treated as not having anticipated receiving payments on the

mortgage.

Section 301.7701(i)-1(d)(3)(ii)--Obligations Secured by Other

Obligations Treated as Principally Secured by Real Property

Under the proposed regulations, an obligation is treated as a real

estate mortgage if it is principally secured by an interest in real

property. Whether an obligation is principally secured by an interest

in real property ordinarily depends on the value of the real property

relative to the amount of the obligation. The proposed regulations also

provide that an obligation secured by real estate mortgages is treated

as an obligation secured by an interest in real property. That

obligation, therefore, may itself qualify as a real estate mortgage.

The final regulations retain these rules and clarify how they are

applied if an obligation is secured by both real estate mortgages and

other property. Under the final regulations, such an obligation is

treated as secured by real property, but only to the extent of the

combined value of the real estate mortgages and any real property that

secures the obligation.

Section 301.7701(i)-1(f)(3)--Certain Liquidating Entities Not Treated

as Taxable Mortgage Pools

The proposed regulations provide that an entity formed to liquidate

real estate mortgages is not treated as a taxable mortgage pool if the

entity meets four conditions. One condition is that the entity must

liquidate within three years of acquiring its first asset. If the

entity fails to liquidate within that time, then the payments the

entity receives on its assets must be paid through to the holders of

the entity's liabilities in proportion to the adjusted issue prices of

the liabilities.

One commentator has asked that this condition be modified. The

commentator suggested that either the three- year liquidation period

should be extended to four years or an entity should have to liquidate

only a certain percentage of its assets within the three-year period.

The commentator alternatively suggested that an entity should be

treated as meeting the condition if it satisfies fifty percent of the

issue price of each of its liabilities using liquidation proceeds.

The final regulations retain the three-year liquidation rule. The

IRS and Treasury believe that performing mortgages that conform to

current underwriting standards may easily be disposed of within that

time. Further, the market has developed to the point where three years

is also ample time to dispose of non-performing mortgages. Mortgages

that require more than three years for disposal are more likely to be

seriously impaired, and a taxpayer who holds a sufficient quantity can

avoid taxable mortgage pool classification by other means. The final

regulations, therefore, do not change the basic rules in the proposed

regulations.

Section 301.7701-1(g)--Anti-Avoidance Rules

An anti-avoidance rule in the proposed regulations authorizes the

Commissioner to disregard or make other adjustments to any transaction

if the transaction is entered into with a view to achieving the same

economic effect as that of an arrangement subject to section 7701(i)

while avoiding the application of that section. This authority is

flexible, and among other things, includes the ability to override any

safe harbor otherwise available under the regulations. The final

regulations retain the anti-avoidance rule and provide two additional

examples illustrating its exercise.

Section 301.7701(i)-4--Certain Governmental Entities Not Treated as

Taxable Mortgage Pools

The proposed regulations provide that an entity is not classified

as a taxable mortgage pool if: (1) The entity issuing the debt

obligations is a State, the District of Columbia, or a political

subdivision within the meaning of Sec. 1.103-1(b), or is empowered to

issue obligations on behalf of one of the foregoing; (2) the entity

issues the debt obligations in the performance of a governmental

purpose; and (3) the entity holds the remaining interest in any asset

that supports the outstanding debt obligations until those obligations

are satisfied.

Two commentators have asked that the third requirement be dropped

because it prevents a governmental entity from reselling a package of

mortgages. The IRS and Treasury believe, however, that dropping the

requirement is inappropriate. Typically, when a mortgage pool is used

to create multiple class debt, tax gains in excess of economic gains

are generated during the early part of the pool's life and tax losses

in excess of economic losses are generated during the latter part of

the pool's life. Without the third requirement, a governmental entity

can hold an interest in the pool during the early period and then

convey that interest to a taxable entity during the latter period.

Moreover, requiring a governmental entity to maintain an interest in

pool assets is consistent with the second requirement that debt

obligations supported by the pool are issued in performance of a

governmental purpose.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal authors of these regulations are Marshall D. Feiring

and Arnold P. Golub, Office of Assistant Chief Counsel (Financial

Institutions and Products), and Carol E. Schultze, formerly of that

office. However, other personnel from the IRS and Treasury Department

participated in their development.

The Office of Assistant Chief Counsel (Financial Institutions and

Products) notes with sadness the passing of Susan E. Overlander, who

contributed significantly to this project.

List of Subjects in 26 CFR Part 301

Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income

taxes, Penalties, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 301 is amended as follows:

PART 301--PROCEDURE AND ADMINISTRATION

Paragraph 1. The authority citation for part 301 is amended by

adding the following citations in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 301.7701(i)-1(g)(1) also issued under 26 U.S.C.

7701(i)(2)(D).

