7695 / What is a "residual interest" issued by a REMIC? How is the owner of a residual interest taxed?

The holder of a residual interest takes into account his or her daily portion of the taxable income or net loss of the REMIC for each day that he or she held the interest during the taxable year.³ Any reasonable convention may be used to determine the holder’s daily portion of income or loss.⁴ This amount is treated as ordinary income or loss.⁵ Such income in excess of daily accruals of income on the issue price at 120 percent of the long-term federal rate is called “excess inclusions,” and a holder of a residual interest can in no event have a taxable income of less than his or her excess inclusions. In other words, they cannot be offset by any deductions.⁶

In addition, a REMIC must allocate to certain residual interest holders each calendar quarter a proportionate share of investment expenses paid or accrued for the quarter for which a deduction is allowed under IRC Section 212 to the REMIC: these holders are (1) individuals, (2) any other persons (such as a trust or estate) that compute taxable income in the same manner as an individual, and (3) certain pass-through entities (such as partnerships, S corporations, and grantor trusts) having as a partner, shareholder, beneficiary, participant, or interest holder (x) an individual, (y) a person who computes taxable income in the same manner as an individual, or (z) a pass-through entity. Such a residual interest holder must include in income his or her allocable share of these expenses. Prior to 2018, a residual interest holder was permitted to deduct them as miscellaneous itemized expenses subject to the 2 percent floor (these deductions have been suspended for 2018-2025).⁷

Distributions from a REMIC are not included in gross income by the holder unless they exceed his or her adjusted basis in the interest. To the extent distributions exceed the holder’s basis, the excess is treated as gain from sale of the residual interest.⁸ The amount of net loss that may be taken into account by the holder with respect to any calendar quarter is limited to the adjusted basis of the interest as of the close of the quarter. Disallowed loss may be carried over indefinitely in succeeding quarters.⁹

The adjusted basis of a residual interest is increased by the amount of taxable income of the REMIC taken into account by the holder; it is decreased (not below zero) by the amount of distributions and by any net loss taken into account.¹⁰ However, no increase in the holder’s basis is allowed for the amount of miscellaneous expenses allocated to the holder and included in his or her income.¹¹

With certain exceptions, a REMIC’s taxable income, for purposes of determining the amount includable by holders of residual interests, is determined in the same manner as for individuals, using a calendar year and using the accrual method of accounting.¹²

The Service privately ruled that whether a holder is liable for taxes associated with a noneconomic REMIC residual interest depends on the facts and circumstances associated with the transfer of the interest.¹³

The REMIC is required to provide information quarterly (on Schedule Q) to holders of residual interests regarding their share of income or loss, the amount of excess inclusion, and allocable investment expenses.¹⁴

For purposes of the wash sale rules (see Q 7537), a residual interest in a REMIC is treated as a security and, except as provided in regulations, such a residual interest and an interest in a “taxable mortgage pool” are treated as substantially identical stock or securities. Furthermore, the 30-day period in the wash sale rules is enlarged to six months in applying it to such interests. (For this purpose, the definition of a taxable mortgage pool is treated as if in effect in tax years beginning after 1986.)¹⁵

The Service released regulations in 2002 relating to safe harbor transfers of noneconomic REMIC residual interests in REMICs. The regulations provide additional limitations on the circumstances under which transferors may claim safe harbor treatment.¹⁶

The Service also issued regulations in 2008 relating to income associated with a residual interest in a REMIC that is allocated through certain entities to foreign persons who have invested in those entities.¹⁷

If a charitable remainder trust (CRT—see Q 8079, Q 8088, and Q 8089) is a partner in a partnership or a shareholder in a real estate investment trust (REIT—see Q 7975), and if the partnership or the REIT has excess inclusion income from holding a residual interest in a REMIC, the Service has ruled that: (1) the excess inclusion income allocated to a CRT is not unrelated business taxable income (UBTI) to the CRT and, thus, does not affect the CRT’s tax exemption for the taxable year; (2) a CRT is a disqualified organization for purposes of IRC Section 860E; and (3) a pass-through entity that has excess inclusion income allocable to a CRT is subject to the pass-through entity tax under IRC Section 860E(e)(6)(A).¹⁸ In a legal memorandum, the Service concluded that, in general, a holder of a residual interest in a REMIC may not offset excess inclusion income by an otherwise allowable charitable contribution deduction.¹⁹

In 2006, the Service provided interim guidance relating to excess inclusion income of pass-through entities, particularly real estate investment trusts. See Q 7975. The interim guidance applies to excess inclusion income from REMIC residual interests (and REIT taxable mortgage pools), whether received directly or allocated from another pass-through entity.²⁰