Rev. Rul. 73-559

Advice has been requested whether the basis of mortgages acquired by the Federal National Mortgage Association ("FNMA") through the Government National Mortgage Association ("GNMA") is decreased by payments received from GNMA in recovery of the "market discount" or "price differential" sustained by FNMA upon the acquisition of such mortgages.

The President of the United States, by letter dated August 6, 1971, authorized two new special assistance programs to support the market for FHA-insured and VA-guaranteed mortgages. Special Assistance Program 21 deals with mortgages in connection with financing proposed construction of multi-family units, and Special Assistance Program 22 deals with mortgages in connection with existing and proposed residences.

Under Special Assistance Program 21 and Special Assistance Program 22, GNMA will issue commitments to acquire mortgages from approved mortgage originators (including banks, savings and loan associations, and mortgage companies). Pursuant to an "Assignment Agreement," FNMA will participate in the carrying on of the above programs. FNMA's function, under the Special Assistance Program, is essentially to "warehouse" commitments and mortgages on behalf of GNMA.

Prior to delivery of the mortgages (if the originator has not exercised a "buy-back" option), FNMA will normally reassign the commitments to GNMA so that the latter may take delivery and consummate the purchase of the subject mortgages. Commitments reassigned to GNMA and purchased mortgages held by it will be a charge against GNMA's dollar authorization under the Special Assistance Program. In order to maintain GNMA's liquidity, it is anticipated that GNMA will promptly resell acquired mortgages to FNMA and others at auction sales conducted by GNMA. FNMA has agreed to purchase mortgages offered at auction sales by GNMA by submitting bids which are competitive with those submitted by other bidders.

The Assignment Agreement grants GNMA a right to decline reassignment of the commitments held by FNMA. Upon GNMA's declining to accept FNMA's reassignment of commitments, FNMA will be contractually obligated to purchase the mortgage at the supported price specified in the nonreassigned commitment (usually 95 or 96 percent of par). FNMA may sell the acquired mortgages at auction and, thereupon, will be entitled to receive from GNMA an amount equal to the difference between the price at which FNMA acquired the mortgage and the price at which the mortgage was sold by FNMA. As a result, GNMA will incur the "market discount" resulting from the spread between the commitment price and actual sales price realized at auction. Alternatively, however, FNMA may purchase for its own account and hold in its portfolio mortgages delivered to it under nonreassigned GNMA commitments. With respect to these purchases, GNMA has agreed to reimburse FNMA for the "price differential", or difference between the commitment price paid by FNMA upon acquisition of the mortgage and the prevailing market price of comparable mortgages, as determined by independent sales transactions. The reimbursement for the "price differential" will be made at the time FNMA acquires the mortgage pursuant to the nonreassigned commitment.

The following example will illustrate the difference between the "market discount" and "price differential" payments which FNMA may receive from GNMA:

On October 1, GNMA issues a commitment to a mortgage originator, under the Special Assistance Program, to purchase, within 12 months of the date of the commitment, 100 FHA-insured mortgages having aggregate unpaid principal balances of $2,000,000 at a price equal to 96 percent of par. The commitment is automatically assigned to FNMA.

On May 1, when the mortgage originator tenders delivery of the mortgages, GNMA declines reassignment of the commitment. FNMA thus becomes contractually obligated to purchase the mortgages at a supported price (96) even though, as of that date, the prevailing market price for similar obligations is 92. Thus, if not for the "market discount" or "price differential" payments, the cost to FNMA of acquiring the mortgages would be $1,920,000 instead of $1,840,000.

The distinction between the two types of payments is as follows: If FNMA chooses to retain the required mortgages in its own portfolio, then GNMA is required to make a "price differential" payment to FNMA equal to $80,000, the difference between the commitment price paid by FNMA ($1,920,000) and the prevailing market price therefor $1,840,000).

FNMA may, however, decide to sell the mortgages at auction. In that event, it will receive a "market discount" payment from GNMA. Thus, if the mortgages described above were sold at auction by FNMA at a price of 92.1 (that is, slightly above the prevailing market prices), FNMA would be entitled to receive only $78,000, instead of the $80,000 price differential payment. The difference is, of course, attributable to the fact that while the "price differential" payment is computed on prevailing or average market discounts for mortgages, the "market discount" payment is based on an actual sale of the mortgages in question, which may be at slight variance from prevailing market prices.

Section 1012 of the Internal Revenue Code of 1954 provides, in pertinent part, that the basis of property shall be the cost of such property.

In the instant case, the payments received by FNMA from GNMA in recovery of the "market discount" or "price differential" restore FNMA to the position it would have occupied had it acquired the mortgages at prevailing market prices.

GNMA's price differential and market discount payments are designed specifically to induce FNMA's participation in Special Assistance Program 21 and 22 by reducing, to prevailing market prices, FNMA's cost of acquiring the eligible mortgages.

It is held that the basis of the mortgages acquired by FNMA, whether directly from GNMA or from mortgage originators pursuant to commitments assigned by GNMA, is the amount paid therefor by FNMA less the amount, if any, of the payments received from GNMA in recovery of the "market discount" or "price differential" sustained by FNMA upon the acquisition of such mortgages. Therefore, GNMA's "market discount" and "price differential" payments to FNMA are not includible in the gross income of FNMA under section 61 of the Code.

Further, GNMA's "market discount" and "price differential" payments to FNMA shall be applied against, and shall reduce, the basis of the mortgages to which such payments relate as of the earlier date of (a) FNMA's receipt of the "price differential" payment or (b) FNMA's disposition of the mortgage giving rise to the "market discount" payment.