Section 301.7701(i)-4(b) also issued under 26 U.S.C. 7701(i)(3).

* * *

Par. 2. Sections 301.7701(i)-0 through 301.7701(i)-4 are added to

read as follows:

[[Page 40088]]

Sec. 301.7701(i)-0 Outline of taxable mortgage pool provisions.

This section lists the major paragraphs contained in

Secs. 301.7701(i)-1 through 301.7701(i)-4.

Sec. 301.7701(i)-1 Definition of a taxable mortgage pool.

(a) Purpose.

(b) In general.

(c) Asset composition tests.

(1) Determination of amount of assets.

(2) Substantially all.

(i) In general.

(ii) Safe harbor.

(3) Equity interests in pass-through arrangements.

(4) Treatment of certain credit enhancement contracts.

(i) In general.

(ii) Credit enhancement contract defined.

(5) Certain assets not treated as debt obligations.

(i) In general.

(ii) Safe harbor.

(A) In general.

(B) Payments with respect to a mortgage defined.

(C) Entity treated as not anticipating payments.

(d) Real estate mortgages or interests therein defined.

(1) In general.

(2) Interests in real property and real property defined.

(i) In general.

(ii) Manufactured housing.

(3) Principally secured by an interest in real property.

(i) Tests for determining whether an obligation is principally

secured.

(A) The 80 percent test.

(B) Alternative test.

(ii) Obligations secured by real estate mortgages (or interests

therein), or by combinations of real estate mortgages (or interests

therein) and other assets.

(A) In general.

(B) Example.

(e) Two or more maturities.

(1) In general.

(2) Obligations that are allocated credit risk unequally.

(3) Examples.

(f) Relationship test.

(1) In general.

(2) Payments on asset obligations defined.

(3) Safe harbor for entities formed to liquidate assets.

(g) Anti-avoidance rules.

(1) In general.

(2) Certain investment trusts.

(3) Examples.

Sec. 301.7701(i)-2 Special rules for portions of entities.

(a) Portion defined.

(b) Certain assets and rights to assets disregarded.

(1) Credit enhancement assets.

(2) Assets unlikely to service obligations.

(3) Recourse.

(c) Portion as obligor.

(1) In general.

(2) Example.

Sec. 301.7701(i)-3 Effective dates and duration of taxable

mortgage pool classification.

(a) Effective dates.

(b) Entities in existence on December 31, 1991.

(1) In general.

(2) Special rule for certain transfers.

(3) Related debt obligation.

(4) Example.

(c) Duration of taxable mortgage pool classification.

(1) Commencement and duration.

(2) Testing day defined.

Sec. 301.7701(i)-4 Special rules for certain entities.

(a) States and municipalities.

(1) In general.

(2) Governmental purpose.

(3) Determinations by the Commissioner.

(b) REITs. [Reserved]

(c) Subchapter S corporations.

(1) In general.

(2) Portion of an S corporation treated as a separate

corporation.

Sec. 301.7701(i)-1 Definition of a taxable mortgage pool.

(a) Purpose. This section provides rules for applying section

7701(i), which defines taxable mortgage pools. The purpose of section

7701(i) is to prevent income generated by a pool of real estate

mortgages from escaping Federal income taxation when the pool is used

to issue multiple class mortgage-backed securities. The regulations in

this section and in Secs. 301.7701(i)-2 through 301.7701(i)-4 are to be

applied in accordance with this purpose. The taxable mortgage pool

provisions apply to entities or portions of entities that qualify for

REMIC status but do not elect to be taxed as REMICs as well as to

certain entities or portions of entities that do not qualify for REMIC

status.

(b) In general. (1) A taxable mortgage pool is any entity or

portion of an entity (as defined in Sec. 301.7701(i)-2) that satisfies

the requirements of section 7701(i)(2)(A) and this section as of any

testing day (as defined in Sec. 301.7701(i)-3(c)(2)). An entity or

portion of an entity satisfies the requirements of section

7701(i)(2)(A) and this section if substantially all of its assets are

debt obligations, more than 50 percent of those debt obligations are

real estate mortgages, the entity is the obligor under debt obligations

with two or more maturities, and payments on the debt obligations under

which the entity is obligor bear a relationship to payments on the debt

obligations that the entity holds as assets.

(2) Paragraph (c) of this section provides the tests for

determining whether substantially all of an entity's assets are debt

obligations and for determining whether more than 50 percent of its

debt obligations are real estate mortgages. Paragraph (d) of this

section defines real estate mortgages for purposes of the 50 percent

test. Paragraph (e) of this section defines two or more maturities and

paragraph (f) of this section provides rules for determining whether

debt obligations bear a relationship to the assets held by an entity.

