Final REMIC Regs

 [4830-01]

 ACTION: Final Regulations

 SUMMARY: This document contains final regulations relating to real estate mortgage investment conduits, or REMICs. This action is necessary because of changes to the applicable tax law made by the Tax Reform Act of 1986 and by the Technical and Miscellaneous Revenue Act of 1988. The regulations contained in this document provide guidance to REMICs and their investors.

 EFFECTIVE DATES: These regulations are effective November 12, 1991, except as otherwise specified in section 1.860A-1(b).

 FOR FURTHER INFORMATION CONTACT: Carol A. Schwartz (telephone 202-622-3920) (not a toll-free number) of the Office of Assistant Chief Counsel, Financial Institutions and Products, 1111 Constitution Avenue, N. W., Washington, D.C. 20224 Attention CC:FI&P (FI-88-86).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collections of information requirement contained in this final regulation has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1276. The estimated annual burden per respondent or recordkeeper varies from .25 hours to 1.5 hours with an estimated average of 1 hour.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual respondents or recordkeepers may require more or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attention: IRS Report Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

BACKGROUND This document adopts income tax regulations (26 CFR parts 1, 301, and 602) under sections 860A through 860G of the Internal Revenue Code of 1986 (Code) and adopts conforming amendments to other sections of the income tax regulations. Proposed regulations were published in the Federal Register on September 30, 1991 (56 FR 49526) and April 2O, 1992 (57 FR 14369). Following publication of the proposed regulations on September 30, 1991, written comments were received and a public hearing was held on December 5, 1991. Following publication of the proposed regulations on April 20, 1992, no comments or requests to appear were received.

 After consideration of all of the comments relating to the proposed regulations, they are adopted by this Treasury decision as final regulations. The comments and revisions relating to the proposed regulations are discussed below.

EXPLANATION OF PROVISIONS

I. QUALIFICATION AS A REMIC

 In general, a REMIC is a pool of assets, in which investors hold interests, for which a REMIC election is filed, and which satisfies certain requirements concerning the composition of its assets and the nature of its investors' interests. A REMIC must also make arrangements to prevent entities not subject to tax from holding certain of its interests. A REMIC may, for state law purposes, be a corporation, partnership, trust, or segregated pool of assets that is not a separate legal entity.

A. ASSET TEST

 To qualify for REMIC treatment, an organization must, among other things, satisfy certain tests concerning the assets it holds. Specifically, except during an initial startup period and during a limited liquidation period, substantially all of the organization's assets must consist of qualified mortgages and permitted investments (qualified reserve assets, cash flow investments, and foreclosure property). The initial startup period extends from the startup day to the end of the third calendar month beginning after the startup day. Generally, the startup day is the day on which the REMIC issues all of its regular and residual interests.

1. QUALIFIED MORTGAGES

The term "qualified mortgage" includes any obligation (including any participation or certificate of beneficial ownership in an obligation) that is principally secured by an interest in real property and that is either transferred to the REMIC on the startup day in exchange for regular or residual interests or purchased by the REMIC within a three-month startup period pursuant to a fixed price contract in effect on the startup day.

 The final regulations define the terms "interests in real property" and "real property" for purposes of the REMIC rules by referencing the definitions of those terms set out in the real estate investment trust (REIT) regulations. See section 1.856-3. These final regulations also modify the definition of interests in real property set out in section 1.856-3(c) to include certain timeshare interests and shares held by a tenant stockholder in a cooperative housing corporation.

 The proposed regulations explained that an obligation is principally secured by an interest in real property if the fair market value of the real property that secures the obligation at least equals 80 percent of the adjusted issue price of the obligation (a 125% loan-to-value ratio) at one of two times. The 80-percent test must be satisfied either at the time the obligation was originated, or at the time the obligation is contributed to the entity seeking REMIC status.

 The proposed regulations provided that the principally secured requirement is satisfied so long as the REMIC sponsor reasonably believes that the obligation satisfies the 80-percent test. The proposed regulations also provided that a sponsor could base a reasonable belief upon representations or warranties given by the originator of the obligation.

 The final regulations retain the 80-percent test and the reasonable belief safe harbor. The final regulations, however, also amend the proposed "principally secured" standard in three ways.

 First, in addition to the current 80-percent test, the final regulations provide an alternative test for determining whether an obligation is principally secured by an interest in real property. Under the alternative test, an obligation is considered to be principally secured by an interest in real property if substantially all of the loan proceeds were used to acquire or to improve or protect an interest in real property and the interest in real property is the only property securing the loan. Thus, for example, a home improvement loan made in accordance with Title I of the National Housing Act would be considered to satisfy the principally secured standard even though one cannot readily demonstrate that the loan satisfies the 80-percent test because a property appraisal was not required at the time the loan was originated.

 Second, the regulations make it clear that a modification of a loan before it is contributed to the REMIC is treated as the origination of a new loan on the date of the modification only if the modification is a significant one. Thus, for example, if an obligation satisfied the principally secured standard at the time it was originated, but the terms of the obligation were subsequently modified in a workout occasioned by the mortgagor's likely default, that modification would not affect the principally secured status of the obligation.

 Finally, the final regulations expand the "reasonable belief" safe harbor to provide that a sponsor can base a reasonable belief on evidence indicating that (i) the originator of the obligation typically made loans in accordance with a set of established parameters, and (ii) any loan originated in accordance with those established parameters would satisfy the principally secured standard. Of course, the sponsor cannot avail itself of the safe harbor if the sponsor had actual knowledge or had reason to know that a particular obligation did not satisfy that standard at the time it was originated.

 The proposed regulations provided that mortgage pass-thru certificates, such as those guaranteed by GNMA, FNMA, and FHLMC, are treated as obligations secured by an interest in real property. The final regulations provide that in addition to those securities, pass- thru certificates guaranteed by the Canada Mortgage and Housing Corporation (CMHC) are obligations secured by interests in real property. The final regulations also make it clear that other investment trust interests can qualify as obligations secured by interests in real property even if the investment trust holds, in addition to real estate mortgages, related assets that would be permitted investments if the investment trust were a REMIC.

 The final regulations define the term "obligation" for purposes of the REMIC provisions to include any instrument that provides for total noncontingent principal payments that at least equal the instrument's issue price even if that instrument also provides for contingent payments. Thus, for example, an instrument that was issued for $100x and that provides for (i) noncontingent principal payments of $100x, (ii) interest payments at a fixed rate, and (iii) contingent payments based on a percentage of the mortgagor's gross receipts, is an obligation.

 The final regulations also amend the proposed regulations concerning the treatment of income on residual interests held by REITs. The final regulations make it clear that a REIT cannot avoid the limitations imposed by section 856(f) (concerning interest based on mortgagor net profits) and 856(j) (concerning shared appreciation provisions) by forming a wholly owned REMIC to hold an obligation that provides for interest payments based on net profits or an obligation that contains a shared appreciation provision.

2. MORTGAGE MODIFICATIONS

The proposed regulations provided, as a general rule, that if an obligation is modified following its contribution to or acquisition by a REMIC, the modification is treated as the REMIC's acquisition of the modified obligation in exchange for the unmodified obligation. An obligation is modified for purposes of this rule if its new terms differ materially either in kind or in extent, within the meaning of section 1.1001-1(a), from its former terms. The proposed regulations provided, however, that certain changes in the terms of an obligation are not treated as modifications even if those changes would be sufficient to trigger the "differ materially" standard of section 1001. The excepted changes include changes occasioned by (i) default or reasonably foreseeable default on a mortgage, (ii) assumption of a mortgage, (iii) waiver of a due-on-sale clause, or (iv) adjustment of the interest rate on a convertible mortgage.

 The final regulations make certain clarifying changes to the language of the proposed regulations and provide that an exchange of obligations will be deemed to occur only if an obligation is significantly modified. The final regulations explain that, generally, a significant modification is any change in the terms of an obligation that would be treated as an exchange of obligations under section 1001 and the related regulations. The final regulations also add the waiver of a due on encumbrance clause to the list of exceptions to the general rule that were set out in the proposed regulations.

3. DEFECTIVE OBLIGATIONS

The proposed regulations defined the term "defective obligation" as a qualified mortgage that is in default or with respect to which default is reasonably foreseeable, that was fraudulently procured by the mortgagor, or that does not conform to customary representations or warranties. A mortgage is also a defective obligation if, despite the reasonable belief of the sponsor at the time the obligation was contributed to the REMIC, it does not in fact meet the principally secured standard. If it is discovered that an obligation is defective, and the defect is one that, had it been discovered before the startup day, would have prevented the obligation from being a qualified mortgage, then, unless the REMIC either causes the defect to be cured or disposes of the obligation within 90 days of the discovery, the obligation ceases to be a qualified mortgage at the end of the 90-day period.

 The final regulations make it clear that a defective obligation held beyond the 90-day period following discovery of the defect can still be exchanged for a qualified replacement mortgage if the exchange occurs within two years of the startup day. Further, the final regulations make it clear that it is the REMIC's discovery of the defect that determines when the 90-day period starts to run.

4. DEFEASANCE

Commercial mortgages often contain defeasance provisions whereby the mortgagee may release its lien on the real property securing the mortgage in return for the mortgagor's pledge of substitute collateral. The proposed regulations provided that the defeasance of a qualified mortgage does not affect its status as a qualified mortgage only if certain conditions are satisfied. Specifically, the substitute collateral must be government securities, the defeasance must be undertaken pursuant to the terms of the mortgage, the defeasance must not occur within two years of the startup day, and the lien must be released to facilitate the mortgagor's disposition of the encumbered property.

 The final regulations retain the first three limitations. The final regulations provide, however, that the lien on real property can be released for reasons other than a mortgagor's disposition of the encumbered real property if the defeasance transaction is undertaken as part of a customary commercial transaction, and not as part of an arrangement to collateralize a REMIC offering with obligations that are not real estate mortgages.

5. CREDIT ENHANCEMENT

Some form of credit enhancement is employed in most REMIC offerings to improve the marketability of the REMIC interests. The function of credit enhancement arrangements is, in general, to provide payments to replace defaulted or delinquent payments on qualified mortgages and thereby ensure timely payments to REMIC interest holders. Credit enhancement contracts can take many forms, such as mortgage pool insurance contracts, certificate insurance contracts, third party guarantee arrangements, and bank letters of credit.

 The proposed regulations provided that for purposes of the asset test in section 860D(a)(4), all forms of credit enhancement are treated as incidents of the pooled mortgages and not as separate assets of the REMIC. Thus, payments received under credit enhancement arrangements are treated as payments on the qualified mortgages. Similarly, the credit enhancer's right to be reimbursed or the right to be subrogated to the REMIC's claim on a defaulted mortgage is not viewed as an interest in the REMIC.

 The final regulations retain the rules set out in the proposed regulations concerning the treatment of credit enhancement contracts. The final regulations, however, clarify the definition of "credit enhancement contract" in five ways.

 First, the final regulations make it clear that the term "credit enhancement contract" includes arrangements that provide support for residual interests in a REMIC.

 Second, the term "credit enhancement contract" includes an agreement between the REMIC and a third party whereby the third party agrees to make up cash flow shortfalls occasioned by lower than expected returns on cash flow investments.

 Third, the final regulations make it clear that certain arrangements to make advances to the REMIC are credit enhancement contracts even if those arrangements are between the REMIC and a third party other than the mortgage servicer.

