The IRS recently issued a second private letter ruling (the “New PLR”) concluding that the excess servicingspread portion of a mortgage servicing right (an “Excess IO”) is a qualifying asset for the REIT 75% assettest and produces qualifying income for the REIT 75% gross income test. In the New PLR, the REITproposes to acquire the Excess IOs from a taxable REIT subsidiary (a “TRS”), which will acquire the related mortgage servicing rights and will, through a subservicer, service the mortgage loans. The New PLR follows closely the analysis in a similar private letter ruling on Excess IOs issued last year (the “Old PLR”).
Unlike in the Old PLR, the REIT in the New PLR proposes to own the entire mortgage servicing right througha TRS and a qualified REIT subsidiary (a “QRS”), which is a disregarded entity for tax purposes. In theproposed transactions, the TRS will acquire the mortgage servicing rights on a portfolio of mortgage loansand will engage an unrelated third-party subservicer to service the mortgage loans. The TRS will retain thenormal servicing spread and, from that spread, will pay the subservicer its fee for servicing the mortgagesloans. The TRS will sell the Excess IO to the QRS at a fair market value price in an arm’s-length transaction.
Consistent with prior IRS guidance, the New PLR affirms that the Excess IO is the portion of the totalmortgage servicing fee in excess of reasonable compensation for the services performed and obligations undertaken by the servicer. The Excess IO is treated as an entitlement to a portion of the interest paid on theunderlying mortgage loans, rather than as a fee or compensation income. Because the Excess IO represents ownership of a portion of the underlying interest coupon on the underlying mortgages, it is a qualifying asset and generates qualifying income for purposes of the REIT income and asset tests.
The New PLR confirms that the activities of the REIT’s TRS will not cause the REIT to be treated asservicing the related mortgage loans. That conclusion is consistent with the general treatment of a TRS,which can typically engage in activities that are not REIT-compliant without affecting the tax status of itsparent REIT.
We have broad experience representing both servicers and investors concerning Excess IOs, mortgage servicing fees and rights, and REITs. If you would like more information about the New PLR or its analysis orconclusions, please contact any of the attorneys listed on this alert.