Paragraph (g) of this section provides anti-avoidance rules. Section

301.7701(i)-2 provides rules for applying section 7701(i) to portions

of entities and Sec. 301.7701(i)-3 provides effective dates. Section

301.7701(i)-4 provides special rules for certain entities. For purposes

of the regulations under section 7701(i), the term entity includes a

portion of an entity (within the meaning of section 7701(i)(2)(B)),

unless the context clearly indicates otherwise.

(c) Asset composition tests--(1) Determination of amount of assets.

An entity must use the Federal income tax basis of an asset for

purposes of determining whether substantially all of its assets consist

of debt obligations (or interests therein) and whether more than 50

percent of those debt obligations (or interests) consist of real estate

mortgages (or interests therein). For purposes of this paragraph, an

entity determines the basis of an asset with the assumption that the

entity is not a taxable mortgage pool.

(2) Substantially all--(i) In general. Whether substantially all of

the assets of an entity consist of debt obligations (or interests

therein) is based on all the facts and circumstances.

(ii) Safe harbor. Notwithstanding paragraph (c)(2)(i) of this

section, if less than 80 percent of the assets of an entity consist of

debt obligations (or interests therein), then less than substantially

all of the assets of the entity consist of debt obligations (or

interests therein).

(3) Equity interests in pass-through arrangements. The equity

interest of an entity in a partnership, S corporation, trust, REIT, or

other pass-through arrangement is deemed to have the same composition

as the entity's share of the assets of the pass-through arrangement.

For example, if an entity's stock interest in a REIT has an adjusted

basis of $20,000, and the assets of the REIT consist of equal portions

of real estate mortgages and other real estate assets, then the entity

is treated as holding $10,000 of real estate mortgages and $10,000 of

other real estate assets.

(4) Treatment of certain credit enhancement contracts--(i) In

general. A credit enhancement contract (as defined in paragraph

(c)(4)(ii) of this section) is not treated as a separate asset of an

entity for purposes of the asset composition tests set forth in section

[[Page 40089]]

7701(i)(2)(A)(i), but instead is treated as part of the asset to which

it relates. Furthermore, any collateral supporting a credit enhancement

contract is not treated as an asset of an entity solely because it

supports the guarantee represented by that contract.

(ii) Credit enhancement contract defined. For purposes of this

section, a credit enhancement contract is any arrangement whereby a

person agrees to guarantee full or partial payment of the principal or

interest payable on a debt obligation (or interest therein) or on a

pool of such obligations (or interests), or full or partial payment on

one or more classes of debt obligations under which an entity is the

obligor, in the event of defaults or delinquencies on debt obligations,

unanticipated losses or expenses incurred by the entity, or lower than

expected returns on investments. Types of credit enhancement contracts

may include, but are not limited to, pool insurance contracts,

certificate guarantee insurance contracts, letters of credit,

guarantees, or agreements whereby an entity, a mortgage servicer, or

other third party agrees to make advances (regardless of whether, under

the terms of the agreement, the payor is obligated, or merely

permitted, to make those advances). An agreement by a debt servicer to

advance to an entity out of its own funds an amount to make up for

delinquent payments on debt obligations is a credit enhancement

contract. An agreement by a debt servicer to pay taxes and hazard

insurance premiums on property securing a debt obligation, or other

expenses incurred to protect an entity's security interests in the

collateral in the event that the debtor fails to pay such taxes,

insurance premium, or other expenses, is a credit enhancement contract.

(5) Certain assets not treated as debt obligations--(i) In general.

For purposes of section 7701(i)(2)(A), real estate mortgages that are

seriously impaired are not treated as debt obligations. Whether a

mortgage is seriously impaired is based on all the facts and

circumstances including, but not limited to: the number of days

delinquent, the loan-to-value ratio, the debt service coverage (based

upon the operating income from the property), and the debtor's

financial position and stake in the property. However, except as

provided in paragraph (c)(5)(ii) of this section, no single factor in

and of itself is determinative of whether a loan is seriously impaired.

(ii) Safe harbor--(A) In general. Unless an entity is receiving or

anticipates receiving payments with respect to a mortgage, a single

family residential real estate mortgage is seriously impaired if

payments on the mortgage are more than 89 days delinquent, and a multi-

family residential or commercial real estate mortgage is seriously

impaired if payments on the mortgage are more than 59 days delinquent.

Whether an entity anticipates receiving payments with respect to a

mortgage is based on all the facts and circumstances.

(B) Payments with respect to a mortgage defined. For purposes of

paragraph (c)(5)(ii)(A) of this section, payments with respect to a

mortgage mean any payments on the mortgage as defined in paragraph

(f)(2)(i) of this section if those payments are substantial and

relatively certain as to amount and any payments on the mortgage as

defined in paragraph (f)(2) (ii) or (iii) of this section.