 Fourth, the final regulations provide that certain agreements between a REMIC and a third party whereby the third party agrees to advance amounts to the REMIC to provide for the orderly administration of the REMIC, although technically not providing credit support, nonetheless are considered credit enhancement contracts.

 Finally, the final regulations make it clear that a guarantee or insurance arrangement does not fail to qualify as a credit enhancement contract solely because the guarantor or insurer has the right to defer the guarantee or insurance payment that is to substitute for the amounts due on a defaulted mortgage, together with interest, according to the original payment schedule of the mortgage, or according to some other deferred payment schedule. Any deferred payments are payments pursuant to a credit enhancement contract (and therefore treated as payments on a mortgage) even if the mortgage is foreclosed upon and the guarantor is entitled to receive immediately the proceeds of foreclosure.

6. CASH FLOW INVESTMENTS

A cash flow investment is any investment of amounts received under qualified mortgages for a temporary period before distribution to holders of interests in the REMIC. Because a cash flow investment is intended to be a temporary investment, the proposed regulations provided that the period between receipt of amounts from qualified mortgages and distribution of those amounts to interest holders may not exceed thirteen months.

 The final regulations adopt the definition set out in the proposed regulations, and explain that in determining the length of time that a REMIC has held an investment that is part of a commingled account or fund, the REMIC may employ any reasonable method of accounting.

7. QUALIFIED RESERVE FUNDS

The proposed regulations provided that a qualified reserve fund is any reasonably required reserve to provide for (i) full payment of expenses of the REMIC, or (ii) amounts due on regular or residual interests in the event of defaults or delinquencies on qualified mortgages, lower than expected returns on cash flow investments, or interest shortfalls on qualified mortgages caused by prepayments of those mortgages between scheduled payment dates. The final regulations retain the language of the proposed regulations and further explain that a qualified reserve can be maintained to provide for any contingency that could be provided for under a credit enhancement contract.

8. OUTSIDE RESERVE FUNDS

The proposed regulations provided that the assets of certain outside reserve funds that are maintained to pay expenses of the REMIC or to provide credit support for REMIC interest holders are not assets of the REMIC. For a fund to be respected as an outside reserve fund, the REMIC's organizational documents must clearly and expressly (i) provide that the reserve fund is an outside reserve fund and not an asset of the REMIC, (ii) identify the owner(s) of the reserve fund, and (iii) provide that, for all federal tax purposes, amounts transferred by the REMIC to the fund are treated as amounts distributed by the REMIC to the designated owner(s) or transferee(s) of such owner(s). These requirements are intended to ensure that a person other than the REMIC is the true owner of the reserve fund. So long as these requirements are satisfied, a reserve fund will be respected as an outside reserve fund even if it is maintained by the same trustee that holds the REMIC's qualified mortgages and permitted investments.

 The final regulations provide that any reserve fund that satisfies the three requirements set out above is an outside reserve fund and not an asset of the REMIC even if the fund protects the REMIC interest holders against risks other than credit risk.

B. INVESTORS' INTERESTS

 For an organization to qualify as a REMIC, all interests in the organization must be designated as either residual interests or regular interests. The REMIC must issue one, and only one, class of residual interests. A REMIC may issue one or more classes of regular interests.

1. REGULAR INTERESTS

A regular interest is one that is designated as a regular interest and that is issued on the startup day with fixed terms. The regular interest must (except for certain interest-only regular interests) unconditionally entitle the holder to receive a specified principal amount (or other similar amount). Any interest payments (or other similar payments) at or before maturity must be based either on a fixed rate of interest or (to the extent provided in regulations) a variable rate of interest, or consist of a specified portion of interest payments on qualified mortgages, which portion does not vary during the period the regular interest is outstanding.

 Under the proposed regulations a rate is a permissible variable rate if it is based on an objective interest index or based on a weighted average of the interest rates on some or all of the mortgages held by the REMIC. In addition, an otherwise permissible variable rate is not disqualified because it is subject to periodic or permanent caps or floors. Finally, an interest is considered to bear interest at a variable rate if it provides for interest at one permissible rate during one or more accrual or payment periods and a different permissible rate or rates for other accrual or payment periods.

 The final regulations clarify the variable rate definition in the proposed regulations in two ways. First, the final regulations make it clear that a rate is considered to be based on a weighted average rate even if, in determining that rate, the interest rate on some or all of the qualified mortgages is first subject to a cap or a floor, or is first reduced by a number of basis points or a fixed percentage. Second, the final regulations provide that a rate does not fail to qualify as a variable rate because it is subject to a funds-available cap.

 A "funds-available cap", is a limit on the amount of interest to be paid on a regular interest in any payment period that is based on the current funds that a REMIC has available for distribution. The term "funds-available cap" does not, however, include any cap or limit used as a device to avoid the purposes of the otherwise applicable standard for a permissible variable rate.

 The proposed regulations defined "specified portion" to mean a right to receive interest payments that can be expressed as (1) a fixed percentage of the interest payable on qualified mortgages, or (2) a fixed number of basis points of the interest payable on qualified mortgages. The final regulations expand the definition of "specified portion" to include a portion that can be expressed as the interest payable on some or all of the qualified mortgages in excess of a fixed number of basis points or in excess of a variable rate.

 The proposed regulations provided that, except for certain specified contingencies, a regular interest's principal amount and latest possible maturity date must not be contingent. The final regulations adopt the proposed rule and the list of specified contingencies that was set out in the proposed regulations with minor clarifying changes. In addition, the final regulations also make it clear that an interest will not be denied status as a regular interest solely because the payments on that interest are subject to remote and incidental contingencies.

 Prepayment penalty provisions are typically found in commercial mortgage loans. The proposed regulations allowed a REMIC to pass through to regular interest holders customary prepayment penalties received when a qualified mortgage prepays. The final regulations make it clear that a REMIC may allocate a prepayment penalty among its classes of interests in any manner.

2. OTHER RIGHTS THAT ARE NOT INTERESTS

Not every right to receive a payment from a REMIC is an interest in the REMIC. The proposed regulations contained a non-exclusive list of certain rights that are not interests in the REMIC. The final regulations adopt the list set out in the proposed regulations with minor clarifying changes.

 The proposed regulations provided that certain de minimis interests issued by an entity that elects REMIC status to facilitate creation of the entity are not interests in the REMIC. The final regulations make it clear that this rule applies only if the interests are not designated as either regular or residual interests.

 The final regulations also make it clear that certain obligations that contain contingent payment provisions can be stripped of the contingent payment rights and the holder of those rights will not be considered to hold an interest in the REMIC. Thus, for example, if a loan not only has a fixed principal amount and provides for interest at a fixed rate, but also contains a shared appreciation provision, the holder of the loan can contribute the fixed payment rights to a REMIC and retain the shared appreciation rights and those retained rights will not be considered to be an interest in the REMIC. Of course, the owner could have contributed the entire loan to the REMIC and taken back a residual interest that consisted of the right to the contingent payments.

II. FORMATION AND LIQUIDATION OF THE REMIC

 A regular interest in a REMIC can be used to collateralize a second REMIC because regular interests can be qualified mortgages. The proposed regulations provided that two or more REMICs can be formed pursuant to a single set of organizational documents even if, for state law purposes or for Federal securities law purposes, only one entity exists.

 The final regulations adopt the position set out in the proposed regulations concerning tiered REMICs. In addition, the final regulations make it clear that a REMIC and one or more investment trusts can be created pursuant to a single set of organizational documents even if, for state law purposes or for Federal securities law purposes, only one entity exists. Thus, a sponsor can create a REMIC and an investment trust under one set of documents, and the investment trust can hold both an interest in the REMIC and a notional principal contract for the benefit of the trust certificate holders.

 A qualified liquidation is a transaction in which a REMIC adopts a plan of liquidation and then disposes of its assets and distributes the proceeds of disposition in the 90-day period following the adoption of the plan. The date on which the plan is adopted is important because it marks the beginning of a 90-day period during which certain of the restrictions that limit the nature of a REMIC's assets and operations are inapplicable. The proposed regulations indicated that a REMIC is considered to adopt a plan of liquidation on the date that it is signed by a person authorized to sign the REMIC's tax return. The final regulations provide that a plan of liquidation need not be in any special form, and that a REMIC may specify the first day in the 90-day liquidation period in a statement attached to its final return and the REMIC will be considered to have adopted a plan of liquidation on the date specified.

III. THE EXCESS INCLUSION RULES

A. GENERALLY

 A portion of the income allocable to a residual interest, referred to as an excess inclusion, is, with an exception for thrift institutions, subject to Federal income taxation in all events. Residual interest holders other than thrift institutions may not offset excess inclusions with otherwise allowable deductions. An excess inclusion is treated as unrelated business taxable income (UBTI) if the residual interest holder is an exempt organization that is subject to the tax imposed under section 511 on UBTI.

B. SPECIAL RULE FOR THRIFT INSTITUTIONS

 Thrift institutions to which section 593 applies are excepted from the general rule that excess inclusions are, in all events, subject to taxation. Thus, a thrift with NOLs can apply those losses to offset excess inclusions. The Service is given express authority to provide regulations that render this special thrift exception inapplicable where necessary or appropriate to prevent tax avoidance.

 The proposed regulations provided that the exception for thrift institutions applies only if the residual interest has significant value. A residual interest has significant value only if the aggregate of the issue prices of the residual interests in the REMIC is at least two percent of the aggregate of the issue prices of all interests in the REMIC, and only if the anticipated weighted average life of the residual interest is at least 20 percent of the anticipated life of the REMIC.

 The final regulations retain the two-percent of issue price test of the proposed regulations, but modify the anticipated-life test. Under the final regulations, the anticipated-life-test is satisfied if the anticipated weighted average life of the residual interest equals at least 20 percent of the anticipated weighted average life of the REMIC.

 The regulations explain that the anticipated weighted average life of a REMIC is a weighted average of the anticipated weighted average lives of all classes of interests in the REMIC. The final regulations also clarify the procedures for computing the weighted average life of an interest in a REMIC.

 The above described significant value test applies only for purposes of the special rule for thrifts. In adopting this test, the Service has not exercised the regulatory authority provided in section 860E(c)(1) to treat all income allocated to the residual interest as an excess inclusion if the residual interest lacks significant value.

C. TAX ON TRANSFER TO DISQUALIFIED ORGANIZATION

 If a residual interest holder transfers its residual interest to a disqualified organization, a tax is imposed on the transferor (unless the transfer is through an agent, in which case the tax is imposed on the agent). The amount of tax is equal to the sum of the present values of the anticipated excess inclusions attributable to the interest multiplied by the highest corporate rate. The proposed regulations explain how to compute the present value of the anticipated excess inclusions and require that the REMIC provide to the transferor information needed to compute the amount of tax due.

 The final regulations clarify the proposed regulations by providing that a REMIC does not have any obligation to ascertain whether a residual interest has been transferred to a disqualified organization. The REMIC's only obligation is to provide information upon request.

 If a disqualified organization is a record holder of an interest in a pass-thru entity that holds a residual interest, then the pass- thru entity is taxed on the amount of income allocable to the disqualified organization. A pass-thru entity is any partnership, trust, estate, regulated investment company (RIC), REIT, common trust fund, or subchapter T cooperative.

 The proposed regulations provided that any tax imposed on a pass-thru entity, such as a RIC or a REIT, would be deductible against its ordinary income in determining the amount of its required distributions. The final regulations explain further that a RIC?s or a REIT's dividends are not preferential dividends solely because the RIC or REIT allocates any tax expense incurred under section 860E(e)(6) only to the shares held by disqualified organizations.

