Real Estate Mortgage Investment Conduits

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8614]

RIN 1545-AS54

Real Estate Mortgage Investment Conduits

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final regulations relating to variable

rate interest payments and specified portion interest payments on

regular interests in real estate mortgage investment conduits (or

REMICs). This action is necessary because of changes to the applicable

tax law made by the Tax Reform Act of 1986 and by the Technical and

Miscellaneous Revenue Act of 1988. These regulations provide guidance

to REMIC sponsors and investors.

DATES: These regulations are effective August 17, 1995.

For dates of applicability of these regulations, see Sec. 1.860A-1.

FOR FURTHER INFORMATION CONTACT: William P. Cejudo, (202) 622-3920 (not

a toll free number).

SUPPLEMENTARY INFORMATION:

Background

On April 20, 1994, temporary regulations (TD 8534) relating to

variable rate interest payments on REMIC regular interests were

published in the Federal Register (59 FR 18746). A notice of proposed

rulemaking (FI-10-94), published in the Federal Register for the same

day (59 FR 18772), cross-references the temporary regulations. That

notice also proposes guidance on whether interest payments on a regular

interest in a REMIC consist of a specified portion of the interest

payments on the qualified mortgages held by the REMIC.

No public hearing was requested or held, but written comments

responding to the notice were received. After consideration of the

comments, the regulations proposed by FI-10-94 are adopted as revised

by this Treasury decision, and the corresponding temporary regulations

are removed.

Explanation of Provisions

Sections 860A through 860G of the Internal Revenue Code set forth

rules for the treatment of REMICs and for the treatment of persons who

hold interests in REMICs. For an entity to qualify as a REMIC, every

interest in the entity must be either a residual interest or a regular

interest.

A. Variable Rates

Section 860G(a)(1)(B)(i) requires that any interest payments on a

regular interest be payable based on a fixed rate, or on a variable

rate to the extent provided in regulations. Regulations providing

guidance under section 860G(a)(1)(B)(i) are included in a comprehensive

set of final regulations relating to REMICs (the 1992 REMIC

regulations), which was published in the Federal Register for December

24, 1992 (57 FR 61293).

The 1992 REMIC regulations use a building-block approach to

describe the permitted variable rates under section 860G(a)(1)(B)(i). A

taxpayer must start with one permitted variable rate as a base and, if

desired, may subject the rate to additions, subtractions,

multiplications, caps, and floors. Under Sec. 1.860G-1(a)(3)(i) of the

1992 REMIC regulations, a permitted variable rate includes a rate that

is a qualifying variable rate for purposes of sections 1271 through

1275 and the related regulations.

[[Page 42786]]

Notice 93-11, 1993-1 C.B. 298, addresses the application of the

term qualifying variable rate. The notice provides that a qualified

floating rate set at a current value (as defined in proposed

regulations under section 1275 (FI-189-84)) is a qualifying variable

rate for purposes of Sec. 1.860G-1(a)(3)(i) of the 1992 REMIC

regulations. Notice 93-11 also states that the 1992 REMIC regulations

will be amended to conform to the language of the final section 1275

regulations when those regulations become effective. After the section

1275 regulations were revised and published in final form in the

Federal Register for February 2, 1994 (59 FR 4799, 4827), the temporary

regulations (TD 8534) and the proposed regulations (FI-10-94) were

issued to conform Sec. 1.860G-1(a)(3)(i) of the 1992 REMIC regulations

to the final section 1275 regulations.

The final section 1275 regulations define two types of variable

rates. Section 1.1275-5(b) defines a qualified floating rate, and

Sec. 1.1275-5(c) defines an objective rate. Under proposed Sec. 1.860G-

1(a)(3)(i) and Sec. 1.860G-1T(a), permitted variable rates for regular

interests in REMICs include a qualified floating rate. Objective rates,

however, are not permitted.

One commentator proposes that the final version of Sec. 1.860G-

1(a)(3)(i) be expanded to include as a permitted variable rate any

objective rate that relates to one or more debt instruments (excluding

any debt instrument that provides for payments measured in substantial

part by reference to the value of property other than debt

instruments). This would allow, for example, a rate equal to the total

rate of return on a bond, or group of bonds.

