Sale of mortgage loans with retained servicing rights.

• Author: Willis, James B.

Before Rev. Rul. 91-46 and Rev. Procs. 91-49, 91-50 and 91-51 were issued, most financial institutions did not currently recognize taxable income when they mortgages with retained servicing rights. The mortgages were considered to be sold at par (face value) which equaled their basis; thus, there was no gain or loss. Ordinary servicing fee income was recognized in future years as payments were collected.

However, Rev. Rul. 91-46 drastically changed the way financial institutions must report these types of loan sales. Under this ruling, when a loan is sold and the servicing rights are retained, the loan must be treated as a "stripped bond" under Sec. 1286(e)(2) and the "excess" servicing rights as "stripped coupons" under Sec. 1286(e)(3).

A portion of the loan's basis must be allocated to the "excess" servicing rights (the "stripped coupons"), based on relative fair market values. Consequently, the loan's basis is reduced, causing a taxable gain in the year of sale.

The basis allocated to the excess servicing rights is treated under Sec. 1286(a) as the purchase price of an original issue discount (OID) obligation. Accordingly, the difference between the total excess servicing rights ("the redemption price") and the allocated basis is OID.

Generally, the holder of an obligation must currently include in income the sum of the daily portions of any OID pursuant to Sec. 1272(a)(1). A corresponding deduction is allowed to the issuer under Sec. 163(e)(1).

OID is deemed to be zero if it is less than 0.25% of the obligation's stated redemption price at maturity multiplied by the number of complete years to maturity (Sec. 1273(a)(3)). This de minimis rule does not specifically apply to stripped bonds and stripped coupons that have OID because of Sec. 1286(a); nevertheless, Temp. Regs. Sec. 1.1286-1T(a) makes it clear that this de minimis rule applies.

For purposes of these calculations, "excess" servicing is defined as the amount received in excess of "normal" servicing. Rev. Proc. 91-50 provided "normal" servicing safe harbors that generally equal the industry's standards. For servicing one- to four-unit residential mortgages, the safe harbors are

--0.25% for a conventional fixed rate mortgage;

--0.44% for a mortgage less than one year old insured or guaranteed by the Federal Housing Administration, Veterans Administration or Farmers...