I. Introduction

In 2007, the New York Division of Tax Appeals ruled in Delta Financial that the starting point for determining New York State corporate entire net income includes Real Estate Mortgage Investment Conduit (REMIC) excess inclusion.[1] The effect of Delta Financial is that even if a corporation has net losses for a taxable year, REMIC residual interest income remains subject to New York State tax.  This mimics the federal treatment of residual interest income.  Although New York City has not litigated this issue, the reasoning behind Delta Financial also applies to New York City general corporate tax.

Although the State published REMIC guidelines in 1988, the 2007 case was the first on this issue.  This is probably because the REMIC excess inclusion provisions have an impact on State and City tax assessment only in years in which a corporation reports a net loss.  After big losses in 2007 and 2008, corporations have been reporting zero taxable income to both the State and the City, even if they have large amounts of REMIC interest income.  New York City should begin pursuing this untaxed income.  This post briefly describes REMICs and the reasoning behind Delta Financial and the City’s decision to pursue REMIC residual interest income.

II. A Brief Introduction to REMICs

The Tax Reform Act of 1986[2] created a new entity called a real estate mortgage investment conduit (REMIC).  A REMIC is an entity (e.g., trust, corporation, LLC, partnership) which holds a pool of mortgage loans.  A REMIC may also be a segregated pool of mortgage loans within a larger pool of assets.  To be a REMIC, the entity must fulfill certain requirements, as provided by I.R.C. § 860D.  The mortgage loans generate income for the REMIC when the original borrowers make payments on those loans.

A REMIC may issue two types of interests to investors: regular and residual.  A REMIC may issue multiple classes of regular interests with different levels of risk and return. A regular interest is treated as a debt instrument.[3] Additionally, a REMIC must issue one, and only one, class of residual interest.[4] All distributions to residual interest holders must be made on a pro rata basis.[5] Residual interest holders may receive REMIC income that is left over after distributions are made to regular interest holders and REMIC expenses are paid.  Further, residual interest holders may receive “phantom income.”  Phantom income occurs when taxable gain must be realized without a corresponding economic gain.

III. Tax Treatment

A. Federal Tax Treatment

A REMIC is not treated as a separate taxable entity;[6] it is the interest holders that pay tax on REMIC income.[7] Congress intended that REMICs “be the exclusive vehicle (accompanied by exclusive tax consequences) relating to the issuance of multiple class mortgage-backed securities . . . .”[8] Accordingly, “Congress believed that there should be some relief from two levels of taxation . . . where an entity with multiple classes of interests holds only a pool of real estate mortgages and related assets, . . . provided that satisfactory rules are prescribed for the taxation of the multiple interests.”[9] In order to ensure taxation at the shareholder level, REMIC interest income may not be offset by net operating losses.[10]

Taxable REMIC residual interest holder income is determined under the accrual method.[11] To determine taxable income, the holder “shall take into account his daily portion of the taxable income or net loss of such REMIC for each day during the taxable year on which such holder held such interest.”[12] These amounts are treated as ordinary income or ordinary loss.[13] The holder’s basis in the residual interest is increased by the amount of taxable income taken into account[14] and decreased by any net loss taken into account.[15] Net loss for any taxable year shall not exceed the holder’s adjusted basis in the interest.[16] Excess loss may be carried forward indefinitely.[17]

Distributions made by the REMIC to residual interest holders are treated as return of capital.  “Any distribution by a REMIC (1) shall not be included in gross income to the extent it does not exceed the adjusted basis of the interest, and (2) to the extent it exceeds the adjusted basis of the interest, shall be treated as gain from the sale or exchange of such interest.”[18] Adjusted basis is decreased by the sum of any distributions, but not below zero.[19]

Excess inclusion is determined in one of two ways, depending on whether the interest is of “significant value.”

A residual interest has significant value if–

(A) The aggregate of the issue prices of the residual interests in the REMIC is at least 2 percent of the aggregate of the issue prices of all residual and regular interests in the REMIC; and

(B) The anticipated weighted average life of the residual interests is at least 20 percent of the anticipated weighted average life of the REMIC.[20]

If the residual interest does not have significant value (most do not) the excess inclusion is equal to REMIC income.[21] If the residual interest has significant value the excess inclusion equals REMIC income minus “the sum of the daily accruals.”[22] Thus, in most instances, a REMIC residual interest holder’s excess inclusion is equal to the holder’s REMIC income.

The I.R.C. provides that a residual interest holder’s taxable income may not be less than the excess inclusion.[23] Thus, net operating losses do not offset excess inclusion.[24] Even if a taxpayer has no taxable income on Federal form 1120 line 28, its REMIC income is taxable.

B. New York City Tax Treatment

The starting point for computing New York City taxable income is the minimum federal taxable income that a taxpayer is required to report.[25] “One of the fundamental principles of the City’s Business Taxes is that there must be conformity with the methods of reporting items of income and expense for Federal and City purposes.”[26] Accordingly, “[d]eviation from the Federal adjusted gross income may only be permitted in those limited instances provided by the Legislature in the applicable statute.”[27]

Both New York City and New York State exempt REMICs from taxation.[28] REMIC interest holders, however, are not exempt from taxation.[29] The City and State REMIC provisions were enacted in 1988 and 1987, respectively, long after the provisions for determining entire net income.  Neither the City nor State provisions allow for changes to the method of calculating entire net income.

The corporate taxpayer in Delta Financial reported federal taxable income of $640,837 in 2002.[30] Yet, when filing New York State tax returns, the taxpayer used line 28 of the federal form, –$72,675,304, as the starting point for calculating its New York State taxable income.[31] The taxpayer argued that since I.R.C. § 860E(a) had not been expressly adopted by the legislature, net operating losses could be used to offset excess inclusion.[32] The court found, however, that the legislature did not need to adopt the excess inclusion provision in order for it to apply to New York State entire net income.[33] Further, the court found that “[t]he Internal Revenue Code[] . . . clearly intended that federal taxable income would never be less than the excess inclusion . . . New York entire net income would necessarily be the federal taxable income after the adjustment required by I.R.C. § 860E(a)(1).”[34]

The reasoning behind the court’s decision in Delta Financial applies equally well for New York City general corporate tax purposes.  As a result, the New York City Department of Finance should require that REMIC residual interest holders use federal taxable income, adjusted for excess inclusion, as the starting point for calculating New York City entire net income.  Although the excess inclusion provisions only affect taxable income during years in which a taxpayer’s taxable income without the excess inclusion is negative, the recent economic downturn will make this provision especially relevant.  If enforced, it will prove an important source of additional revenue for New York City.

IV. Conclusion

Under federal tax law, REMIC residual interest holders may not use net operating losses to offset interest income.  The New York Division of Tax Appeals recently ruled that federal taxable income is the appropriate starting point for determining entire net income of corporate taxpayers.  That is, that the excess inclusion provision applies equally to New York State taxable income.  Because New York City REMIC and corporate tax law is substantively identical to New York State law, the excess inclusion provision should equally apply to New York City entire net income.  The excess inclusion provision is especially relevant in today’s economic climate because it only affects taxable income during those years in which a taxpayer has declared a net loss.  The New York City Department of Finance should thus require corporate taxpayers to use federal taxable income, adjusted for § 860E(a)(1), as the starting point for calculating New York City entire net income.  Enforcing this provision will provide a much-needed source of revenue for the City and the State.