(C) Entity treated as not anticipating payments. With respect to

any testing day (as defined in Sec. 301.7701(i)-3(c)(2)), an entity is

treated as not having anticipated receiving payments on the mortgage as

defined in paragraph (f)(2)(i) of this section if 180 days after the

testing day, and despite making reasonable efforts to resolve the

mortgage, the entity is not receiving such payments and has not entered

into any agreement to receive such payments.

(d) Real estate mortgages or interests therein defined--(1) In

general. For purposes of section 7701(i)(2)(A)(i), the term real estate

mortgages (or interests therein) includes all--

(i) Obligations (including participations or certificates of

beneficial ownership therein) that are principally secured by an

interest in real property (as defined in paragraph (d)(3) of this

section);

(ii) Regular and residual interests in a REMIC; and

(iii) Stripped bonds and stripped coupons (as defined in section

1286(e) (2) and (3)) if the bonds (as defined in section 1286(e)(1))

from which such stripped bonds or stripped coupons arose would have

qualified as real estate mortgages or interests therein.

(2) Interests in real property and real property defined--(i) In

general. The definition of interests in real property set forth in

Sec. 1.856-3(c) of this chapter and the definition of real property set

forth in Sec. 1.856-3(d) of this chapter apply to define those terms

for purposes of paragraph (d) of this section.

(ii) Manufactured housing. For purposes of this section, the

definition of real property includes manufactured housing, provided the

properties qualify as single family residences under section 25(e)(10)

and without regard to the treatment of the properties under state law.

(3) Principally secured by an interest in real property--(i) Tests

for determining whether an obligation is principally secured. For

purposes of paragraph (d)(1) of this section, an obligation is

principally secured by an interest in real property only if it

satisfies either the test set out in paragraph (d)(3)(i)(A) of this

section or the test set out in paragraph (d)(3)(i)(B) of this section.

(A) The 80 percent test. An obligation is principally secured by an

interest in real property if the fair market value of the interest in

real property (as defined in paragraph (d)(2) of this section) securing

the obligation was at least equal to 80 percent of the adjusted issue

price of the obligation at the time the obligation was originated (that

is, the issue date). For purposes of this test, the fair market value

of the real property interest is first reduced by the amount of any

lien on the real property interest that is senior to the obligation

being tested, and is reduced further by a proportionate amount of any

lien that is in parity with the obligation being tested.

(B) Alternative test. An obligation is principally secured by an

interest in real property if substantially all of the proceeds of the

obligation were used to acquire, improve, or protect an interest in

real property that, at the origination date, is the only security for

the obligation. For purposes of this test, loan guarantees made by

Federal, state, local governments or agencies, or other third party

credit enhancement, are not viewed as additional security for a loan.

An obligation is not considered to be secured by property other than

real property solely because the obligor is personally liable on the

obligation.

(ii) Obligations secured by real estate mortgages (or interests

therein), or by combinations of real estate mortgages (or interests

therein) and other assets--(A) In general. An obligation secured only

by real estate mortgages (or interests therein), as defined in

paragraph (d)(1) of this section, is treated as an obligation secured

by an interest in real property to the extent of the value of the real

estate mortgages (or interests therein). An obligation secured by both

real estate mortgages (or interests therein) and other assets is

treated as an obligation secured by an interest in real property to the

extent of both the value of the real estate mortgages (or interests

therein) and the value of so much of the other assets that constitute

real property. Thus, under this paragraph, a collateralized mortgage

[[Page 40090]]

obligation may be an obligation principally secured by an interest in

real property. This section is applicable only to obligations issued

after December 31, 1991.

(B) Example. The following example illustrates the principles of

this paragraph (d)(3)(ii):

Example. At the time it is originated, an obligation has an

adjusted issue price of $300,000 and is secured by a $70,000 loan

principally secured by an interest in a single family home, a fifty

percent co-ownership interest in a $400,000 parcel of land, and

$80,000 of stock. Under paragraph (d)(3)(ii)(A) of this section, the

obligation is treated as secured by interests in real property and

under paragraph (d)(3)(i)(A) of this section, the obligation is

treated as principally secured by interests in real property.

(e) Two or more maturities--(1) In general. For purposes of section

7701(i)(2)(A)(ii), debt obligations have two or more maturities if they

have different stated maturities or if the holders of the obligations

possess different rights concerning the acceleration of or delay in the

maturities of the obligations.

(2) Obligations that are allocated credit risk unequally. Debt

obligations that are allocated credit risk unequally do not have, by

that reason alone, two or more maturities. Credit risk is the risk that

payments of principal or interest will be reduced or delayed because of

a default on an asset that supports the debt obligations.

