On October 11, 2007, Internal Revenue Service (“IRS”) officials disclosed that the IRS has initiated a compliance project targeted at REMIC sponsors who purportedly have misinterpreted or disregarded the applicable tax rules. According to these officials, the amount of underreported income associated with REMIC securitizations could be “staggering,” potentially running into the hundreds of billions of dollars. One IRS official indicated that more than 23,000 REMIC related returns have been sent to the IRS’s Office of Tax Shelter Analysis for scanning and review. It is anticipated that the scanned returns ultimately will be sent to IRS field agents for the purpose of initiating audits of the applicable REMIC sponsors.

The focus of the IRS compliance project is the purported undervaluation by REMIC sponsors of retained regular interest classes, particularly those in the “first-loss” position. IRS officials allege that some REMIC sponsors have systematically undervalued these retained classes by basing their value on unreasonable or clearly erroneous assumptions, including using projected mortgage default rates that are well above historical averages and unreasonably high discount rates. Undervaluation of retained classes would defer taxable gain or, in some circumstances, produce a phantom tax loss for the REMIC sponsor.

In addition, IRS officials indicated that some REMIC sponsors are not properly reporting income and original issue discount income with respect to retained REMIC regular interest classes. Under current reporting rules, REMICs are not required to provide information returns to institutional holders of REMIC regular interests, including brokers, financial institutions and corporations. The IRS officials suggested that enhanced REMIC reporting obligations could be included in a future tax gap legislative package. IRS officials also indicated that their analysis of REMIC returns has uncovered some taxpayers who are not reporting Schedule Q excess inclusion income generated by the Class R or non-economic REMIC residual interest.