D. NONECONOMIC RESIDUAL INTERESTS

 To qualify as a residual interest in a REMIC, the interest must be designated as such, and it must be issued on the startup day. The residual interest holder need not be entitled to any distributions. The residual interest holder must, however, include in income the amounts allocated to it under section 860C, and to the extent those amounts represent excess inclusions, they are subject to the rules of section 860E.

 If a REMIC will have taxable income over the course of its life, the residual interest represents a future tax liability to the residual interest holder because the residual interest holder must include in gross income the REMIC's taxable income, and the excess inclusion portion of that taxable income cannot be offset with deductions. If, in addition, the residual interest holder is not entitled to any distributions, the interest also represents a net economic liability.

 The proposed regulations set forth a rule that is intended to discourage transfers of noneconomic residual interests for the purpose of avoiding the tax on excess inclusions. Under this rule, the transfer of a noneconomic residual interest is disregarded unless no significant purpose of the transfer was to impede the assessment or collection of tax.

 The proposed regulations provided that a residual interest is a noneconomic residual interest unless (1) the present value of the expected distributions on the residual interest at least equals the present value of the expected tax on the excess inclusions, and (2) the transferor reasonably expects that the transferee will receive distributions with respect to the residual interest at or after the time the taxes accrue on the anticipated excess inclusions in an amount sufficient to satisfy the accrued taxes.

 The final regulations provide that a significant purpose to impede the assessment or collection of tax exists if the transferor, at the time of the transfer has "improper knowledge" (i.e. either knew, or should have known that the transferee would be unwilling or unable to pay taxes due on its share of the taxable income of the REMIC). The final regulations explain that a transferor of a noneconomic residual interest can establish a presumptive lack of improper knowledge by satisfying two conditions. First, the transferor conducts a reasonable investigation of the transferee and, as a result of that investigation, finds that the transferee has historically paid its debts as they come due and finds no significant evidence to indicate that the transferee will not continue to pay its debts as they come due in the future. Second, the transferor obtains from the transferee a representation that the transferee understands that the residual interest may generate tax liabilities in excess of cash flows and that the transferee intends to pay those tax liabilities as they come due.

 Section 860G(b)(1) sets out special rules for the tax treatment of foreign persons that hold residual interests. These rules provide that, unlike other residual interest holders, nonresident alien individuals and foreign corporations are to take into account the income attributable to their residual interests only when they receive distributions or when they dispose of their interests.

 The proposed regulations set forth an anti-abuse rule that is similar to the general anti-abuse rule described above in that it is intended to discourage the transfer of residual interests to foreign persons for the purpose of avoiding tax on excess inclusions. The rule here provides that the transfer of a residual interest to a foreign transferee is disregarded if the residual interest has tax avoidance potential. A residual interest has tax avoidance potential unless at the time of the transfer, the transferor reasonably expects that the REMIC will distribute to the transferee residual interest holder amounts that will equal at least 30 percent of each excess inclusion, and that such amounts will be distributed at or after the time at which the excess inclusion accrues and not later than the close of the calendar year following the calendar year of accrual.

 The final regulations retain the "tax avoidance potential" rules.

IV. OTHER ISSUES

 The Service recognizes that these final regulations do not address all of the issues that arise in connection with the formation and operation of a REMIC. The Service may, however, provide future guidance on the seven items listed below.

 (1) Regulations under section 1272(a)(6) concerning the application and scope of the OID rules to regular interests, qualified mortgages, and other obligations.

 (2) Rules concerning the proper tax treatment of a payment made by a transferor of a noneconomic residual interest to induce the transferee to acquire the interest.

 (3) Regulations concerning the allocation of excess inclusions among interest holders in RICs and REITs.

 (4) Clarification of the "improper knowledge" standard in section 1.856-6(b)(3) for purposes of determining whether property acquired by a REMIC or a REIT in foreclosure will qualify as foreclosure property.

 (5) Regulations that (i) finalize the temporary and proposed REMIC reporting regulations that allow issuers 41 days instead of 30 days after the close of a quarter to report financial information with respect to the regular interests they have issued, or (ii) propose a new system that may allow issuers less than 41 days to report information, but that would also allow issuers to use estimated data in fulfilling their reporting obligations.

 (6) Modification of section 1.860F-4(d) to expand the class of persons that may be designated as tax matters person.

 (7) Regulations concerning withholding on distributions to foreign holders of residual interests to satisfy accrued tax liability due to excess inclusions.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required.

 It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal authors of these proposed regulations are Carol A. Schwartz and Tom Lyden, Office of the Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service. However, personnel from other offices of the IRS and Treasury Department participated in the development of the proposed regulations.

LIST OF SUBJECTS

26 CFR 1.591-1 through 1.1.596-1

 Banks, banking, Income taxes, Reporting and recordkeeping requirements.

26 CFR 1.856-0 through 1.860-5

 Income taxes, Investments, Trusts and trustees.

26 CFR 1.860D-1 through 1.860F-4

 Income taxes, Investments, Mortgages, Reporting and recordkeeping requirements.

26 CFR 1.6031-1 through 1.6060-1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR 301

 Administrative practice and procedure, Alimony, Bankruptcy, Child support, Continental shelf, Courts, Crime, Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Investigations, Law enforcement, Oil pollution, Penalties, Pensions, Reporting and recordkeeping requirements, Statistics, Taxes.

Treasury Decision 8458

ADOPTION OF AMENDMENTS TO THE REGULATIONS.

Accordingly, 26 CFR parts 1, 301, and 602 are amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by adding the following citations:

Authority: 26 U.S.C. 7805 * * * Section 1.860D-1 also issued under 26 U.S.C. 860G(e). Section 1.860E-1 also issued under 26 U.S.C. 860E and 860G(e). Section 1.860E-2 also issued under 26 U.S.C. 860E(e). Section 1.860F-2 also issued under 26 U.S.C. 860G(e). Section 1.860G-1 also issued under 26 U.S.C. 860G(a)(1)(B) and (e). Section 1.860G-3 also issued under 26 U.S.C. 860G(b) and 26 U.S.C. 860G(e).

* * * * *

Par. 2. Section 1.593-11 is amended by adding a sentence at the end of paragraph (b)(1) and by adding paragraph (e) to read as follows:

SECTION 1.593-11 QUALIFYING REAL PROPERTY LOAN AND NONQUALIFYING LOAN DEFINED.

* * * * *

(b) * * *

(1) * * * See paragraph (e) of this section for the treatment of a REMIC interest as a qualifying real property loan.

* * * *

(e) TREATMENT OF REMIC INTERESTS AS QUALIFYING REAL PROPERTY LOANS -- (1) IN GENERAL. For purposes of section 593 and sections 1.593-4 through 1.593-10, if, for any calendar quarter, at least 95 percent of a REMIC's assets (as determined in accordance with section 1.860F-4(e)(1)(ii) or section 1.6049-7(f)(3)) are qualifying real property loans (as defined in paragraph (b) of this section), then, for that calendar quarter, all the regular and residual interests in that REMIC are treated as qualifying real property loans. If less than 95 percent of a REMIC's assets are qualifying real property loans, then a percentage of each regular or residual interest is treated as a qualifying real property loan. The percentage equals the percentage of the REMIC's assets that are qualifying real property loans. See section 1.860F-4(e)(1)(ii)(B) and section 1.6049-7(f)(3) for information required to be provided to regular and residual interest holders if the 95-percent test is not met.

(2) TREATMENT OF REMIC ASSETS FOR SECTION 593 PURPOSES -- (i) MANUFACTURED HOUSING TREATED AS QUALIFYING REAL PROPERTY. For purposes of paragraph (e)(1) of this section, the term "qualifying real property" includes manufactured housing treated as a single family residence under section 25(e)(10).

(ii) STATUS OF CASH FLOW INVESTMENTS. For purposes of paragraph (e)(1) of this section, cash flow investments (as defined in section 860G(a)(6) and section 1.860G-2(g)(1)) are treated as qualifying real property loans.

Par. 3. Section 1.856-3 is amended as follows:

1. The text of paragraph (b) is redesignated as paragraph (b)(1).

2. A heading is added for new paragraph (b)(1).

3. Paragraph (b)(2) is added.

4. Paragraph (c) is revised.

5. The additions and revisions read as follows:

Section 1.856-3 Definitions.

* * * * *

(b) REAL ESTATE ASSETS -- (1) IN GENERAL. * * *

(2) TREATMENT OF REMIC INTERESTS AS REAL ESTATE ASSETS -- (i) IN GENERAL. If, for any calendar quarter, at least 95 percent of a REMIC's assets (as determined in accordance with section 1.860F- 4(e)(1)(ii) or section 1.6049-7(f)(3)) are real estate assets (as defined in paragraph (b)(1) of this section), then, for that calendar quarter, all the regular and residual interests in that REMIC are treated as real estate assets and, except as provided in paragraph (b)(2)(iii) of this section, any amount includible in gross income with respect to those interests is treated as interest on obligations secured by mortgages on real property. If less than 95 percent of a REMIC's assets are real estate assets, then the real estate investment trust is treated as holding directly its proportionate share of the assets and as receiving directly its proportionate share of the income of the REMIC. See sections 1.860F-4(e)(1)(ii)(B) and 1.6049-7(f)(3) for information required to be provided to regular and residual interest holders if the 95-percent test is not met.

(ii) TREATMENT OF REMIC ASSETS FOR SECTION 856 PURPOSES -- (A) MANUFACTURED HOUSING TREATED AS REAL ESTATE ASSET. For purposes of paragraphs (b)(1) and (2) of this section, the term "real estate asset" includes manufactured housing treated as a single family residence under section 25(e)(10).

(B) STATUS OF CASH FLOW INVESTMENTS. For purposes of this paragraph (b)(2), cash flow investments (as defined in section 860G(a)(6) and section 1.860G-2(g)(1)) are real estate assets.

(iii) CERTAIN CONTINGENT INTEREST PAYMENT OBLIGATIONS HELD BY A REIT. If a REIT holds a residual interest in a REMIC for a principal purpose of avoiding the limitation set out in section 856(f) (concerning interest based on mortgagor net profits) or section 856(j) (concerning shared appreciation provisions), then, even if the REMIC satisfies the 95-percent test of paragraph (b)(i) of this section, the REIT is treated as receiving directly the REMIC's items of income for purposes of section 856.

(c) INTERESTS IN REAL PROPERTY. The term "interests in real property" includes fee ownership and co-ownership of land or improvements thereon, leaseholds of land or improvements thereon, options to acquire land or improvements thereon, and options to acquire leaseholds of land or improvements thereon. The term also includes timeshare interests that represent an undivided fractional fee interest, or undivided leasehold interest, in real property, and that entitle the holders of the interests to the use and enjoyment of the property for a specified period of time each year. The term also includes stock held by a person as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in section 216). Such term does not, however, include mineral, oil, or gas royalty interests, such as a retained economic interest in coal or iron ore with respect to which the special provisions of section 681(c) apply.

Par. 4. Sections 1.860A-0, 1.860A-1, 1.860C-1 and 1.860C-2 are added to read as follows:

SECTION 1.860A-0 OUTLINE OF REMIC PROVISIONS.

This section lists the paragraphs contained in sections 1.860A-1 through 1.860G-3.

 SECTION 1.860A-1 EFFECTIVE DATES AND TRANSITION RULES.