(3) Examples. The following examples illustrate the principles of

this paragraph (e):

Example 1. (i) Corporation M transfers a pool of real estate

mortgages to a trustee in exchange for Class A bonds and a

certificate representing the residual beneficial ownership of the

pool. All Class A bonds have a stated maturity of March 1, 2002, but

if cash flows from the real estate mortgages and investments are

sufficient, the trustee may select one or more bonds at random and

redeem them earlier.

(ii) The Class A bonds do not have different maturities. Each

outstanding Class A bond has an equal chance of being redeemed

because the selection process is random. The holders of the Class A

bonds, therefore, have identical rights concerning the maturities of

their obligations.

Example 2. (i) Corporation N transfers a pool of real estate

mortgages to a trustee in exchange for Class C bonds, Class D bonds,

and a certificate representing the residual beneficial ownership of

the pool. The Class D bonds are subordinate to the Class C bonds so

that cash flow shortfalls due to defaults or delinquencies on the

real estate mortgages are borne first by the Class D bond holders.

The terms of the bonds are otherwise identical in all relevant

aspects except that the Class D bonds carry a higher coupon rate

because of the subordination feature.

(ii) The Class C bonds and the Class D bonds share credit risk

unequally because of the subordination feature. However, neither

this difference, nor the difference in interest rates, causes the

bonds to have different maturities. The result is the same if, in

addition to the other terms described in paragraph (i) of this

Example 2, the Class C bonds are accelerated as a result of the

issuer becoming unable to make payments on the Class C bonds as they

become due.

(f) Relationship test--(1) In general. For purposes of section

7701(i)(2)(A)(iii), payments on debt obligations under which an entity

is the obligor (liability obligations) bear a relationship to payments

(as defined in paragraph (f)(2) of this section) on debt obligations an

entity holds as assets (asset obligations) if under the terms of the

liability obligations (or underlying arrangement) the timing and amount

of payments on the liability obligations are in large part determined

by the timing and amount of payments or projected payments on the asset

obligations. For purposes of the relationship test, any payment

arrangement, including a swap or other hedge, that achieves a

substantially similar result is treated as satisfying the test. For

example, any arrangement where the timing and amount of payments on

liability obligations are determined by reference to a group of assets

(or an index or other type of model) that has an expected payment

experience similar to that of the asset obligations is treated as

satisfying the relationship test.

(2) Payments on asset obligations defined. For purposes of section

7701(i)(2)(A)(iii) and this section, payments on asset obligations

include--

(i) A payment of principal or interest on an asset obligation,

including a prepayment of principal, a payment under a credit

enhancement contract (as defined in paragraph (c)(4)(ii) of this

section) and a payment from a settlement at a discount (other than a

substantial discount);

(ii) A payment from a settlement at a substantial discount, but

only if the settlement is arranged, whether in writing or otherwise,

prior to the issuance of the liability obligations; and

(iii) A payment from the foreclosure on or sale of an asset

obligation, but only if the foreclosure or sale is arranged, whether in

writing or otherwise, prior to the issuance of the liability

obligations.

(3) Safe harbor for entities formed to liquidate assets. Payments

on liability obligations of an entity do not bear a relationship to

payments on asset obligations of the entity if--

(i) The entity's organizational documents manifest clearly that the

entity is formed for the primary purpose of liquidating its assets and

distributing proceeds of liquidation;

(ii) The entity's activities are all reasonably necessary to and

consistent with the accomplishment of liquidating assets;

(iii) The entity plans to satisfy at least 50 percent of the total

issue price of each of its liability obligations having a different

maturity with proceeds from liquidation and not with scheduled payments

on its asset obligations; and

(iv) The terms of the entity's liability obligations (or underlying

arrangement) provide that within three years of the time it first

acquires assets to be liquidated the entity either--

(A) Liquidates; or

(B) Begins to pass through without delay all payments it receives

on its asset obligations (less reasonable allowances for expenses) as

principal payments on its liability obligations in proportion to the

adjusted issue prices of the liability obligations.

(g) Anti-avoidance rules--(1) In general. For purposes of

determining whether an entity meets the definition of a taxable

mortgage pool, the Commissioner can disregard or make other adjustments

to a transaction (or series of transactions) if the transaction (or

series) is entered into with a view to achieving the same economic

effect as that of an arrangement subject to section 7701(i) while

avoiding the application of that section. The Commissioner's authority

includes treating equity interests issued by a non-REMIC as debt if the

entity issues equity interests that correspond to maturity classes of

debt.

(2) Certain investment trusts. Notwithstanding paragraph (g)(1) of

this section, an ownership interest in an entity that is classified as

a trust under Sec. 301.7701-4(c) will not be treated as a debt

obligation of the trust.

