At least two law firms last week provided summary comments to their clients on the new Internal Revenue Service proposed regulations for treatment of inducement fees paid to holders of the non-economic residual interest in real estate mortgage investment conduits (REMICs).

The holder of the residual interest is paid the inducement fee to offset the tax liability of its ownership, which exceeds any REMIC-related revenue tied to the residual, especially in the early phases of the conduit.

In its proposal, the IRS states, "To clearly reflect income, an inducement fee must be included in income over a period that is reasonably related to the period during which the applicable REMIC is expected to generate taxable income or net loss to the holder of the non-economic residual interest."

The IRS proposes two safe harbor methods for tax treatment of this income. In method No. 1, the residual holder recognizes the inducement fee as taxable income over the same period for which it books the fee as income for financial reporting purposes, "provided that the period is not shorter than the period over which the applicable REMIC is expected to generate taxable income." In method No. 2, the residual holder books the inducement fee as taxable income for the weighted average life of the REMIC.

Attorneys at Cadwalader, Wickersham & Taft note that in the method No. 1, there's uncertainty in how the IRS expects taxpayers to treat prepayment assumptions in the calculation of the period in which the REMIC is expected to generate income. "It is unclear whether this expectation should be based on the prepayment assumption of the REMIC's mortgage loans at the time of formation, the time

of transfer, or some other method," the firm states.

Stroock's Bloomfield notes that, "One anomaly of the proposed regulations,wrote Micah Bloomfield of Stroock & Stroock & Lavan, in a letter sent out to clients, is that if the holder disposes of the residual in most transactions, including transfers to a partnership, the holder is required to recognize the remaining inducement fee in income at that time. This would seem to give taxpayers an election to recognize income up front, by contributing their non-economic residual to a partnership."

The new regulations will apply during taxable years that end on or after the publishing of the rules in the Federal Register. When adopting the new methods, the taxpayer will be required to standardize the accounting approach across all existing inducement fees.

The proposal was released on July 18, and the IRS is seeking commentary due Oct. 20. For more information on submissions, contact IRS official Treena Garrett at 202-622-7180.

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