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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Saturday, November 24, 2012

Fleischer: A Tax Crackdown Is Not Needed on Mortgage-Backed Securities

NY Times DealBookNew York Times DealBook:  Why a Tax Crackdown Is Not Needed on Mortgage-Backed Securities, by Victor Fleischer (Colorado):

Capitol Hill is poking around for tax revenue. One sleeping dog to let lie is the tax treatment of real estate mortgage investment conduits, or Remics.

These are the tax plumbing that allows the modern mortgage market to function. Most residential mortgages in the United States are securitized. This means that, as a method of financing the mortgages they originate, banks bundle together mortgages and sell them to a trust. The trust then issues securities to investors. The securities are backed by the mortgages held by the trust. The Remic rules allow the trust to be treated as a pass-through entity for tax purposes, avoiding the corporate tax in the same way that a mutual fund, pension fund or other investment conduit avoids an extra level of tax.

That is the theory. The collapse of the mortgage-backed securities market a few years ago exposed systematic failures in the transfer of title from the originator of the mortgages to the trusts. ...

Two professors at Brooklyn Law School, Bradley T. Borden and David J. Reiss, have argued that many purported Remics may not in fact qualify as such [Wall Street Rules Applied to REMIC Classification]. In many cases, they explain, mortgage originators failed to legally transfer mortgages into the trust. Instead, they argue, the failed Remics were probably taxable mortgage pools or perhaps publicly traded partnerships. This means that Remic investors would be subject to additional taxes and penalties.

The IRS began a review of the tax status of Remics last year, but it is unclear whether additional enforcement action is forthcoming. Mr. Borden and Mr. Reiss attribute this apparent nonenforcement to the so-called Wall Street Rule, part of the lore among tax lawyers that holds that after X million dollars of securities have been issued (and no one knows exactly what X is) and enough tax lawyers take the same position, the IRS will not intervene and blow up the deals.

What should the IRS do? Tax liability would probably fall on investors, who might then turn around and sue the mortgage originators, servicers, law firms and other intermediaries, further gumming up the market for mortgage-backed securities.

The Wall Street Rule is objectionable from a tax policy perspective when aggressive tax lawyers sanction a deal structure that contravenes the rules, or one that resides in a gray area but is contrary to what Congress intended.

I do not think that is the case here. The Remic rules are designed to prevent operating companies from avoiding the corporate tax. Banks and other financial institutions that originate mortgages should pay the corporate tax. Passive conduits should not. The lawyers failed here because they relied too quickly on a client’s representations about the status of mortgages in the trust, not because they were overly aggressive in their interpretation of the Internal Revenue Code.

Instead of going after old, failed Remics, additional IRS resources would be better put to use in policing the rules going forward for all types of securitization vehicles.

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