(3) Examples. The following examples illustrate the principles of

this paragraph (g):

Example 1. (i) Partnership P, in addition to its other

investments, owns $10,000,000 of mortgage pass-through certificates

guaranteed by FNMA (FNMA Certificates). On May 15, 1997, Partnership

P transfers the FNMA Certificates to Trust 1 in exchange for 100

Class A bonds and Certificate 1. The Class A bonds, under which

Trust 1 is the obligor, have a stated principal amount of $5,000,000

and bear a relationship to the FNMA Certificates (within the meaning

of Sec. 301.7701(i)-1(f)). Certificate 1 represents the residual

beneficial ownership of the FNMA Certificates.

(ii) On July 5, 1997, with a view to avoiding the application of

section 7701(i), Partnership P transfers Certificate 1 to Trust 2 in

exchange for 100 Class B bonds and Certificate 2. The Class B bonds,

under which

[[Page 40091]]

Trust 2 is the obligor, have a stated principal amount of $5,000,000,

bear a relationship to the FNMA Certificates (within the meaning of

Sec. 301.7701(i)-1(f)), and have a different maturity than the Class

A bonds (within the meaning of Sec. 301.7701(i)-1(e)). Certificate 2

represents the residual beneficial ownership of Certificate 1.

(iii) For purposes of determining whether Trust 1 is classified

as a taxable mortgage pool, the Commissioner can disregard the

separate existence of Trust 2 and treat Trust 1 and Trust 2 as a

single trust.

Example 2. (i) Corporation Q files a consolidated return with

its two wholly-owned subsidiaries, Corporation R and Corporation S.

Corporation R is in the business of building and selling single

family homes. Corporation S is in the business of financing sales of

those homes.

(ii) On August 10, 1998, Corporation S transfers a pool of its

real estate mortgages to Trust 3, taking back Certificate 3 which

represents beneficial ownership of the pool. On September 25, 1998,

with a view to avoiding the application of section 7701(i),

Corporation R issues bonds that have different maturities (within

the meaning of Sec. 301.7701(i)-1(e)) and that bear a relationship

(within the meaning of Sec. 301.7701(i)-1(f)) to the real estate

mortgages in Trust 3. The holders of the bonds have an interest in a

credit enhancement contract that is written by Corporation S and

collateralized with Certificate 3.

(iii) For purposes of determining whether Trust 3 is classified

as a taxable mortgage pool, the Commissioner can treat Trust 3 as

the obligor of the bonds issued by Corporation R.

Example 3. (i) Corporation X, in addition to its other assets,

owns $110,000,000 in Treasury securities. From time to time,

Corporation X acquires pools of real estate mortgages, which it

immediately uses to issue multiple-class debt obligations.

(ii) On October 1, 1996, Corporation X transfers $20,000,000 in

Treasury securities to Trust 4 in exchange for Class C bonds, Class

D bonds, Class E bonds, and Certificate 4. Trust 4 is the obligor of

the bonds. The different classes of bonds have the same stated

maturity date, but if cash flows from the Trust 4 assets exceed the

amounts needed to make interest payments, the trustee uses the

excess to retire the classes of bonds in alphabetical order.

Certificate 4 represents the residual beneficial ownership of the

Treasury securities.

(iii) With a view to avoiding the application of section

7701(i), Corporation X reserves the right to replace any Trust 4

asset with real estate mortgages or guaranteed mortgage pass-through

certificates. In the event the right is exercised, cash flows on the

real estate mortgages and guaranteed pass-through certificates will

be used in the same manner as cash flows on the Treasury securities.

Corporation X exercises this right of replacement on February 1,

1997.

(iv) For purposes of determining whether Trust 4 is classified

as a taxable mortgage pool, the Commissioner can treat February 1,

1997, as a testing day (within the meaning of Sec. 301.7701(i)-

3(c)(2)). The result is the same if Corporation X has an obligation,

rather than a right, to replace the Trust 4 assets with real estate

mortgages and guaranteed pass-through certificates.

Example 4. (i) Corporation Y, in addition to its other assets,

owns $1,900,000 in obligations secured by personal property. On

November 1, 1995, Corporation Y begins negotiating a $2,000,000 loan

to individual A. As security for the loan, A offers a first deed of

trust on land worth $1,700,000.

(ii) With a view to avoiding the application of section 7701(i),

Corporation Y induces A to place the land in a partnership in which

A will have a 95 percent interest and agrees to accept the

partnership interest as security for the $2,000,000 loan.

Thereafter, the loan to A, together with the $1,900,000 in

obligations secured by personal property, are transferred to Trust 5

and used to issue bonds that have different maturities (within the

meaning of Sec. 301.7701(i)-1(e)) and that bear a relationship

(within the meaning of Sec. 301.7701(i)-1(f)) to the $1,900,000 in

obligations secured by personal property and the loan to A.

