IRS Approves ‘Excess Servicing Spreads’ as a New Qualifying Asset for REIT Purposes

Skadden, Arps, Slate, Meagher & Flom LLP

David F. Levy David Polster Fred T. Goldberg, Jr. John D. Rayis

Real estate investment trusts interested in broadening the range of assets in which they invest should take some encouragement from a recent private letter ruling. On August 24, 2012, the IRS released Private Letter Ruling 201234006, addressing the classification of certain “excess servicing spreads” (also known as “excess mortgage servicing rights” or “excess MSRs”) for purposes of the tax rules applicable to real estate investment trusts (REITs). Those rules require, among other things, that 75 percent of a REIT’s assets consist of “real estate assets” and that 75 percent of a REIT’s income consist of certain types of qualifying income, including interest on mortgages. Private Letter Ruling 201234006 concludes that excess servicing spreads are real estate assets that produce qualifying mortgage interest income for purposes of the REIT rules.

As described in the ruling, an excess servicing spread represents the right to receive a portion of the interest payments made on a pool of residential mortgages. Originators of residential mortgage loans will often bundle those loans into pools and sell the pools to a government agency or government-sponsored entity (GSE), such as Fannie Mae or Freddie Mac, or a private securitization vehicle. Often, the servicer of the pool (which may be the originator or another party) will retain, as compensation for its servicing duties, the right to receive a portion of the total interest payments made on the pool, as well as items of ancillary income such as late fees (collectively, mortgage servicing rights or MSRs). For example, the servicer may retain the right to receive 35 basis points of interest, plus the ancillary income. Typically, however, GSE policies and other factors require that the total amount of the MSR exceed the arm’s-length reasonable compensation that the servicer would demand for its services. The excess servicing spread represents this excess. For example, the arm’s-length reasonable compensation of a servicer may be 25 basis points of interest on the underlying pool of loans. If the servicer actually receives 35 basis points, then the servicer has an excess servicing spread of 10 basis points. The excess servicing spread therefore represents a passive investment in the interest component of a pool of mortgages, akin to an “interest-only strip.”

In anticipation of new financial industry regulations and in order to improve their liquidity and capital positions, many servicers have begun selling their excess servicing spreads to passive investors, and many REITs are beginning to explore opportunities to participate in the new market created by these developments. Before Private Letter Ruling 201234006, however, no IRS authority squarely addressed whether excess servicing spreads are qualifying “real estate assets” that produce qualifying mortgage interest income for purposes of the REIT requirements. In a welcomed development, Private Letter Ruling 201234006 builds on earlier IRS guidance on excess servicing spreads in non-REIT contexts and concludes that excess servicing spreads are qualifying REIT assets that produce qualifying REIT income.

Although Private Letter Ruling 201234006 is not binding precedent and therefore cannot be relied on by other taxpayers, it is indicative of the IRS’s comfort in treating excess servicing spreads as qualifying REIT assets that generate qualifying REIT income.

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