(a) IN GENERAL. Except as otherwise provided in paragraph (b) of this section, the regulations under sections 860A through 860G are effective only for a qualified entity (as defined in section 1.860D- 1(c)(3)) whose startup day (as defined in section 860G(a)(9) and section 1.860G-2(k)) is on or after November 12, 1991.

(b) EXCEPTIONS -- (1) REPORTING REGULATIONS -- (i) Sections 1.860D-1(c)(1) and (3), and section 1.860D-1(d)(1) through (3) are effective after December 31, 1986.

(ii) Sections 1.860F-4(a) through (e) are effective after December 31, 1986 and are applicable after that date except as follows:

(A) Section 1.860F-4(c)(1) is effective for REMICs with a startup day on or after November 10, 1988.

(B) Sections 1.860F-4(e)(1)(ii)(A) and (B) are effective for calendar quarters and calendar years beginning after December 31, 1988.

(C) Section 1.860F-4(e)(1)(ii)(C) is effective for calendar quarters and calendar years beginning after December 31, 1986 and ending before January 1, 1988.

(D) Section 1.860F-4(e)(1)(ii)(D) is effective for calendar quarters and calendar years beginning after December 31, 1987 and ending before January 1, 1990.

(2) TAX AVOIDANCE RULES -- (i) TRANSFERS OF CERTAIN RESIDUAL INTERESTS. Section 1.860E-1(c) (concerning transfers of noneconomic residual interests) and section 1.860G-3(a)(4) (concerning transfers by a foreign holder to a United States person) are effective for transfers of residual interests on or after September 27, 1991.

(ii) TRANSFERS TO FOREIGN HOLDERS. Generally, section 1.860G- 3(a) (concerning transfers of residual interests to foreign holders) is effective for transfers of residual interests after April 20, 1992. However, section 1.860G-3(a) does not apply to a transfer of a residual interest in a REMIC by the REMIC's sponsor (or by another transferor contemporaneously with formation of the REMIC) on or before June 30, 1992 if --

(A) The terms of the regular interests and the prices at which regular interests were offered had been fixed on or before April 20, 1992;

(B) On or before June 30, 1992, a substantial portion of the regular interests in the REMIC were transferred, with the terms and at the prices that were fixed on or before April 20, 1992, to investors who were unrelated to the REMIC's sponsor at the time of the transfer; and

(C) At the time of the transfer of the residual interest, the expected future distributions on the residual interest were equal to at least 30 percent of the anticipated excess inclusions (as defined in section 1.860E-2(a)(3)), and the transferor reasonably expected that the transferee would receive sufficient distributions from the REMIC at or after the time at which the excess inclusions accrue in an amount sufficient to satisfy the taxes on the excess inclusions.

(iii) RESIDUAL INTERESTS THAT LACK SIGNIFICANT VALUE. The significant value requirement in section 1.860E-1(a)(1) and (3) (concerning excess inclusions accruing to organizations to which section 593 applies) generally is effective for residual interests acquired on or after September 27, 1991. The significant value requirement in section 1.860E-1(a)(1) and (3) does not apply, however, to residual interests acquired by an organization to which section 593 applies as a sponsor at formation of a REMIC in a transaction described in section 1,860F-2(a)(1) if more than 50 percent of the interests in the REMIC (determined by reference to issue price) were sold to unrelated investors before November 12, 1991. The exception from the significant value requirement provided by the preceding sentence applies only so long as the sponsor owns the residual interests.

(3) EXCISE TAXES. Section 1.860E-2(a)(1) is effective for transfers of residual interests to disqualified organizations after March 31, 1988. Section 1.860E-2(b)(1) is effective for excess inclusions accruing to pass-thru entities after March 31, 1988.

SECTION 1.860C-1 TAXATION OF HOLDERS OF RESIDUAL INTERESTS.

(a) PASS-THRU OF INCOME OR LOSS. Any holder of a residual interest in a REMIC must take into account the 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 owned the residual interest.

(b) ADJUSTMENTS TO BASIS OF RESIDUAL INTERESTS -- (1) INCREASE IN BASIS. A holder's basis in a residual interest is increased by --

(i) The daily portions of taxable income taken into account by that holder under section 860C(a) with respect to that interest; and

(ii) The amount of any contribution described in section 860G(d)(2) made by that holder.

(2) DECREASE IN BASIS. A holder's basis in a residual interest is reduced (but not below zero) by --

(i) First, the amount of any cash or the fair market value of any property distributed to that holder with respect to that interest; and

(ii) Second, the daily portions of net loss of the REMIC taken into account under section 860C(a) by that holder with respect to that interest.

(3) ADJUSTMENTS MADE BEFORE DISPOSITION. If any person disposes of a residual interest, the adjustments to basis prescribed in paragraph (b)(1) and (2) of this section are deemed to occur immediately before the disposition.

(c) COUNTING CONVENTIONS. For purposes of determining the daily portion of REMIC taxable income or net loss under section 860C(a)(2), any reasonable convention may be used. An example of a reasonable convention is "30 days per month/90 days per quarter/360 days per year."

SECTION 1.860C-2 DETERMINATION OF REMIC TAXABLE INCOME OR NET LOSS.

(a) TREATMENT OF GAIN OR LOSS. For purposes of determining the taxable income or net loss of a REMIC under section 860C(b), any gain or loss from the disposition of any asset, including a qualified mortgage (as defined in section 860G(a)(3)) or a permitted investment (as defined in section 860G(a)(5) and section 1.860G-2(g)), is treated as gain or loss from the sale or exchange of property that is not a capital asset.

(b) DEDUCTIONS ALLOWABLE TO A REMIC -- (1) IN GENERAL. Except as otherwise provided in section 860C(b) and in paragraph (b)(2) through (5) of this section, the deductions allowable to a REMIC for purposes of determining its taxable income or net loss are those deductions that would be allowable to an individual, determined by taking into account the same limitations that apply to an individual.

(2) DEDUCTION ALLOWABLE UNDER SECTION 163. A REMIC is allowed a deduction, determined without regard to section 163(d), for any interest expense accrued during the taxable year.

(3) DEDUCTION ALLOWABLE UNDER SECTION 166. For purposes of determining a REMIC's bad debt deduction under section 166, debt owed to the REMIC is not treated as nonbusiness debt under section 166(d).

(4) DEDUCTION ALLOWABLE UNDER SECTION 212. A REMIC is not treated as carrying on a trade or business for purposes of section 162. Ordinary and necessary operating expenses paid or incurred by the REMIC during the taxable year are deductible under section 212, without regard to section 67. Any expenses that are incurred in connection with the formation of the REMIC and that relate to the organization of the REMIC and the issuance of regular and residual interests are not treated as expenses of the REMIC for which a deduction is allowable under section 212. See section 1.860F- 2(b)(3)(ii) for treatment of those expenses.

(5) EXPENSES AND INTEREST RELATING TO TAX-EXEMPT INCOME. Pursuant to section 265(a), a REMIC is not allowed a deduction for expenses and interest allocable to tax-exempt income. The portion of a REMIC's interest expense that is allocable to tax-exempt interest is determined in the manner prescribed in section 265(b)(2), without regard to section 265(b)(3).

Par. 5. Section 1.860D-1 is amended by adding the text of paragraphs (a) and (b), and revising paragraph (c)(2) to read as follows:

SECTION 1.860D-1 DEFINITION OF A REMIC.

(a) IN GENERAL. A real estate mortgage investment conduit (or REMIC) is a qualified entity, as defined in paragraph (c)(3) of this section, that satisfies the requirements of section 860D(a). See paragraph (d)(1) of this section for the manner of electing REMIC status.

(b) SPECIFIC REQUIREMENTS -- (1) INTERESTS IN A REMIC -- (i) IN GENERAL. A REMIC must have one class, and only one class, of residual interests. Except as provided in paragraph (b)(1)(ii) of this section, every interest in a REMIC must be either a regular interest (as defined in section 860G(a)(1) and section 1.860G-1(a)) or a residual interest (as defined in section 860G(a)(2) and section 1.860G-1(c)).

(ii) DE MINIMIS INTERESTS. If, to facilitate the creation of an entity that elects REMIC status, an interest in the entity is created and, as of the startup day (as defined in section 860G(a)(9) and section 1.860G-2(k)), the fair market value of that interest is less than the lesser of $1,000 or 1/1,000 of one percent of the aggregate fair market value of all the regular and residual interests in the REMIC, then, unless that interest is specifically designated as an interest in the REMIC, the interest is not treated as an interest in the REMIC for purposes of section 860D(a)(2) and (3) and paragraph (b)(1)(i) of this section.

(2) CERTAIN RIGHTS NOT TREATED AS INTERESTS. Certain rights are not treated as interests in a REMIC. Although not an exclusive list, the following rights are not interests in a REMIC.

(i) PAYMENTS FOR SERVICES. The right to receive from the REMIC payments that represent reasonable compensation for services provided to the REMIC in the ordinary course of its operation is not an interest in the REMIC. Payments made by the REMIC in exchange for services may be expressed as a specified percentage of interest payments due on qualified mortgages or as a specified percentage of earnings from permitted investments. For example, a mortgage servicer's right to receive reasonable compensation for servicing the mortgages owned by the REMIC is not an interest in the REMIC.

(ii) STRIPPED INTERESTS. Stripped bonds or stripped coupons not held by the REMIC are not interests in the REMIC even if, in a transaction preceding or contemporaneous with the formation of the REMIC, they and the REMIC's qualified mortgages were created from the same mortgage obligation. For example, the right of a mortgage servicer to receive a servicing fee in excess of reasonable compensation from payments it receives on mortgages held by a REMIC is not an interest in the REMIC. Further, if an obligation with a fixed principal amount provides for interest at a fixed or variable rate and for certain contingent payment rights (e.g., a shared appreciation provision or a percentage of mortgagor profits provision), and the owner of the obligation contributes the fixed payment rights to a REMIC and retains the contingent payment rights, the retained contingent payment rights are not an interest in the REMIC.

(iii) REIMBURSEMENT RIGHTS UNDER CREDIT ENHANCEMENT CONTRACTS. A credit enhancer's right to be reimbursed for amounts advanced to a REMIC pursuant to the terms of a credit enhancement contract (as defined in section 1.860G-2(c)(2)) is not an interest in the REMIC even if the credit enhancer is entitled to receive interest on the amounts advanced.

(iv) RIGHTS TO ACQUIRE MORTGAGES. The right to acquire or the obligation to purchase mortgages and other assets from a REMIC pursuant to a clean-up call (as defined in section 1.860G-2(j)) or a qualified liquidation (as defined in section 860F(a)(4)), or on conversion of a convertible mortgage (as defined in section 1.860G- 2(d)(5)), is not an interest in the REMIC.

(3) ASSET TEST -- (i) IN GENERAL. For purposes of the asset test of section 860D(a)(4), substantially all of a qualified entity's assets are qualified mortgages and permitted investments if the qualified entity owns no more than a de minimis amount of other assets.

(ii) SAFE HARBOR. The amount of assets other than qualified mortgages and permitted investments is de minimis if the aggregate of the adjusted bases of those assets is less than one percent of the aggregate of the adjusted bases of all of the REMIC's assets. Nonetheless, a qualified entity that does not meet this safe harbor may demonstrate that it owns no more than a de minimis amount of other assets.