(iii) For purposes of determining whether Trust 5 is a taxable

mortgage pool, the Commissioner can treat the loan to A as an

obligation secured by an interest in real property rather than as an

obligation secured by an interest in a partnership.

Example 5. (i) Corporation Z, in addition to its other assets,

owns $3,000,000 in notes secured by interests in retail shopping

centers. Partnership L, in addition to its other assets, owns

$20,000,000 in notes that are principally secured by interests in

single family homes and $3,500,000 in notes that are principally

secured by interests in personal property.

(ii) On December 1, 1995, Partnership L asks Corporation Z for

two separate loans, one in the amount of $9,375,000 and another in

the amount of $625,000. Partnership L offers to collateralize the

$9,375,000 loan with $10,312,500 of notes secured by interests in

single family homes and the $625,000 loan with $750,000 of notes

secured by interests in personal property. Corporation Z has made

similar loans to Partnership L in the past.

(iii) With a view to avoiding the application of section

7701(i), Corporation Z induces Partnership L to accept a single

$10,000,000 loan and to post as collateral $7,500,000 of the notes

secured by interests in single family homes and all $3,500,000 of

the notes secured by interests in personal property. Ordinarily,

Corporation Z would not make a loan on these terms. Thereafter, the

loan to Partnership L, together with the $3,000,000 in notes secured

by interests in retail shopping centers, are transferred to Trust 6

and used to issue bonds that have different maturities (within the

meaning of Sec. 301.7701(i)-1(e)) and that bear a relationship

(within the meaning of Sec. 301.7701(i)-1(f)) to the loans secured

by interests in retail shopping centers and the loan to Partnership

L.

(iv) For purposes of determining whether Trust 6 is a taxable

mortgage pool, the Commissioner can treat the $10,000,000 loan to

Partnership L as consisting of a $9,375,000 obligation secured by

interests in real property and a $625,000 obligation secured by

interests in personal property. Under Sec. 301.7701(i)-

1(d)(3)(ii)(A), the notes secured by single family homes are treated

as $7,500,000 of interests in real property. Under Sec. 301.7701(i)-

1(d)(3)(i)(A), $7,500,000 of interests in real property are

sufficient to treat the $9,375,000 obligation as principally secured

by an interest in real property ($7,500,000 equals 80 percent of

$9,375,000).

Sec. 301.7701(i)-2 Special rules for portions of entities.

(a) Portion defined. Except as provided in paragraph (b) of this

section and Sec. 301.7701(i)-1, a portion of an entity includes all

assets that support one or more of the same issues of debt obligations.

For this purpose, an asset supports a debt obligation if, under the

terms of the debt obligation (or underlying arrangement), the timing

and amount of payments on the debt obligation are in large part

determined, either directly or indirectly, by the timing and amount of

payments or projected payments on the asset or a group of assets that

includes the asset. Indirect payment arrangements include, for example,

a swap or other hedge, or arrangements where the timing and amount of

payments on the debt obligations are determined by reference to a group

of assets (or an index or other type of model) that has an expected

payment experience similar to that of the assets. For purposes of this

paragraph, the term payments includes all proceeds and receipts from an

asset.

(b) Certain assets and rights to assets disregarded--(1) Credit

enhancement assets. An asset that qualifies as a credit enhancement

contract (as defined in Sec. 301.7701(i)-1(c)(4)(ii)) is not included

in a portion as a separate asset, but is treated as part of the assets

in the portion to which it relates under Sec. 301.7701(i)-1(c)(4)(i).

An asset that does not qualify as a credit enhancement contract (as

defined in Sec. 301.7701(i)-1(c)(4)(ii)), but that nevertheless serves

the same function as a credit enhancement contract, is not included in

a portion as a separate asset or otherwise.

(2) Assets unlikely to service obligations. A portion does not

include assets that are unlikely to produce any significant cash flows

for the holders of the debt obligations. This paragraph applies even if

the holders of the debt obligations are legally entitled to cash flows

from the assets. Thus, for example, even if the sale of a building

would cause a series of debt obligations to be redeemed, the building

is not included in a portion if it is not likely to be sold.

(3) Recourse. An asset is not included in a portion solely because

the holders

[[Page 40092]]

of the debt obligations have recourse to the holder of that asset.

(c) Portion as obligor--(1) In general. For purposes of section

7701(i)(2)(A)(ii), a portion of an entity is treated as the obligor of

all debt obligations supported by the assets in that portion.

(2) Example. The following example illustrates the principles of

this section:

Example. (i) Corporation Z owns $1,000,000,000 in assets

including an office complex and $90,000,000 of real estate

mortgages.

