Distressed Debt in REMICs Panelists James Gouwar Bingham McCutchen LLP David Nirenberg Ashurst LLP John Rogers IRS Office of Chief Counsel (FIP)* *These slides should not be interpreted as reflecting the views of the IRS Office of Chief Counsel REMIC Overview Enacted as part of 1986 Tax Reform Act Designed to hold a static pool of mortgage loans and issue multiple classes of securities Can issue multiple regular interests, but only single residual interest Residual interest does not need to be entitled to any distributions; it exists to absorb timing differences between net income on the collateral held by the REMIC and income accrued by the regular interests 1
Relevant REMIC Rules A residual holder in a REMIC takes into account its daily portion of a REMIC s taxable income. Section 860C(a) REMIC regular interests are treated as debt regardless of form. Section 860B(a) All income and loss flowing through a REMIC to a residual holder is ordinary. See Treas. Reg. 1.860C-2(a)(all assets ordinary) All debt owed to a REMIC is treated as business debt. Treas. Reg. 1.860C-2(b)(3) A REMIC must use a prepayment assumption to calculate OID, market discount and premium inclusions or amortizations for both its assets and its regular interests. Section 1272(a)(6) REMIC s basis in its assets contributed by sponsor is equal to aggregate issue price of all its regular and residual interests. Treas. Reg. 1.860F-2(c) Relevant COD Concepts In the absence of an actual repayment or purchase of debt, cancellation of debt occurs when it becomes clear that the debt will not be repaid Under Centennial Savings v. Comm r, a debtor may not realize cancellation of debt (COD) subject to section 108 exclusions if the cancellation occurs pursuant to terms agreed to at the outset of the debtor-creditor relationship. Under Section 108, COD is excludable from income if debtor is insolvent or bankrupt, but tax attribute reduction required, which, if applicable to REMIC, would require basis reduction in remaining assets. 2
REMIC formed to hold Distressed Mortgage Debt Residential mortgage loans are bearer obligations Interest paid to investors in residential mortgage loans can qualify as exempt from withholding under portfolio interest rules if held through a REMIC or a grantor trust. See Treas. Reg. 1.871-14(d) Use of REMIC avoids grantor trust issues (prohibition on varying investments) related to modifying mortgage loans Foreclosure property (REO or real estate owned) from loan acquired distressed problematic for a REMIC. See Section 860G(a)(8), Treas. Reg. 1.856-6(b)(3) Timing Issues When a REMIC suffers a loss on a loan there is a corresponding reduction in future cash flow to a REMIC regular interest. Subordinate Interest Issued at a Discount IO interest entitled that functions as economic residual Tiered Structures 3
IO Regular Interest Accrue all income under OID rules (all cash flow included in stated redemption price) At least four possibilities for When REMIC has COD from a loss reducing an IO s cash flow When AIP exceeds PV of future flows (no negative OID concept) When AIP exceeds aggregate value of future flows using prepayment assumption When AIP exceeds aggregate value of future flows using no prepayment assumption When no future flows remain Subordinate Interest If AIP of subordinate interest is less than par, then a loss on a loan creates greater loss for REMIC than COD from reduction of principal balance of subordinate interest. 4
REMIC s Basis in its Assets Not clear how basis allocated to assets held by REMIC if basis isn t allocated essentially to entire pool. FMV Principal Balance PV of future cashflow Prepayment Assumption assumes how much principal will be received each month from pool, not from particular loan Largely doesn t matter until loans are modified Income from modification is function of basis in a particular loan Should modifications be examined only from mass asset theory for REMIC? Gain Recognition from Loan Modification Basis of individual loan needs to be determined. Section 1274 generally would cause issue price of modified loan to be par query recent sale of loan (within prior six months) would result in FMV issue price as potentially abusive situation could installment sales treatment under Section 453 apply. 5
REMIC Regular Interest Not a security under Section 165(g)(2)(C) Not issued by corporation or government entity Holder Loss covered by Bad Debt rules of Section 166 Partially worthless requires charge off on books and records Short term capital loss for non-corporate holders unless business bad debt 6