(4) ARRANGEMENTS TEST. Generally, a qualified entity must adopt reasonable arrangements designed to ensure that --

(i) Disqualified organizations (as defined in section 860E(e)(5)) do not hold residual interests in the qualified entity; and

(ii) If a residual interest is acquired by a disqualified organization, the qualified entity will provide to the Internal Revenue Service, and to the persons specified in section 860E(e)(3), information needed to compute the tax imposed under section 860E(e) on transfers of residual interests to disqualified organizations.

(5) REASONABLE ARRANGEMENTS -- (i) ARRANGEMENTS TO PREVENT DISQUALIFIED ORGANIZATIONS FROM HOLDING RESIDUAL INTERESTS. A qualified entity is considered to have adopted reasonable arrangements to ensure that a disqualified organization (as defined in section 860E(e)(5)) will not hold a residual interest if --

(A) The residual interest is in registered form (as defined in section 5f.103-1(c) of this chapter); and

(B) The qualified entity's organizational documents clearly and expressly prohibit a disqualified organization from acquiring beneficial ownership of a residual interest, and notice of the prohibition is provided through a legend on the document that evidences ownership of the residual interest or through a conspicuous statement in a prospectus or private offering document used to offer the residual interest for sale.

(ii) ARRANGEMENTS TO ENSURE THAT INFORMATION WILL BE PROVIDED. A qualified entity is considered to have made reasonable arrangements to ensure that the Internal Revenue Service and persons specified in section 860E(e)(3) as liable for the tax imposed under section 860E(e) receive the information needed to compute the tax if the qualified entity's organizational documents require that it provide to the Internal Revenue Service and those persons a computation showing the present value of the total anticipated excess inclusions with respect to the residual interest for periods after the transfer. See section 1.860E-2(a)(5) for the obligation to furnish information on request.

(6) CALENDAR YEAR REQUIREMENT. A REMIC's taxable year is the calendar year. The first taxable year of a REMIC begins on the startup day and ends on December 31 of the same year. If the startup day is other than January 1, the REMIC has a short first taxable year.

(c) * * *

(2) IDENTIFICATION OF ASSETS. Formation of the REMIC does not occur until --

(i) The sponsor identifies the assets of the REMIC, such as through execution of an indenture with respect to the assets; and

(ii) The REMIC issues the regular and residual interests in the REMIC.

* * * * *

Par. 6. Sections 1.860E-1, 1.860E-2, 1.860F-1, and 1.860F-2 are added to read as follows:

SECTION 1.860E-1 TREATMENT OF TAXABLE INCOME OF A RESIDUAL INTEREST HOLDER IN EXCESS OF DAILY ACCRUALS.

(a) EXCESS INCLUSION CANNOT BE OFFSET BY OTHERWISE ALLOWABLE DEDUCTIONS -- (1) IN GENERAL. Except as provided in paragraph (a)(3) of this section, the taxable income of any holder of a residual interest for any taxable year is in no event less than the sum of the excess inclusions attributable to that holder's residual interests for that taxable year. In computing the amount of a net operating loss (as defined in section 172(c)) or the amount of any net operating loss carryover (as defined in section 172(b)(2)), the amount of any excess inclusion is not included in gross income or taxable income. Thus, for example, if a residual interest holder has $100 of gross income, $25 of which is an excess inclusion, and $90 of business deductions, the holder has taxable income of $25, the amount of the excess inclusion, and a net operating loss of $15 ($75 of other income -- $90 of business deductions).

(2) AFFILIATED GROUPS. If a holder of a REMIC residual interest is a member of an affiliated group filing a consolidated income tax return, the taxable income of the affiliated group cannot be less than the sum of the excess inclusions attributable to all residual interests held by members of the affiliated group.

(3) SPECIAL RULE FOR CERTAIN FINANCIAL INSTITUTIONS -- (i) IN GENERAL. If an organization to which section 593 applies holds a residual interest that has significant value (as defined in paragraph (a)(3)(iii) of this section), section 860E(a)(1) and paragraph (a)(1) of this section do not apply to that organization with respect to that interest. Consequently, an organization to which section 593 applies may use its allowable deductions to offset an excess inclusion attributable to a residual interest that has significant value, but, except as provided in section 860E(a)(4)(A), may not use its allowable deductions to offset an excess inclusion attributable to a residual interest held by any other member of an affiliated group, if any, of which the organization is a member. Further, a net operating loss of any other member of an affiliated group of which the organization is a member may not be used to offset an excess inclusion attributable to a residual interest held by that organization.

(ii) ORDERING RULE -- (A) IN GENERAL. In computing taxable income for any year, an organization to which section 593 applies is treated as having applied its allowable deductions for the year first to offset that portion of its gross income that is not an excess inclusion and then to offset that portion of its income that is an excess inclusion.

(B) EXAMPLE. The following example illustrates the provisions of paragraph (a)(3)(ii) of this section:

EXAMPLE. Corp. X, a corporation to which section 593 applies, is a member of an affiliated group that files a consolidated return. For a particular taxable year, Corp. X has gross income of $1,000, and of this amount, $150 is an excess inclusion attributable to a residual interest that has significant value. Corp. X has $975 of allowable deductions for the taxable year. Corp. X must apply its allowable deductions first to offset the $850 of gross income that is not an excess inclusion, and then to offset the portion of its gross income that is an excess inclusion. Thus, Corp. X has $25 of taxable income ($1,000 - $975), and that $25 is an excess inclusion that may not be offset by losses sustained by other members of the affiliated group.

(iii) 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.

(iv) DETERMINING ANTICIPATED WEIGHTED AVERAGE LIFE -- (A) ANTICIPATED WEIGHTED AVERAGE LIFE OF THE REMIC. The anticipated weighted average life of a REMIC is the weighted average of the anticipated weighted average lives of all classes of interests in the REMIC. This weighted average is determined under the formula in paragraph (a)(3)(iv)(B) of this section, applied by treating all payments taken into account in computing the anticipated weighted average lives of regular and residual interests in the REMIC as principal payments on a single regular interest.

(B) REGULAR INTERESTS THAT HAVE A SPECIFIED PRINCIPAL AMOUNT. Generally, the anticipated weighted average life of a regular interest is determined by --

(1) Multiplying the amount of each anticipated principal payment to be made on the interest by the number of years (including fractions thereof) from the startup day (as defined in section 860G(a)(9) and section 1.860G-2(k)) to the related principal payment date;

(2) Adding the results; and

(3) Dividing the sum by the total principal paid on the regular interest.

(C) REGULAR INTERESTS THAT HAVE NO SPECIFIED PRINCIPAL AMOUNT OR THAT HAVE ONLY A NOMINAL PRINCIPAL AMOUNT, AND ALL RESIDUAL INTERESTS. If a regular interest has no specified principal amount, or if the interest payments to be made on a regular interest are disproportionately high relative to its specified principal amount (as determined by reference to section 1.860G-1(b)(5)(i)), then, for purposes of computing the anticipated weighted average life of the interest, all anticipated payments on that interest, regardless of their designation as principal or interest, must be taken into account in applying the formula set out in paragraph (a)(3)(iv)(B) of this section. Moreover, for purposes of computing the weighted average life of a residual interest, all anticipated payments on that interest, regardless of their designation as principal or interest, must be taken into account in applying the formula set out in paragraph (a)(3)(iv)(B) of this section.

(D) ANTICIPATED PAYMENTS. The anticipated principal payments to be made on a regular interest subject o paragraph (a)(3)(iv)(B) of this section, and the anticipated payments to be made on a regular interest subject to paragraph (a)(3)(iv)(C) of this section or on a residual interest, must be determined based on --

(1) The prepayment and reinvestment assumptions adopted under section 1272(a)(6), or that would have been adopted had the REMIC's regular interests been issued with original issue discount; and

(2) Any required or permitted clean up calls or any required qualified liquidation provided for in the REMIC's organizational documents.

(b) TREATMENT OF RESIDUAL INTERESTS HELD BY REITS, RICS, COMMON TRUST FUNDS, AND SUBCHAPTER T COOPERATIVES.

[RESERVED]

(c) TRANSFERS OF NONECONOMIC RESIDUAL INTERESTS -- (1) IN GENERAL. A transfer of a noneconomic residual interest is disregarded for all Federal tax purposes if a significant purpose of the transfer was to enable the transferor to impede the assessment or collection of tax. A significant purpose to impede the assessment or collection of tax exists if the transferor, at the time of the transfer, either knew or should have known (had "improper knowledge") that the transferee would be unwilling or unable to pay taxes due on its share of the taxable income of the REMIC.

(2) NONECONOMIC RESIDUAL INTEREST. A residual interest is a noneconomic residual interest unless, at the time of the transfer --

(i) The present value of the expected future distributions on the residual interest at least equals the product of the present value of the anticipated excess inclusions and the highest rate of tax specified in section 11(b)(1) for the year in which the transfer occurs; and

(ii) The transferor reasonably expects that, for each anticipated excess inclusion, the transferee will receive distributions from the REMIC at or after the time at which the taxes accrue on the anticipated excess inclusion in an amount sufficient to satisfy the accrued taxes.

(3) COMPUTATIONS. The present value of the expected future distributions and the present value of the anticipated excess inclusions must be computed under the procedure specified in section 1.860E-2(a)(4) for determining the present value of anticipated excess inclusions in connection with the transfer of a residual interest to a disqualified organization.

(4) SAFE HARBOR FOR ESTABLISHING LACK OF IMPROPER KNOWLEDGE. A transferor is presumed not to have improper knowledge if --

(i) The transferor conducted, at the time of the transfer, a reasonable investigation of the financial condition of the transferee and, as a result of the investigation, the transferor found that the transferee had historically paid its debts as they came due and found no significant evidence to indicate that the transferee will not continue to pay its debts as they come due in the future; and

(ii) The transferee represents to the transferor that it understands that, as the holder of the noneconomic residual interest, the transferee may incur tax liabilities in excess of any cash flows generated by the interest and that the transferee intends to pay taxes associated with holding the residual interest as they become due.

(d) TRANSFERS TO FOREIGN PERSONS. Paragraph (c) of this section does not apply to transfers of residual interests to which section 1.860G-3(a)(1), concerning transfers to certain foreign persons, applies.

SECTION 1.860E-2 TAX ON TRANSFERS OF RESIDUAL INTERESTS TO CERTAIN ORGANIZATIONS.

(a) TRANSFERS TO DISQUALIFIED ORGANIZATIONS -- (1) PAYMENT OF TAX. Any excise tax due under section 860E(e)(1) must be paid by the later of March 24, 1993, or April 15th of the year following the calendar year in which the residual interest is transferred to a disqualified organization. The Commissioner may prescribe rules for the manner and method of collecting the tax.

(2) TRANSITORY OWNERSHIP. For purposes of section 860E(e) and this section, a transfer of a residual interest to a disqualified organization in connection with the formation of a REMIC is disregarded if the disqualified organization has a binding contract to sell the interest and the sale occurs within 7 days of the startup day (as defined in section 860G(a)(9) and section 1.860G-2(k)).

(3) ANTICIPATED EXCESS INCLUSIONS. The anticipated excess inclusions are the excess inclusions that are expected to accrue in each calendar quarter (or portion thereof) following the transfer of the residual interest. The anticipated excess inclusions must be determined as of the date the residual interest is transferred and must be based on --

(i) Events that have occurred up to the time of the transfer;

(ii) The prepayment and reinvestment assumptions adopted under section 1272(a)(6), or that would have been adopted had the REMIC's regular interests been issued with original issue discount; and

(iii) Any required or permitted clean up calls, or required qualified liquidation provided for in the REMIC's organizational documents.