Many objective rates reflect the returns on equities and

commodities. The IRS and Treasury believe that proposed Sec. 1.860G-

1(a)(3)(i) draws a sensible and necessary line between rates tied to

interest rates (that is, qualified floating rates), and rates tied to

commodities and equities. Moreover, the building-block approach adopted

by the 1992 REMIC regulations affords taxpayers considerable

flexibility to devise permitted variable rates, and the building-block

approach would continue to apply after adoption of the proposed

regulations. The rule in the temporary and proposed regulations,

therefore, is retained in the final regulations under Sec. 1.860G-

1(a)(3)(i).

Retaining Sec. 1.860G-1(a)(3)(i) as proposed affects a cross

reference contained in Sec. 1.860G-1(a)(3)(ii)(A). Commentators suggest

revising Sec. 1.860G-1(a)(3)(ii)(A) to modify the restrictions imposed

by the cross reference in that section to Sec. 1.860G-1(a)(3), which

reference incorporates proposed Sec. 1.860G-1(a)(3)(i). Section 1.860G-

1(a)(3)(ii)(A) permits a REMIC regular interest to have an interest

rate based on a weighted average of the interest rates on some or all

of the mortgages held by the REMIC (a passthrough rate). A mortgage

taken into account in determining a passthrough rate (an underlying

mortgage) must itself have a fixed rate or a permitted variable rate.

Accordingly, a mortgage based on a qualified floating rate may be used

to determine a passthrough rate but the underlying mortgage must

conform to proposed Sec. 1.860G-1(a)(3)(i). This means the qualified

floating rate must be set at a current value. A qualified floating rate

is not set at a current value if it is set more than 3 months before

the start of the related accrual period on the underlying mortgage. The

commentators suggest loan servicers may need more than 3 months to

compute revised interest and payment amounts and to tell borrowers of

those revised amounts. Thus, according to the commentators, the 3-month

period should be extended.

As noted above, the IRS and Treasury believe proposed Sec. 1.860G-

1(a)(3)(i) sensibly distinguishes interest rate returns from other

types of returns. For regular interests having a passthrough rate to

reflect this distinction, any underlying mortgage based on a qualified

floating rate that is used to determine the passthrough rate must also

reflect this distinction. Thus, any underlying mortgage bearing

interest at a qualified floating rate must have the rate set at a

current value. Otherwise, proposed Sec. 1.860G-1(a)(3)(i) could be

circumvented merely by creating a passthrough rate based on underlying

mortgages bearing qualified floating rates not set at current values.

Moreover, the ability of servicers to take more time to calculate

revised rates and to notify borrowers of those rates appears to be

limited by the Truth in Lending Act and Regulation Z (12 CFR Ch. 11

Sec. 226.20(c) (1995)), which require notice, within prescribed time

periods, to a consumer of changes in a rate. Thus, this comment is not

adopted here.

B. Specified Portions

Under section 860G(a)(1)(B)(ii), interest payments on a regular

interest in a REMIC may also consist of a specified portion of the

interest payments on the qualified mortgages held by the REMIC,

provided the specified portion does not vary while the regular interest

is outstanding. A specified portion regular interest is sometimes

called an Interest Only regular interest or IO. The 1992 REMIC

regulations identify the specified portions permitted under section

860G(a)(1)(B)(ii).

Requests for further guidance prompted the publication of the

proposed regulations addressing specified portions. Taxpayers requested

the IRS clarify that a REMIC may issue an IO that is expressed as a

percentage of the interest payable on an IO acquired from another REMIC

(a collateral IO). In response, the notice of proposed rulemaking (FI-

10-94) would add Sec. 1.860G-1(a)(2)(i)(D), under which the cash flows

from a collateral IO issued by one REMIC can be proportionately divided

through another REMIC. The proposed provision would negate the need for

any other arrangement such as a grantor trust and would apply whether

the collateral IO is acquired on formation by a related upper-tier

REMIC or after formation by an unrelated REMIC (a re-REMIC

transaction).

According to one commentator, the addition of Sec. 1.860G-

1(a)(2)(i)(D) implies that more complex re-REMIC transactions are not

allowed. According to another commentator, the language of the proposed

rule implies that all qualified mortgages held by the REMIC must be IO

regular interests. To remove both of those implications, the proposed

rule is adopted in revised form, which appears as Sec. 1.860G-

1(a)(2)(v).

C. Other Comments

Commentators also addressed other REMIC regulations not affected by

this Treasury decision. Those comments may be considered in future

guidance projects.

