Exclusive: IRS weighs tax penalties on mortgage securities
WASHINGTON (Reuters) - The Internal Revenue Service has launched a review of the tax-exempt status of a widely-held form of mortgage-backed securities called REMICs.
The IRS confirmed to Reuters that the review comes in response to mounting evidence that banks violated tax requirements by mishandling the transfer of mortgages to REMICs, short for Real Estate Mortgage Conduits.
Should the IRS find reason to take tough action, the financial impact could be enormous. REMIC investments are held by pension funds, in individual retirement plans such as 401(k)s and by state and local government entities.
As of the end of 2010, investments in REMICs totaled more than $3 trillion, according to data supplied by the Securities Industry and Financial Markets Association.
In a brief statement in response to questions from Reuters, the agency said: "The IRS is aware of questions in the market regarding REMICs and proper ownership of the underlying mortgages as set out in federal tax law, and is actively reviewing certain aspects of this issue."
The statement said the IRS would not make any further comment. An IRS spokesman declined to say anything about the extent of the review, or whether the agency is likely to take action.
The review, however, is a sign that the widespread bank misdeeds in home foreclosure cases are spilling over to threaten the interests of investors in mortgage-backed securities. The banks originated the mortgages and packaged them into securities.
These banks' transgressions, confirmed in court decisions and through recent action by federal bank regulators, include the failure to formally transfer ownership of mortgages to the trusts that invested in them and the subsequent creation of fraudulent mortgage assignments and other false documents.
These investment trusts already have suffered big drops in income because of vast numbers of mortgage defaults after the housing boom collapse. They have been hurt too because in an increasing number of instances they have been blocked by courts from foreclosing on defaulted mortgages. The courts ruled that because the trusts never received the required documents establishing that they owned the mortgages, they have no standing to foreclose.
PROFITS AT STAKE
For investors, one of the big attractions of REMICs has been that they aren't "double-taxed." While individual investors pay taxes on income they receive from REMICs, the securities themselves are exempt from business income tax.
But if the IRS concludes that the REMIC investments failed to comply with strict requirements in the federal tax code, the REMIC would have to pay a 100 percent tax on the income from those investments.
That means that the IRS could confiscate the full amount. Tax law experts said the REMICs also could be subjected to additional penalties for failing to file tax returns on the income.
James Peaslee, a partner at law firm Cleary Gottlieb who is an expert on taxation of securitized investments, said that even if the IRS finds wrongdoing, it might be loath to act because of the wide financial damage the penalties would cause. He notes that the REMIC investors, who he called "innocent parties," would have to pay rather than the banks that were responsible for any wrongdoing in transferring mortgage ownership.
But Adam Levitin, a Georgetown University Law School professor and expert on taxation, said that if the IRS fails to act, "it would be a backdoor bailout of the financial system."
If the IRS did impose penalties, the REMICs could turn around and sue the banks for causing the problems and not living up to the terms of the agreements establishing each REMIC, thus transferring the costs to the banks. If the IRS finds wrongdoing but fails to act, the IRS would forego "potentially enormous tax revenue that would be passed on to the federal government," Levitin said. "Given the federal budget deficit that's not something to sniff at," he added.
At least for some REMICs, though, prospects for suing the banks may be limited. April Charney, a Florida legal aid attorney and leading expert on mortgage backed securities and foreclosures, said that the agreements establishing the REMICs specify strict time limits for investors to sue the banks for any deficiencies in turning over promised mortgages.
For the IRS, one of the main issues will be whether REMICs actually owned the mortgages from which they received income. If not, for tax purposes they wouldn't qualify as REMICs, and the income would become taxable.
The arcane tax rules governing REMICs tax rules require that all mortgages be transferred to them on the dates that they are formed. There is a 120-day grace period for correcting any errors, and after that the rules strictly forbid acquiring any additional mortgages. Levitin said the reason for this limitation is that REMICs are tax exempt because they are considered vehicles for passive, static investments. If they were to continue buying and selling mortgages they would be acting as ordinary businesses, which are required to pay income taxes.
Peaslee said that to date there haven't been any rulings by the U.S. Tax Court on what is required for REMICs to establish timely ownership of mortgages.
(Editing by Claudia Parsons and Jim Impoco)