Ruling Illustrates Interaction Between Remic 'Excess Inclusion' And Nol Rules.

Rev. Rul. 2005-68

ISSUES

(1) If, during the same taxable year, the holder of a residual interest in a Real Estate Mortgage Investment Conduit (REMIC) both incurs a net operating loss (NOL) and recognizes income from an excess inclusion (as defined in section 860E(c)), then how is taxable income determined, and how is any NOL carryback or carryover computed?

(2) If an NOL is carried back or carried over to a taxable year in which an excess inclusion is recognized, how is taxable income computed?

FACTS

X, a domestic corporation, is the sole holder of the residual interest in a REMIC. During the 2004 taxable year, X has a $25 excess inclusion attributable to its ownership of the residual interest. Also during 2004, independent of holding the REMIC residual interest, X has $75 in gross rental income and $65 in deductible rental expenses. During the 2005 taxable year, X has $25 of excess inclusion income, $75 in gross rental income, and $90 in deductible rental expenses. X began business operations in 2004 and therefore has no income or loss carryover for any prior year.

LAW

Section 860C(a)(1) provides that each holder of a residual interest in a REMIC shall take into account that holder's daily portion of the taxable income or net loss of the REMIC for each day during the taxable year on which the holder held the interest. Additionally, some or all of a residual holder's allocable share of a REMIC's taxable income may be an excess inclusion. Section 860E embodies a statutory mandate to tax currently a residual holder's excess inclusion. Rev. Rul. 95-81, 1995-2 C.B. 70. To ensure that the excess inclusion is fully taxed, section 860E(a)(1) provides, "The taxable income of any holder of a residual interest in a REMIC for any taxable year shall in no event be less than the excess inclusion for such taxable year."

Section 172 provides for NOL carrybacks and carryovers to prior or future taxable years. The amount of an NOL is determined under section 172(c) for the year in which the loss arises (the "loss year"). Section 172(b)(1) then specifies the taxable years to which the NOL may potentially be carried. Under section 172(b)(2), the NOL is carried to the earliest of those years. The second sentence of section 172(b)(2) provides, "The portion of such loss which shall be carried to each of the other taxable years shall be the excess, if any, of the amount of such loss over the sum of the taxable income for each of the prior taxable years to which such loss may be carried."

Section 860E(a)(3) sets forth rules for coordinating the provisions that govern excess inclusions with the net operating loss provisions of section 172. Section 860E(a)(3)(A) provides that any excess inclusion for any taxable year shall not be taken into account "in determining under section 172 the amount of any net operating loss for such taxable year" (that is, in determining the loss for a "loss year"). Section 860E(a)(3)(B) provides that any excess inclusion for a taxable year shall not be taken into account "in determining taxable income for such taxable year for purposes of the 2nd sentence of section 172(b)(2)."

ANALYSIS

Calculation 1. Calculation for 2004 Return. For its 2004 return, X has total taxable income of $35, calculated as indicated below.

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Calculation 2. Calculation for 2005. For 2005, X has a $15 net rental loss plus a $25 excess inclusion. X's taxable income of $25 and NOL of $15 are calculated as indicated below.

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Calculation 3. Application of NOL Carryback to 2004. As indicated in Calculation 1 above, on X's return as originally filed for the 2004 gain year (now the carryback year), X reported $10 of net rental income plus $25 of excess inclusion income. The $15 NOL carryback results in taxable income of $25, as shown below.

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Calculation 4: Determination of NOL Carryover to 2006. As illustrated in the table under Calculation 3, X's NOL carryover to the 2006 taxable year is $5. For purposes of determining the amount of the NOL carryover, in accordance with the second sentence of section 172(b)(2), X's excess inclusion for 2004 is not taken into account.

In each of the calculations above, the full rental expense is either used to offset gross income (other than the excess inclusion) or used in calculating an NOL. No portion of the excess inclusion is offset either by any of the rental expense or by any NOL. No portion of the excess inclusion reduces the amount of the NOL that may be carried back or carried over.

HOLDINGS

(1) In computing an NOL for the taxable year, no excess inclusion is taken into account. If, during the same taxable year, a taxpayer both recognizes an excess inclusion and incurs an NOL, the excess inclusion may not be offset by the NOL and is not taken into account in determining the amount of the NOL that may be carried to another taxable year.

(2) If an NOL is carried back or carried over to a taxable year in which an excess inclusion is recognized, the excess inclusion cannot be offset by the NOL carryback or carry over and is not included in the calculation of taxable income for NOL absorption purposes.

DRAFTING INFORMATION

The principal author of this revenue ruling is Arturo Estrada of the Office of Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Mr. Estrada at 202-622-3900 (not a toll-free call).