While servicers quickly focused on the impact of the tax rules for mortgage servicing laid down last year by the Internal Revenue Service, many did not realize that the rules have a major effect on purchasers of servicing rights from loan originators.

"I think it has been one of those IRS rulings that people have been slow in understanding," said John S. Hopkins, president of a Bethesda, Md., firm that specializes in the sale and acquisition of mortgage servicing rights.

While the new tax burden faced by both owners and purchasers of mortgager servicing rights tends to reduce the value of the rights, Hopkins said the effect thus far has been minor.

Prior to the announcement of this new rule, many purchasers used the economic forecast method to amortize the costs of purchased servicing. This method results in an accelerated amortization and a period shorter than the actual life of the mortgages. Now, however, the subsequent purchaser will be using two methods to amortize its purchase price. The normal servicing will continue to be amortized under the economic forecast method, while the excess servicing piece will use the original issue discount (OID) rules. The amortization under the OID rules will be slower than the amortization under the economic forecast method, thus lengthening the period necessary for the subsequent purchaser to recover its costs. This will likely mean that purchasers will be forced to reduce the price they are willing to pay for such servicing.

The effect of this new rule on the originator is significant. The allocation of part of the mortgage's basis to the excess servicing will result in a taxable gain on the sale even if the mortgage is sold at par.

Thus the originator will have to pay tax on a gain for which it receives no cash. The originator will, of course, pay less tax on the income from the servicing contract, since it will not be taxed on the portion of the excess servicing income it receives that represents the amortization of its basis.

While the total tax to be paid over the life of the servicing contract has not changed, the requirement that a portion of the tax be paid up front, before any income has been received, means that a portion of the originator's capital must be used for paying taxes rather than for new originations.

Though most services are expected to grudgingly accept the IRS ruling last summer setting safe harbors for defining excess servicing, there are some taxpayers who are considering a legal fight over the issue.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.