(4) PRESENT VALUE COMPUTATION. The present value of the anticipated excess inclusions is determined by discounting the anticipated excess inclusions from the end of each remaining calendar quarter in which those excess inclusions are expected to accrue to the date the disqualified organization acquires the residual interest. The discount rate to be used for this present value computation is the applicable Federal rate (as specified in section 1274(d)(1)) that would apply to a debt instrument that was issued on the date the disqualified organization acquired the residual interest and whose term ended on the close of the last quarter in which excess inclusions were expected to accrue with respect to the residual interest.

(5) OBLIGATION OF REMIC TO FURNISH INFORMATION. A REMIC is not obligated to determine if its residual interests have been transferred to a disqualified organization. However, upon request of a person designated in section 860E(e)(3), the REMIC must furnish information sufficient to compute the present value of the anticipated excess inclusions. The information must be furnished to the requesting party and to the Internal Revenue Service within 60 days of the request. A reasonable fee charged to the requestor is not income derived from a prohibited transaction within the meaning of section 860F(a).

(6) AGENT. For purposes of section 860E(e)(3), the term "agent" includes a broker (as defined in section 6045(c) and section 1.6045-1(a)(1)), nominee, or other middleman.

(7) RELIEF FROM LIABILITY -- (i) TRANSFEREE FURNISHES INFORMATION UNDER PENALTIES OF PERJURY. For purposes of section 860E(e)(4), a transferee is treated as having furnished an affidavit if the transferee furnishes --

(A) A social security number, and states under penalties of perjury that the social security number is that of the transferee; or

(B) A statement under penalties of perjury that it is not a disqualified organization.

(ii) AMOUNT REQUIRED TO BE PAID. The amount required to be paid under section 860E(e)(7)(B) is equal to the product of the highest rate specified in section 11(b)(1) for the taxable year in which the transfer described in section 860E(e)(1) occurs and the amount of excess inclusions that accrued and were allocable to the residual interest during the period that the disqualified organization held the interest.

(b) TAX ON PASS-THRU ENTITIES -- (1) TAX ON EXCESS INCLUSIONS. Any tax due under section 860E(e)(6) must be paid by the later of March 24, 1993, or by the fifteenth day of the fourth month following the close of the taxable year of the pass-thru entity in which the disqualified person is a record holder. The Commissioner may prescribe rules for the manner and method of collecting the tax.

(2) RECORD HOLDER FURNISHES INFORMATION UNDER PENALTIES OF PERJURY. For purposes of section 860E(e)(6)(D), a record holder is treated as having furnished an affidavit if the record holder furnishes --

(i) A social security number and states, under penalties of perjury, that the social security number is that of the record holder; or

(ii) A statement under penalties of perjury that it is not a disqualified organization.

(3) DEDUCTIBILITY OF TAX. Any tax imposed on a pass-thru entity pursuant to section 860E(e)(6)(A) is deductible against the gross amount of ordinary income of the pass-thru entity. For example, in the case of a REIT, the tax is deductible in determining real estate investment trust taxable income under section 857(b)(2).

(4) ALLOCATION OF TAX. Dividends paid by a RIC or by a REIT are not preferential dividends within the meaning of section 562(c) solely because the tax expense incurred by the RIC or REIT under section 860E(e)(6) is allocated solely to the shares held by disqualified organizations.

SECTION 1.860F-1 QUALIFIED LIQUIDATIONS.

A plan of liquidation need not be in any special form. If a REMIC specifies the first day in the 90-day liquidation period in a statement attached to its final return, then the REMIC will be considered to have adopted a plan of liquidation on the specified date.

SECTION 1.860F-2 TRANSFERS TO A REMIC.

(a) FORMATION OF A REMIC -- (1) IN GENERAL. For Federal income tax purposes, a REMIC formation is characterized as the contribution of assets by a sponsor (as defined in paragraph (b)(1) of this section) to a REMIC in exchange for REMIC regular and residual interests. If, instead of exchanging its interest in mortgages and related assets for regular and residual interests, the sponsor arranges to have the REMIC issue some or all of the regular and residual interests for cash, after which the sponsor sells its interests in mortgages and related assets to the REMIC, the transaction is, nevertheless, viewed for Federal income tax purposes as the sponsor's exchange of mortgages and related assets for regular and residual interests, followed by a sale of some or all of those interests. The purpose of this rule is to ensure that the tax consequences associated with the formation of a REMIC are not affected by the actual sequence of steps taken by the sponsor.

(2) TIERED ARRANGEMENTS -- (i) TWO OR MORE REMICS FORMED PURSUANT TO A SINGLE SET OF ORGANIZATIONAL DOCUMENTS. Two or more REMICs can be created pursuant to a single set of organizational documents even if for state law purposes or for Federal securities law purposes those documents create only one organization. The organizational documents must, however, clearly and expressly identify the assets of, and the interests in, each REMIC, and each REMIC must satisfy all of the requirements of section 860D and the related regulations.

(ii) A REMIC AND ONE OR MORE INVESTMENT TRUSTS FORMED PURSUANT TO A SINGLE SET OF DOCUMENTS. A REMIC (or two or more REMICs) and one or more investment trusts can be created pursuant to a single set of organizational documents and the separate existence of the REMIC(s) and the investment trust(s) will be respected for Federal income tax purposes even if for state law purposes or for Federal securities law purposes those documents create only one organization. The organizational documents for the REMIC(s) and the investment trust(s) must, however, require both the REMIC(s) and the investment trust(s) to account for items of income and ownership of assets for Federal tax purposes in a manner that respects the separate existence of the multiple entities. See section 1.860G-2(i) concerning issuance of regular interests coupled with other contractual rights for an illustration of the provisions of this paragraph.

(b) TREATMENT OF SPONSOR -- (1) SPONSOR DEFINED. A sponsor is a person who directly or indirectly exchanges qualified mortgages and related assets for regular and residual interests in a REMIC. A person indirectly exchanges interests in qualified mortgages and related assets for regular and residual interests in a REMIC if the person transfers, other than in 8 nonrecognition transaction, the mortgages and related assets to another person who acquires a transitory ownership interest in those assets before exchanging them for interests in the REMIC, after which the transitory owner then transfers some or all of the interests in the REMIC to the first person.

(2) NONRECOGNITION OF GAIN OR LOSS. The sponsor does not recognize gain or loss on the direct or indirect transfer of any property to a REMIC in exchange for regular or residual interests in the REMIC. However, the sponsor, upon a subsequent sale of the REMIC regular or residual interests, may recognize gain or loss with respect to those interests.

(3) BASIS OF CONTRIBUTED ASSETS ALLOCATED AMONG INTERESTS -- (i) IN GENERAL. The aggregate of the adjusted bases of the regular and residual interests received by the sponsor in the exchange described in paragraph (a) of this section is equal to the aggregate of the adjusted bases of the property transferred by the sponsor in the exchange, increased by the amount of organizational expenses (as described in paragraph (b)(3)(ii) of this section). That total is allocated among all the interests received in proportion to their fair market values on the pricing date (as defined in paragraph (b)(3)(iii) of this section) if any, or, if none, the startup day (as defined in section 860G(a)(9) and section 1.860G-2(k)).

(ii) ORGANIZATIONAL EXPENSES -- (A) ORGANIZATIONAL EXPENSE DEFINED. An organizational expense is an expense that is incurred by the sponsor or by the REMIC and that is directly related to the creation of the REMIC. Further, the organizational expense must be incurred during a period beginning a reasonable time before the startup day and ending before the date prescribed by law for filing the first REMIC tax return (determined without regard to any extensions of time to file). The following are examples of organizational expenses: legal fees for services related to the formation of the REMIC, such as preparation of a pooling and servicing agreement and trust indenture; accounting fees related to the formation of the REMIC; and other administrative costs related to the formation of the REMIC.

(B) SYNDICATION EXPENSES. Syndication expenses are not organizational expenses. Syndication expenses are those expenses incurred by the sponsor or other person to market the interests in a REMIC, and, thus, are applied to reduce the amount realized on the sale of the interests. Examples of syndication expenses are brokerage fees, registration fees, fees of an underwriter or placement agent, and printing costs of the prospectus or placement memorandum and other selling or promotional material.

(iii) PRICING DATE. The term "pricing date" means the date on which the terms of the regular and residual interests are fixed and the prices at which a substantial portion of the regular interests will be sold are fixed.

(4) TREATMENT OF UNRECOGNIZED GAIN OR LOSS -- (i) UNRECOGNIZED GAIN ON REGULAR INTERESTS. For purposes of section 860F(b)(1)(C)(i), the sponsor must include in gross income the excess of the issue price of a regular interest over the sponsor's basis in the interest as if the excess were market discount (as defined in section 1278(a)(2)) on a bond and the sponsor had made an election under section 1278(b) to include this market discount currently in gross income. The sponsor is not, however, by reason of this paragraph (b)(4)(i), deemed to have made an election under section 1278(b) with respect to any other bonds.

(ii) UNRECOGNIZED LOSS ON REGULAR INTERESTS. For purposes of section 860F(b)(1)(D)(i), the sponsor treats the excess of the sponsor's basis in a regular interest over the issue price of the interest as if that excess were amortizable bond premium (as defined in section 171(b)) on a taxable bond and the sponsor had made an election under section 171(c). The sponsor is not, however, by reason of this paragraph (b)(4)(ii), deemed to have made an election under section 171(c) with respect to any other bonds.

(iii) UNRECOGNIZED GAIN ON RESIDUAL INTERESTS. For purposes of section 860F(b)(1)(C)(ii), the sponsor must include in gross income the excess of the issue price of a residual interest over the sponsor's basis in the interest ratably over the anticipated weighted average life of the REMIC (as defined in section 1.860E-1(a)(3)(iv)).

(iv) UNRECOGNIZED LOSS ON RESIDUAL INTERESTS. For purposes of section 860F(b)(1)(D)(ii), the sponsor deducts the excess of the sponsor's basis in a residual interest over the issue price of the interest ratably over the anticipated weighted average life of the REMIC.

(5) ADDITIONS TO OR REDUCTIONS OF THE SPONSOR'S BASIS. The sponsor's basis in a regular or residual interest is increased by any amount included in the sponsor's gross income under paragraph (b)(4) of this section. The sponsor's basis in a regular or residual interest is decreased by any amount allowed as a deduction and by any amount applied to reduce interest payments to the sponsor under paragraph (b)(4)(ii) of this section.

(6) TRANSFERRED BASIS PROPERTY. For purposes of paragraph (b)(4) of this section, a transferee of a regular or residual interest is treated in the same manner as the sponsor to the extent that the basis of the transferee in the interest is determined in whole or in part by reference to the basis of the interest in the hands of the sponsor.

(c) REMIC'S BASIS IN CONTRIBUTED ASSETS. For purposes of section 860F(b)(2), the aggregate of the REMIC's bases in the assets contributed by the sponsor to the REMIC in a transaction described in paragraph (a) of this section is equal to the aggregate of the issue prices (determined under section 860G(a)(10) and section 1.860G-1(d)) of all regular and residual interests in the REMIC.

Par. 7. Section 1.860F-4 is amended by adding paragraph (f) and sections 1.860G-1 through 1.860G-3 are added to read as follows:

SECTION 1.860F-4 REMIC REPORTING REQUIREMENTS AND OTHER ADMINISTRATIVE RULES.

