WASHINGTON -- Interest earned on some tax-exempt bonds that are secured by mortgages could be taxed under one interpretation of provisions of the Tax Reform Act of 1986 that go into effect on Jan. 1, several bond lawyers cautioned this week.
Section 7701(i) of the tax code was enacted to apply to "taxable mortgage pools" but now could be read as being broader than Congress intended, they said.
Taken to the extreme, its provisions could require the taxation of mortgage payments and interest earnings for any new mortgage-backed, taxable or tax-exempt serialized bonds, the proceeds of which are lent to more than one borrower, the lawyers said, although most cautioned against overreaction.
These could include single-family mortgage bonds, multifamily housing, nonprofit health care, and college issues, as well as private-activity bonds or others in pooled financings. Such double taxation could eliminate the tax exemption of bonds sold as tax-exempt and trigger defaults of tax-exempt or taxable bonds if the after-tax mortgage payments are insufficient to meet debt service, they said.
But the bond lawyers, most of whom have only recently focused on them, and one issuer said there may not be any major market impact from the provisions, which were enacted along with real estate mortgage investment conduit requirements in 1986.
"We don't think it's a problem that people need to seriously worry about. Clearly, the intention of the Remic law was to regulate the market for taxable mortgage pass-throughs and was never intended to affect public securities in the form of mortgage revenue bonds," said John T. McEvoy, executive director of the National Council of State Housing Agencies.
Mr. McEvoy said he hoped concerns about the provisions would be resolved by bond lawyers in their tax opinions on such deals or through guidance from the Treasury Department or the IRS. Most bond lawyers said they hope IRS officials will clarify that the provisions are not intended to adversely affect the municipal market.
"This is going to come as a surprise to a lot of people," said George Wolf, a lawyer with Orrick, Herrington & Sutcliffe in San Francisco." But it should not be a problem if it's correctly interpreted."
"I would hope that reasonable people would conclude that 770I(i) does not apply to the tax-exempt area," said William H. McBride, a partner at Hunton & Williams in Raleigh. "But it certainly would be nice to have something from the service confirming that it is not a problem, at least for tax-exempts, and hopefully for taxable bonds, too."
IRS officials said they are aware of the potential problem and have asked the lawyers and others with concerns about the provisions to provide more information and to recommend possible remedies.
One agency official, however, said that even if a clarificaiton is issued, it will not be before January, possibly causing problems for bond lawyers who must give unqualified opinions on such deals.
The provisions, which are supposed to ensure that most mortgage-backed securities are issued by Remics, or real estate mortgage investment conduits, and are specially taxed, state that all other such issuers will be defined as "taxable mortgage pools" and taxed like separate, stand-alone corporations.
The problem, said the lawyers, is that the provisions' definition of taxable mortgage pools is so broad, it can be read to include any taxable or tax-exempt serialized obligations that are backed by mortgages and benefit more than one borrower.
Specifically, the provisions define a taxable mortgage pool as any entity that has assets that are mostly debt obligations, at least 50% of which are backed by real estate mortgages; that is the obligor of debt obligations with two or more maturities; and whose debt obligations' payments bear a relationship to the mortgage payments.
While Congress enacted the provisions in 1986, they delayed their effective date to make sure the Remic requirements would work.
"I've known about this rule since 1986. But it wasn't a problem until now," said Mr. Wolf. Most of the lawyers said most issuers are not even aware of the provisions.
Dale S. Collinson, a partner with the law firm of Willkie, Farr & Gallagher in New York City, tried recently to get the congressional Joint Tax Committee to support a proposed amendment that could be added to tax legislation to clarify that the provisions were not intended to hurt the tax-exempt bond market. But committee aides told Mr. Collinson it was too late in the congressional session to explore the issue.
Mr. Collinson and other bond lawyers have now turned to the IRS and Treasury Department for such a clarification. "We know that Treasury is sympathetic to our concerns and that they will entertain suggestions as to how to fix" the provisions, said Mr. Wolf.
One poasible source of relief, according to the lawyers said, is Section 115 of the tax code, which says income will not be taxed if it is "derived from any public utility" or results from an "essential government function" and is "accruing to a state or any political subdivision."
But Mr. McBride said, "It's not clear whether the entity hypothesized in 7701(i) would qualify for being exempt from federal taxation under 115."
Mr. Collinson agreed that existing tax law may not provide relief. "Everybody assumes that state housing authorities are not subject to federal taxation. But these provisions create something that hasn't existed before -- a taxable mortgage pool -- and taxes it as a separate corporation," he said.