(ii) On November 30, 1998, Corporation Z issues eight classes of

bonds, Class A through Class H. Each class is secured by a separate

letter of credit and by a lien on the office complex. One group of

the real estate mortgages supports Class A through Class D, another

group supports Class E through Class G, and a third group supports

Class H. It is anticipated that the cash flows from each group of

mortgages will service its related bonds.

(iii) Each of the following constitutes a separate portion of

Corporation Z: the group of mortgages supporting Class A through

Class D; the group of mortgages supporting Class E through Class G;

and the group of mortgages supporting Class H. No other asset is

included in any of the three portions notwithstanding the lien of

the bonds on the office complex and the fact that Corporation Z is

the issuer of the bonds. The letters of credit are treated as

incidents of the mortgages to which they relate.

(iv) For purposes of section 7701(i)(2)(A)(ii), each portion

described above is treated as the obligor of the bonds of that

portion, notwithstanding the fact that Corporation Z is the legal

obligor with respect to the bonds.

Sec. 301.7701(i)-3 Effective dates and duration of taxable mortgage

pool classification.

(a) Effective dates. Except as otherwise provided, the regulations

under section 7701(i) are effective and applicable September 6, 1995.

(b) Entities in existence on December 31, 1991--(1) In general. For

transitional rules concerning the application of section 7701(i) to

entities in existence on December 31, 1991, see section 675(c) of the

Tax Reform Act of 1986.

(2) Special rule for certain transfers. A transfer made to an

entity on or after September 6, 1995, is a substantial transfer for

purposes of section 675(c)(2) of the Tax Reform Act of 1986 only if--

(i) The transfer is significant in amount; and

(ii) The transfer is connected to the entity's issuance of related

debt obligations (as defined in paragraph (b)(3) of this section) that

have different maturities (within the meaning of Sec. 301.7701-1(e)).

(3) Related debt obligation. A related debt obligation is a debt

obligation whose payments bear a relationship (within the meaning of

Sec. 301.7701-1(f)) to payments on debt obligations that the entity

holds as assets.

(4) Example. The following example illustrates the principles of

this paragraph (b):

Example. On December 31, 1991, Partnership Q holds a pool of

real estate mortgages that it acquired through retail sales of

single family homes. Partnership Q raises $10,000,000 on October 25,

1996, by using this pool to issue related debt obligations with

multiple maturities. The transfer of the $10,000,000 to Partnership

Q is a substantial transfer (within the meaning of Sec. 301.7701(i)-

3(b)(2)).

(c) Duration of taxable mortgage pool classification--(1)

Commencement and duration. An entity is classified as a taxable

mortgage pool on the first testing day that it meets the definition of

a taxable mortgage pool. Once an entity is classified as a taxable

mortgage pool, that classification continues through the day the entity

retires its last related debt obligation.

(2) Testing day defined. A testing day is any day on or after

September 6, 1995, on which an entity issues a related debt obligation

(as defined in paragraph (b)(3) of this section) that is significant in

amount.

Sec. 301.7701(i)-4 Special rules for certain entities.

(a) States and municipalities--(1) In general. Regardless of

whether an entity satisfies any of the requirements of section

7701(i)(2)(A), an entity is not classified as a taxable mortgage pool

if--

(i) The entity is a State, territory, a possession of the United

States, the District of Columbia, or any political subdivision thereof

(within the meaning of Sec. 1.103-1(b) of this chapter), or is

empowered to issue obligations on behalf of one of the foregoing;

(ii) The entity issues the debt obligations in the performance of a

governmental purpose; and

(iii) The entity holds the remaining interests in all assets that

support those debt obligations until the debt obligations issued by the

entity are retired.

(2) Governmental purpose. The term governmental purpose means an

essential governmental function within the meaning of section 115. A

governmental purpose does not include the mere packaging of debt

obligations for re-sale on the secondary market even if any profits

from the sale are used in the performance of an essential governmental

function.

(3) Determinations by the Commissioner. If an entity is not

described in paragraph (a)(1) of this section, but has a similar

purpose, then the Commissioner may determine that the entity is not

classified as a taxable mortgage pool.

(b) REITs. [Reserved]

(c) Subchapter S corporations--(1) In general. An entity that is

classified as a taxable mortgage pool may not elect to be an S

corporation under section 1362(a) or maintain S corporation status.

(2) Portion of an S corporation treated as a separate corporation.

An S corporation is not treated as a member of an affiliated group

under section 1361(b)(2)(A) solely because a portion of the S

corporation is treated as a separate corporation under section 7701(i).

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: July 17, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-19285 Filed 8-4-95; 8:45 am]

BILLING CODE 4830-01-U