Tax Aspects of REMIC Residual Interests

Abstract

With the creation in 1986 of the "real estate mortgage investment conduit" (REMIC), there came into existence a new type of financial instrument, the REMIC residual interest, the economics and tax treatment of which are quite unlike those of any other financial instrument. The REMIC residual interest is a unique creature of the tax laws and exists only because the tax laws say it must, and not because there is a particular demand for such instruments in the marketplace. Moreover, residual interests are intensely regulated by arcane and complicated tax rules that are designed principally to maximize a holder's tax liability. Yet, REMIC residual interests are a staple of the mortgage-backed securities marketplace today-a marketplace that has become gargantuan in recent years. The raw number of residual interests and their prevalence in the portfolios of sophisticated investors and securities dealers can only increase steadily as more and more mortgages are pooled into REMICs. Accordingly, it is appropriate to examine the complex tax rules associated with residual interests, particularly since these rules are relevant not only to the holder of a residual interest, but also to the REMIC itself, and therefore indirectly to the holders of regular interests in the REMIC.
This Article provides a comprehensive analysis of the tax issues associated with creating, issuing, holding and trading REMIC residual interests. This far ranging inquiry is necessary because REMIC residual interests are a novelty and do not fit within, nor are they readily analogized to, normal tax concepts and rules that apply to other financial instruments. For example, the tax laws have spent many decades working out the appropriate treatment of debt and equity, and how to distinguish between the two. And in recent years the tax laws have become increasingly adept at untangling the tax treatment of various derivative financial instruments, such as notional principal contracts. Yet, the REMIC residual interest is neither debt, equity, option nor notional principal contract-although it has points of similarity to each of these-and consequently it has the fortune or misfortune of entering the marketplace with no applicable tax common law to help establish the appropriate tax treatment. As a result, although a handful of specific provisions in the REMIC rules resolve a great many issues, the tax treatment of residual interests is unsettled in a number of important respects.
This Article seeks to catalogue the tax aspects of residual interests and, in doing so, to identify the open issues, address the relevant tax policy considerations, and suggest possible solutions.