Accounting for originated mortgage servicing rights.

• Author: O'Connell, Frank J., Jr.

A commercial bank often sells mortgages it originated, while retaining the servicing rights. The bank continues to collect the mortgage payment, and provides statements and other services to and from the borrower for a prearranged fee.

For financial reporting purposes, the bank records originated mortgage servicing rights in accordance with Statement of Financial Accounting Standards No. 140 (FAS 140). Under FAS 140, the bank recognizes a servicing fee (i.e., income) at the time of the sale for the right to service mortgages or other loans it sold. The servicing fee is normally expressed as a percentage of the principal balance of the outstanding loans and is collected over the life of the loans as payments are received. The income recognition creates an asset, amortized as an expense, over the life of the loans for which the bank retains the servicing rights. This method shifts income to the time of sale; the future cashflow from servicing the loans that constitutes income to the bank is offset by amortization of the originated mortgage servicing asset that had been created when the loans were sold.

In Rev. Rul. 91-46, the IRS described the manner in which the amounts received under a mortgage-servicing contract should be reported for tax purposes. The Service also issued Rev. Proc. 91-51, containing rules that require taxpayers to change their accounting method to comply with Rev. Rul. 91-46 and Rev. Proc. 91-50, to provide safe harbors for applying Sec. 1286 to taxpayers who sell mortgages and contract to service them.

Rev. Rul. 91-46 indicated that amounts received under a mortgage-servicing contract were interest payments for stripped bonds if (1) the amounts exceeded reasonable compensation for services and (2) the mortgages were sold at the time the mortgage-servicing contract was entered into. Mortgage lenders that sell mortgage loans and at the same time enter into contracts to service the mortgages for the buyer would be subject to the "stripped bond" rules described in Sec. 1286, if their fee exceeds reasonable compensation for servicing. The excess amount retained over reasonable compensation that the bank has the right to receive from interest payments collected on the mortgages would be treated as a "stripped coupon" under Sec. 1286. Sec. 1286 requires the purchaser to treat the purchased mortgages as a bond with an original issue discount equal to the excess of the stated redemption price at maturity over the bond's ratable...