* * * * *

(f) INFORMATION RETURNS FOR PERSONS ENGAGED IN A TRADE OR BUSINESS. See section 1.6041-1(b)(2) for the treatment of a REMIC under sections 6041 and 6041A.

SECTION 1.860G-1 DEFINITION OF REGULAR AND RESIDUAL INTERESTS.

(a) REGULAR INTEREST -- (1) DESIGNATION AS A REGULAR INTEREST. For purposes of section 860G(a)(1), a REMIC designates an interest as a regular interest by providing to the Internal Revenue Service the information specified in section 1.860D-1(d)(2)(ii) in the time and manner specified in section 1.860D-1(d)(2).

(2) SPECIFIED PORTION OF THE INTEREST PAYMENTS ON QUALIFIED MORTGAGES -- (i) IN GENERAL. For purposes of section 860G(a)(1)(B)(ii), a specified portion of the interest payments on qualified mortgages means a portion of the interest payable on qualified mortgages, but only if the portion can be expressed as --

(A) A fixed percentage of the interest that is payable at either a fixed rate or at a variable rate described in paragraph (a)(3) of this section on some or all of the qualified mortgages;

(B) A fixed number of basis points of the interest payable on some or all of the qualified mortgages; or

(C) The interest payable at either a fixed rate or at a variable rate described in paragraph (a)(3) of this section on some or all of the qualified mortgages in excess of a fixed number of basis points or in excess of a variable rate described in paragraph (a)(3) of this section.

(ii) SPECIFIED PORTION CANNOT VARY. The portion must be established as of the startup day (as defined in section 860G(a)(9) and section 1.860G-2(k)) and, except as provided in paragraph (a)(2)(iii) of this section, it cannot vary over the period that begins on the startup day and ends on the day that the interest holder is no longer entitled to receive payments.

(iii) DEFAULTED OR DELINQUENT MORTGAGES. A portion is not treated as varying over time if an interest holder's entitlement to a portion of the interest on some or all of the qualified mortgages is dependent on the absence of defaults or delinquencies on those mortgages.

(iv) NO MINIMUM SPECIFIED PRINCIPAL AMOUNT IS REQUIRED. If an interest in a REMIC consists of a specified portion of the interest payments on the REMIC's qualified mortgages, no minimum specified principal amount need be assigned to that interest. The specified principal amount can be zero.

(v) EXAMPLES. The following examples, each of which describes a pass-thru trust that is intended to qualify as a REMIC, illustrate the provisions of this paragraph (a)(2).

EXAMPLE 1. (i) A sponsor transferred a pool of fixed rate mortgages to a trustee in exchange for two classes of certificates. The Class A certificate holders are entitled to all principal payments on the mortgages and to interest on outstanding principal at a variable rate based on the current value of One-Month LIBOR, subject to a lifetime cap equal to the weighted average rate payable on the mortgages. The Class B certificate holders are entitled to all interest payable on the mortgages in excess of the interest paid on the Class A certificates. The Class B certificates are subordinate to the Class A certificates so that cash flow shortfalls due to defaults or delinquencies on the mortgages will be borne first by the Class B certificate holders.

(ii) The Class B certificate holders are entitled to all interest payable on the pooled mortgages in excess of a variable rate described in paragraph (a)(3)(vi) of this section. Moreover, the portion of the interest payable to the Class B certificate holders is not treated as varying over time solely because payments on the Class B certificates may be reduced as a result of defaults or delinquencies on the pooled mortgages. Thus, the Class B certificates provide for interest payments that consist of a specified portion of the interest payable on the pooled mortgages under paragraph (a)(2)(i)(C) of this section.

EXAMPLE 2. (i) A sponsor transferred a pool of variable rate mortgages to a trustee in exchange for two classes of certificates. The mortgages call for interest payments at a variable rate based on the current value of the One-Year Constant Maturity Treasury Index (hereinafter "CMTI") plus 200 basis points, subject to a lifetime cap of 12 percent. Class C certificate holders are entitled to all principal payments on the mortgages and interest on the outstanding principal at a variable rate based on the One-Year CMTI plus 100 basis points, subject to a lifetime cap of 12 percent. The interest rate on the Class C certificates is reset at the same time the rate is reset on the pooled mortgages.

(ii) The Class D certificate holders are entitled to all interest payments on the mortgages in excess of the interest paid on the Class C certificates. So long as the One-Year CMTI is at 10 percent or lower, the Class D certificate holders are entitled to 100 basis points of interest on the pooled mortgages. If, however, the index exceeds 10 percent on a reset date, the Class D certificate holders' entitlement shrinks, and it disappears if the index is at 11 percent or higher.

(iii) The Class D certificate holders are entitled to all interest payable on the pooled mortgages in excess of a qualified variable rate described in paragraph (a)(3) of this section. Thus, the Class D certificates provide for interest payments that consist of a specified portion of the interest payable on the qualified mortgages under paragraph (a)(2)(i)(C) of this section.

EXAMPLE 3. (i) A sponsor transferred a pool of fixed rate mortgages to a trustee in exchange for two classes of certificates. The fixed interest rate payable on the mortgages varies from mortgage to mortgage, but a11 rates are between 8 and 10 percent. The Class E certificate holders are entitled to receive all principal payments on the mortgages and interest on outstanding principal at 7 percent. The Class F certificate holders are entitled to receive all interest on the mortgages in excess of the interest paid on the Class E certificates.

(ii) The Class F certificates provide for interest payments that consist of a specified portion of the interest payable on the mortgages under paragraph (a)(2)(i) of this section. Although the portion of the interest payable to the Class F certificate holders varies from mortgage to mortgage, the interest payable can be expressed as a fixed percentage of the interest payable on each particular mortgage.

(3) VARIABLE RATE. A regular interest may bear interest at a variable rate. For purposes of section 860G(a)(1)(B)(i), a variable rate of interest is a rate described in this paragraph (a)(3).

(i) RATE BASED ON INDEX. A rate that is a qualifying variable rate for purposes of sections 1271 through 1275 and the related regulations is a variable rate. For example, a rate based on the average cost of funds of one or more financial institutions is a variable rate. Further, a rate equal to the highest, lowest, or average of two or more objective interest indices is a variable rate for purposes of this section.

(ii) WEIGHTED AVERAGE RATE -- (A) IN GENERAL. A rate based on a weighted average of the interest rates on some or all of the qualified mortgages held by a REMIC is a variable rate. The qualified mortgages taken into account must, however, bear interest at a fixed rate or at a rate described in this paragraph (a)(3). Generally, a weighted average interest rate is a rate that, if applied to the aggregate outstanding principal balance of a pool of mortgage loans for an accrual period, produces an amount of interest that equals the sum of the interest payable on the pooled loans for that accrual period. Thus, for an accrual period in which a pool of mortgage loans comprises $300,000 of loans bearing a 7 percent interest rate and $700,000 of loans bearing a 9.5 percent interest rate, the weighted average rate for the pool of loans is 8.75 percent.

(B) REDUCTION IN UNDERLYING RATE. For purposes of paragraph (a)(3)(ii)(A) of this section, an interest rate is considered to be based on a weighted average rate even if, in determining that rate, the interest rate on some or all of the qualified mortgages is first subject to a cap or a floor, or is first reduced by a number of basis points or a fixed percentage. A rate determined by taking a weighted average of the interest rates on the qualified mortgage loans net of any servicing spread, credit enhancement fees, or other expenses of the REMIC is a rate based on a weighted average rate for the qualified mortgages. Further, the amount of any rate reduction described above may vary from mortgage to mortgage.

(iii) ADDITIONS, SUBTRACTIONS, AND MULTIPLICATIONS. A rate is a variable rate if it is --

(A) Expressed as the product of a rate described in paragraph (a)(3)(i) or (ii) of this section and a fixed multiplier;

(B) Expressed as a constant number of basis points more or less than a rate described in paragraph (a)(3)(i) or (ii) of this section; or

(C) Expressed as the product, plus or minus a constant number of basis points, of a rate described in paragraph (a)(3)(i) or (ii) of this section and a fixed multiplier (which may be either a positive or a negative number).

(iv) CAPS AND FLOORS. A rate is a variable rate if it is a rate that would be described in paragraph (a)(3)(i) through (iii) of this section except that it is --

(A) Limited by a cap or ceiling that establishes either a maximum rate or a maximum number of basis points by which the rate may increase from one accrual or payment period to another or over the term of the interest; or

(B) Limited by a floor that establishes either a minimum rate or a maximum number of basis points by which the rate may decrease from one accrual or payment period to another or over the term of the interest.

(v) FUNDS-AVAILABLE CAPS -- (A) IN GENERAL. A rate is a variable rate if it is a rate that would be described in paragraph (a)(3)(i) through (iv) of this section except that it is subject to a "funds- available" cap. A funds-available cap is a limit on the amount of interest to be paid on an instrument in any accrual or payment period that is based on total amount available for distribution, including both principal and interest received by an issuing entity on some or all of its qualified mortgages as well as amounts held in a reserve fund. The term "funds-available cap" does not, however, include any cap or limit on interest payments used as a device to avoid the standards of paragraph (a)(3)(i) through (iv) of this section.

(B) FACTS AND CIRCUMSTANCES TEST. In determining whether a cap or limit on interest payments is a funds-available cap within the meaning of this section and not a device used to avoid the standards of paragraph (a)(3)(i) through (iv) of this section, one must consider all of the facts and circumstances. Facts and circumstances that must be taken into consideration are --

(1) Whether the rate of the interest payable to the regular interest holders is below the rate payable on the REMIC's qualified mortgages on the start-up day; and

(2) Whether, historically, the rate of interest payable to the regular interest holders has been consistently below that payable on the qualified mortgages.

(C) EXAMPLES. The following examples, both of which describe a pass-thru trust that is intended to qualify as a REMIC, illustrate the provisions of this paragraph (a)(3)(v).

EXAMPLE 1. (i) A sponsor transferred a pool of mortgages to a trustee in exchange for two classes of certificates. The pool of mortgages has an aggregate principal balance of $100x. Each mortgage in the pool provides for interest payments based on the eleventh district cost of funds index (hereinafter COFI) plus a margin. The initial weighted average rate for the pool is COFI plus 200 basis points. The trust issued a Class X certificate that has a principal amount of $100x and that provides for interest payments at a rate equal to One-Year LIBOR plus 100 basis points, subject to a cap described below. The Class R certificate, which the sponsor designated as the residual interest, entitles its holder to all funds left in the trust after the Class X certificates have been retired. The Class R certificate holder is not entitled to current distributions.

(ii) At the time the certificates were issued, COFI equaled 4.874 percent and One-Year LIBOR equaled 3.375 percent. Thus, the initial weighted average pool rate was 6.874 percent and the Class X certificate rate was 4.375 percent. Based on historical data, the sponsor does not expect the rate paid on the Class X certificate to exceed the weighted average rate on the pool.

(iii) Initially, under the terms of the trust instrument, the excess of COFI plus 200 over One-Year LIBOR plus 100 (excess interest) will be applied to pay expenses of the trust, to fund any required reserves, and then to reduce the principal balance on the Class X certificate. Consequently, although the aggregate principal balance of the mortgages initially matched the principal balance of the Class X certificate, the principal balance on the Class X certificate will pay down faster than the principal balance on the mortgages as long as the weighted average rate on the mortgages is greater than One-Year LIBOR plus 100. If, however, the rate on the Class X certificate (One- Year LIBOR plus 100) ever exceeds the weighted average rate on the mortgages, then the Class X certificate holders will receive One-Year LIBOR plus 100 subject to a cap based on the current funds that are available for distribution.

