When the Internal Revenue Service publishes final regulations on real estate mortgage investment conduits, investors who has hoped for greater flexibility will probably be disappointed.
"What I hoped they would develop is something other than the cookbook they published as proposed regulations," said Donald B. Susswein, partner in the Washington law firm of Thacher, Proffitt & Wood.
But, according to one of the authors of the rules, the final version will look a lot like the regulations proposed in September 1991.
"We made very, very few changes and none that were dramatic," said Thomas J. Lynden, a lawyer who is now a lawyer with the National Tax Practice of KPMG Peat Marwick in Washington.
Susswein said the proposed version was too specific to the type of security issued through a Remic. The attorney said new variations of Remic securities are constantly being developed.
The final regulators will be published late this year or early next.
A Remic is a pass-through vehicle created by the Tax Reform Act of 1986 to issue multiclass mortgage-backed securities. It may be organized as a corporation, partnership, trust or any other entity meeting certain qualifications. Interest in Remics may be "regular" (debt interests) or residual (equity interests).
Remic are generally structured with a residual piece that picks up excess cash flows, which, as income, accrue some tax liability. The so-called "phantom income" or, in IRS parlance, "excess inclusive income," is often not enough to pay the tax liability on the residual.
The proposed rules would ensure that residuals are structured and purchased for economic reasons and not simply to avoid taxes.
Tax avoidance, the IRS believes, would be prevented is there is more cash flow into the residuals.
The regulations make it clear that excess inclusion, which is the specific portion of income that is allocated to a residual interest, is subject to taxes.
While thrifts would be exempt from this rule, all other holders of residuals are not allowed to offset excess inclusion income with allowable tax deductions.
At the end of each quarter, a residual interest holder would be required to take into account its daily portion of the Remic's income or loss for each day the holders holds its interest.
The daily portion of the Remic's income is to be determined quarterly and allocated ratably among the days in the quarter.
Generally, a Remic determines its taxable income or loss as though it were an individual using the accrual accounting method. But the regulations will create several exceptions, enabling a Remic to deduct interest expense without regard to the limitations imposed by current tax rules on net investment income.
