7694 / What is a “regular interest” issued by a REMIC? How is the owner of a regular interest taxed?

As a general rule, REMICs issue several classes of “regular” interests and a single class of “residual interests.” (See Q 7695 for a discussion of “residual interests.”) Regular interests are subject to federal income tax under the following rules.

An interest in a REMIC is a regular interest if it (1) was issued as a designated regular interest on the “startup day” selected by the REMIC, (2) unconditionally entitles the holder to a specified principal amount, and (3) provides for interest payments (if any) that (a) are based on a fixed rate, or, to the extent provided in regulations, at a variable rate, or (b) consist of a specified, unvarying portion of the interest payments on qualified mortgages.² See Notice 93-112 for the Service’s acceptance of a floating rate as a variable rate.³

Under regulations effective for most obligations issued on or after April 4, 1994, a variable rate includes a qualified floating rate as defined in Treasury Regulation Section 1.1275-5(b)(1). In addition, a rate equal to the highest, lowest, or average of two or more qualified floating rates is a variable rate for purposes of IRC Section 860G.

A REMIC may issue a regular interest that bears interest that can be expressed as a percentage of the interest payable on a specified portion of a regular interest acquired from another REMIC (sometimes called a specified portion regular interest or an “Interest Only” interest or “IO”). The Treasury Department and the Service are considering whether to issue regulations with respect to the tax treatment of REMIC IOs for issuers and initial- and secondary-market purchasers. An advance notice of proposed rulemaking was released in 2004 regarding the proper timing of income or deduction attributable to an “interest only” regular interest in a REMIC. The advance notice provided additional background information and set forth summary descriptions of possible approaches to the pertinent issues.⁴ Nothing has yet come of this project, however.

The timing (but not the amount) of the principal payment may be contingent on the extent of prepayment on mortgages and the amount of income from permitted investments.⁵ No minimum specified principal amount is required; it may be zero.⁶

Similar requirements apply if the interest is in the form of stock, a partnership interest, interest in a trust, or other form permitted under state law. If an interest is not in the form of debt, it must entitle the holder to a specified amount (even if it is zero) that would, if it were issued in debt form, be identified as the principal amount of the debt.⁷

A REMIC may issue regular interests that are subordinated to other classes of regular interests, which bear all or a disproportionate share of losses or expenses from cash flow shortfalls, such as losses from defaults or delinquencies on mortgages or other permitted investments.⁸

The Service has ruled that, in the event payments received from certain pre-existing interests were insufficient to distribute interest at the applicable stated rate on interests in a newly formed REMIC, a “funds-available” cap would not prevent the new interests from qualifying as regular interests under IRC Section 860G.⁹

Generally, holders of regular interests are taxed as if the interest were a debt instrument, except that holders must account for income from the interest using the accrual method of accounting (regardless of the accounting method otherwise used by the holder).¹⁰ Periodic payments of interest (or similar amounts) are treated as accruing pro rata between interest payment dates. Original issue discount on regular interests is includable as it accrues. Special rules apply to the determination of original issue discount on regular interests.¹¹ For proposed regulations issued in 2004 addressing the special rule for accruing original issue discount on certain REMIC regular interests, which provide for delayed payment periods of fewer than 32 days, see Proposed Treasury Regulation Section 1.1275-2(m).¹²

The IRC prohibits (with some exceptions) the indirect deduction through pass-through entities of amounts that would not be allowable as a deduction if paid or incurred directly by an individual.¹³ Under some circumstances (e.g., if the REMIC is substantially similar to an investment trust) holders of regular interests may be required under IRC Section 67(c) and regulations thereunder to include in income as interest an allocable share of certain investment expenses of the REMIC. Prior to 2018, the amount could be deducted as a miscellaneous itemized deduction if the holder itemized deductions; however, aggregate miscellaneous deductions were subject to a 2 percent floor (all of these miscellaneous itemized deductions were suspended for 2018-2025).¹⁴ No increase in basis was allowed for the amount passed through as miscellaneous expense even though it was included in income.¹⁵ See Q 733 regarding the treatment of miscellaneous itemized deductions.

The REMIC is required to report to regular interest holders amounts includable as interest and original discount and the allocable share of expenses.¹⁶ However, under regulations effective June 16, 2000, the requirement that REMIC issuers set forth certain “legending” information on the face of certificates when issued (i.e., the total amount of original issue discount on the instruments, the issue date, the rate at which interest is payable as of the issue date, and the yield to maturity) has been eliminated.¹⁷

On disposition, gain is ordinary income to the extent that it does not exceed the excess (if any) of (1) the interest the holder would have included in gross income if the yield on the regular interest were calculated at a rate of 110 percent of the applicable federal rate as of the beginning of the taxpayer’s holding period, over (2) the amount of interest actually includable in gross income by the taxpayer prior to disposition.¹⁸

Regular interests may be treated as market discount bonds (see Q 7643) if the revised issue price (within the meaning of IRC Section 1278) exceeds the holder’s basis in the interest. Market premium on a regular interest can be amortized currently. See Q 7654.

FASIT transfers to REMICS. The FASIT rules have been repealed.¹⁹ The amendments are generally effective on January 1, 2005.²⁰ The definitions of REMIC regular interests, qualified mortgages, and permitted investments have been modified so that certain types of real estate loans and loan pools can be transferred to, or purchased by, a REMIC. According to the Conference Committee Report, modifications to the present-law REMIC rules are intended to permit the use of REMICS by taxpayers that have relied on FASITs to securitize certain obligations secured by interests in real property.²¹