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 Feiring, Office of Assistant Chief Counsel (Financial

Institutions and Products), and Carol A. Schwartz, formerly of that

office. However, other personnel from the IRS and

[[Page 42787]]

Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

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

removing the entry for ``Section 1.860G-1T'' to read in part as

follows:

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

Par. 2. Section 1.860A-0 is amended by:

1. Adding entries for Sec. 1.860A-1(b)(4).

2. Revising the entry for Sec. 1.860G-1(a)(2)(v).

3. Adding an entry for Sec. 1.860G-1(a)(2)(vi).

4. Revising the entry for Sec. 1.860G-1(a)(3)(i).

The additions and revisions read as follows:

Sec. 1.860A-0 Outline of REMIC provisions.

* * * * *

Sec. 1.860A-1 Effective dates and transition rules.

* * * * *

(b) * * *

(4) Rate based on current interest rate.

(i) In general.

(ii) Rate based on index.

(iii) Transition obligations.

* * * * *

Sec. 1.860G-1 Definition of regular and residual interests.

(a) * * *

(2) * * *

(v) Specified portion includes portion of interest payable on

regular interest.

(vi) Examples.

(3) * * *

(i) Rate based on current interest rate.

* * * * *

Par. 3. In Sec. 1.860A-1, paragraph (b)(4) is added to read as

follows:

Sec. 1.860A-1 Effective dates and transition rules.

* * * * *

(b) * * *

(4) Rate based on current interest rate--(i) In general. Section

1.860G-1(a)(3)(i) applies to obligations (other than transition

obligations described in paragraph (b)(4)(iii) of this section)

intended to qualify as regular interests that are issued on or after

April 4, 1994.

(ii) Rate based on index. Section 1.860G-1(a)(3)(i) (as contained

in 26 CFR part 1 revised as of April 1, 1994) applies to obligations

intended to qualify as regular interests that--

(A) Are issued by a qualified entity (as defined in Sec. 1.860D-

1(c)(3)) whose startup date (as defined in section 860G(a)(9) and

Sec. 1.860G-2(k)) is on or after November 12, 1991; and

(B) Are either--

(1) Issued before April 4, 1994; or

(2) Transition obligations described in paragraph (b)(4)(iii) of

this section.

(iii) Transition obligations. Obligations are described in this

paragraph (b)(4)(iii) if--

(A) The terms of the obligations and the prices at which the

obligations are offered are fixed before April 4, 1994; and

(B) On or before June 1, 1994, a substantial portion of the

obligations are transferred, with the terms and at the prices that are

fixed before April 4, 1994, to investors who are unrelated to the

REMIC's sponsor at the time of the transfer.

Par. 4. Section 1.860G-1 is amended by:

1. Redesignating paragraph (a)(2)(v) as paragraph (a)(2)(vi).

2. Adding a new paragraph (a)(2)(v).

3. Revising paragraph (a)(3)(i).

The addition and revisions read as follows:

Sec. 1.860G-1 Definition of regular and residual interests.

(a) * * *

(2) * * *

(v) Specified portion includes portion of interest payable on

regular interest. (A) The specified portions that meet the requirements

of paragraph (a)(2)(i) of this section include a specified portion that

can be expressed as a fixed percentage of the interest that is payable

on some or all of the qualified mortgages where--

(1) Each of those qualified mortgages is a regular interest issued

by another REMIC; and

(2) With respect to that REMIC in which it is a regular interest,

each of those regular interests bears interest that can be expressed as

a specified portion as described in paragraph (a)(2)(i)(A), (B), or (C)

of this section.

(B) See Sec. 1.860A-1(a) for the effective date of this paragraph

(a)(2)(v).

* * * * *

(3) * * *

(i) Rate based on current interest rate. A qualified floating rate

as defined in Sec. 1.1275-5(b)(1) (but without the application of

paragraph (b)(2) or (3) of that section) set at a current value, as

defined in Sec. 1.1275-5(a)(4), is a variable rate. In addition, a rate

equal to the highest, lowest, or average of two or more qualified

floating rates is a variable rate. For example, a rate based on the

average cost of funds of one or more financial institutions is a

variable rate.

* * * * *

Sec. 1.860G-1T [Removed]

Par. 5. Section 1.860G-1T is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: July 31, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-20319 Filed 8-16-95; 8:45 am]

BILLING CODE 4830-01-U