(iv) The funds available cap here is not a device used to avoid the standards of paragraph (a)(3)(i) through (iv) of this section. First, on the date the Class X certificates were issued, a significant spread existed between the weighted average rate payable on the mortgages and the rate payable on the Class X certificate. Second, historical data suggest that the weighted average rate payable on the mortgages will continue to exceed the rate payable on the Class X certificate. Finally, because the excess interest will be applied to reduce the outstanding principal balance of the Class X certificate more rapidly than the outstanding principal balance on the mortgages is reduced, One-Year LIBOR plus 100 basis points would have to exceed the weighted average rate on the mortgages by an increasingly larger amount before the funds available cap would be triggered. Accordingly, the rate paid on the Class X certificates is a variable rate.

EXAMPLE 2. (i) The facts are the same as those in EXAMPLE 1, except that the pooled mortgages are commercial mortgages that provide for interest payments based on the gross profits of the mortgagors, and the rate on the Class X certificates is 400 percent of One-Year LIBOR (a variable rate under paragraph (a)(3)(iii) of this section), subject to a cap equal to current funds available to the trustee for distribution.

(ii) Initially, 400 percent of One-Year LIBOR exceeds the weighted average rate payable on the mortgages. Furthermore, historical data suggest that there is a significant possibility that, in the future, 400 percent of One-Year LIBOR will exceed the weighted average rate on the mortgages.

(iii) The facts and circumstances here indicate that the use of 400 percent of One-Year LIBOR with the above-described cap is a device to pass through to the Class X certificate holder contingent interest based on mortgagor profits. Consequently, the rate paid on the Class X certificate here is not a variable rate.

(vi) COMBINATION OF RATES. A rate is a variable rate if it is based on --

(A) One fixed rate during one or more accrual or payment periods and a different fixed rate or rates, or a rate or rates described in paragraph (a)(3)(i) through (v) of this section, during other accrual or payment periods; or

(B) A rate described in paragraph (a)(3)(i) through (v) of this section during one or more accrual or payment periods and a fixed rate or rates, or a different rate or rates described in paragraph (a)(3)(i) through (v) of this section in other periods.

(4) FIXED TERMS ON THE STARTUP DAY. For purposes of section 860G(a)(1), a regular interest in a REMIC has fixed terms on the startup day if, on the startup day, the REMIC's organizational documents irrevocably specify --

(i) The principal amount (or other similar amount) of the regular interest;

(ii) The interest rate or rates used to compute any interest payments (or other similar amounts) on the regular interest; and

(iii) The latest possible maturity date of the interest.

(5) CONTINGENCIES PROHIBITED. Except for the contingencies specified in paragraph (b)(3) of this section, the principal amount (or other similar amount) and the latest possible maturity date of the interest must not be contingent.

(b) SPECIAL RULES FOR REGULAR INTERESTS -- (1) CALL PREMIUM. An interest in a REMIC does not qualify as a regular interest if the terms of the interest entitle the holder of that interest to the payment of any premium that is determined with reference to the length of time that the regular interest is outstanding and is not described in paragraph (b)(2) of this section.

(2) CUSTOMARY PREPAYMENT PENALTIES RECEIVED WITH RESPECT TO QUALIFIED MORTGAGES. An interest in a REMIC does not fail to qualify as a regular interest solely because the REMIC's organizational documents provide that the REMIC must allocate among and pay to its regular interest holders any customary prepayment penalties that the REMIC receives with respect to its qualified mortgages. Moreover, a REMIC may allocate prepayment penalties among its classes of interests in any manner specified in the REMIC's organizational documents. For example, a REMIC could allocate all or substantially all of a prepayment penalty that it receives to holders of an interest-only class of interests because that class would be most significantly affected by prepayments.

(3) CERTAIN CONTINGENCIES DISREGARDED. An interest in a REMIC does not fail to qualify as a regular interest solely because it is issued subject to some or all of the contingencies described in paragraph (b)(3)(i) through (vi) of this section.

(i) PREPAYMENTS, INCOME, AND EXPENSES. An interest does not fail to qualify as a regular interest solely because --

(A) The timing of (but not the right to or amount of) principal payments (or other similar amounts) is affected by the extent of prepayments on some or all of the qualified mortgages held by the REMIC or the amount of income from permitted investments (as defined in section 1.860G-2(g)); or

(B) The timing of interest and principal payments is affected by the payment of expenses incurred by the REMIC.

(ii) CREDIT LOSSES. An interest does not fail to qualify as a regular interest solely because the amount or the timing of payments of principal or interest (or other similar amounts) with respect to a regular interest is affected by defaults on qualified mortgages and permitted investments, unanticipated expenses incurred by the REMIC, or lower than expected returns on permitted investments.

(iii) SUBORDINATED INTERESTS. An interest does not fail to qualify as a regular interest solely because that interest bears all, or a disproportionate share, of the losses stemming from cash flow shortfalls due to defaults or delinquencies on qualified mortgages or permitted investments, unanticipated expenses incurred by the REMIC, lower than expected returns on permitted investments, or prepayment interest shortfalls before other regular interests or the residual interest bear losses occasioned by those shortfalls.

(iv) DEFERRAL OF INTEREST. An interest does not fail to qualify as a regular interest solely because that interest, by its terms, provides for deferral of interest payments.

(v) PREPAYMENT INTEREST SHORTFALLS. An interest does not fail to qualify as a regular interest solely because the amount of interest payments is affected by prepayments of the underlying mortgages.

(vi) REMOTE AND INCIDENTAL CONTINGENCIES. An interest does not fail to qualify as a regular interest solely because the amount or timing of payments of principal or interest (or other similar amounts) with respect to the interest is subject to a contingency if there is only a remote likelihood that the contingency will occur. For example, an interest could qualify as a regular interest even though full payment of principal and interest on that interest is contingent upon the absence of significant cash flow shortfalls due to the operation of the Soldiers and Sailors Civil Relief Act, 50 U.S.C. app. section 526 (1988).

(4) FORM OF REGULAR INTEREST. A regular interest in a REMIC may be issued in the form of debt, stock, an interest in a partnership or trust, or any other form permitted by state law. If a regular interest in a REMIC is not in the form of debt, it must, except as provided in paragraph (a)(2)(iv) of this section, entitle the holder to a specified amount that would, were the interest issued in debt form, be identified as the principal amount of the debt.

(5) INTEREST DISPROPORTIONATE TO PRINCIPAL -- (i) IN GENERAL. An interest in a REMIC does not qualify as a regular interest if the amount of interest (or other similar amount) payable to the holder is disproportionately high relative to the principal amount or other specified amount described in paragraph (b)(4) of this section (specified principal amount). Interest payments (or other similar amounts) are considered disproportionately high if the issue price (as determined under paragraph (d) of this section) of the interest in the REMIC exceeds 125 percent of its specified principal amount.

(ii) EXCEPTION. A regular interest in a REMIC that entitles the holder to interest payments consisting of a specified portion of interest payments on qualified mortgages qualifies as a regular interest even if the amount of interest is disproportionately high relative to the specified principal amount.

(6) REGULAR INTEREST TREATED AS A DEBT INSTRUMENT FOR ALL FEDERAL INCOME TAX PURPOSES. In determining the tax under chapter 1 of the Internal Revenue Code, a REMIC regular interest (as defined in section 860G(a)(1)) is treated as a debt instrument that is an obligation of the REMIC. Thus, sections 1271 through 1288, relating to bonds and other debt instruments, apply to a regular interest. For special rules relating to the accrual of original issue discount on regular interests, see section 1272(a)(6).

(c) RESIDUAL INTEREST. A residual interest is an interest in a REMIC that is issued on the startup day and that is designated as a residual interest by providing the information specified in section 1.860D-1(d)(2)(ii) at the time and in the manner provided in section 1.860D-1(d)(2). A residual interest need not entitle the holder to any distributions from the REMIC.

(d) ISSUE PRICE OF REGULAR AND RESIDUAL INTERESTS -- (1) IN GENERAL. The issue price of any REMIC regular or residual interest is determined under section 1273(b) as if the interest were a debt instrument and, if issued for property, as if the requirements of section 1273(b)(3) were met. Thus, if a class of interests is publicly offered, then the issue price of an interest in that class is the initial offering price to the public at which a substantial amount of the class is sold. If the interest is in a class that is not publicly offered, the issue price is the price paid by the first buyer of that interest regardless of the price paid for the remainder of the class. If the interest is in a class that is retained by the sponsor, the issue price is its fair market value on the pricing date (as defined in section 1.860F-2(b)(3)(iii)), if any, or, if none, the startup day, regardless of whether the property exchanged therefor is publicly traded.

(2) THE PUBLIC. The term "the public" for purposes of this section does not include brokers or other middlemen, nor does it include the sponsor who acquires all of the regular and residual interests from the REMIC on the startup day in a transaction described in section 1.860F-2(a).

SECTION 1.860G-2 OTHER RULES.

(a) OBLIGATIONS PRINCIPALLY SECURED BY AN INTEREST IN REAL PROPERTY -- (1) TESTS FOR DETERMINING WHETHER AN OBLIGATION IS PRINCIPALLY SECURED. For purposes of section 860G(a)(3)(A), an obligation is principally secured by an interest in real property only if it satisfies either the test set out in paragraph (a)(1)(i) or the test set out in paragraph (a)(1)(ii) of this section.

(i) THE 80-PERCENT TEST. An obligation is principally secured by an interest in real property if the fair market value of the interest in real property securing the obligation --

(A) Was at least equal to 80 percent of the adjusted issue price of the obligation at the time the obligation was originated (see paragraph (b)(1) of this section concerning the origination date for obligations that have been significantly modified); or

(B) Is at least equal to 80 percent of the adjusted issue price of the obligation at the time the sponsor contributes the obligation to the REMIC.

(ii) ALTERNATIVE TEST. For purposes of section 860G(a)(3)(A), an obligation is principally secured by an interest in real property if substantially all of the proceeds of the obligation were used to acquire or to improve or protect an interest in real property that, at the origination date, is the only security for the obligation. For purposes of this test, loan guarantees made by the United States or any state (or any political subdivision, agency, or instrumentality of the United States or of any state), or other third party credit enhancement are not viewed as additional security for a loan. An obligation is not considered to be secured by property other than real property solely because the obligor is personally liable on the obligation.

(2) TREATMENT OF LIENS. For purposes of paragraph (a)(1)(i) of this section, the fair market value of the real property interest must be first reduced by the amount of any lien on the real property interest that is senior to the obligation being tested, and must be further reduced by a proportionate amount of any lien that is in parity with the obligation being tested.

(3) SAFE HARBOR -- (i) REASONABLE BELIEF THAT AN OBLIGATION IS PRINCIPALLY SECURED. If, at the time the sponsor contributes an obligation to a REMIC, the sponsor reasonably believes that the obligation is principally secured by an interest in real property within the meaning of paragraph (a)(1) of this section, then the obligation is deemed to be so secured for purposes of section 860G(a)(3). A sponsor cannot avail itself of this safe harbor with respect to an obligation if the sponsor actually knows or has reason to know that the obligation fails both of the tests set out in paragraph (a)(1) of this section.

(ii) BASIS FOR REASONABLE BELIEF. For purposes of paragraph (a)(3)(i) of this section, a sponsor may base a reasonable belief concerning any obligation on --

(A) Representations and warranties made by the originator of the obligation; or

(B) Evidence indicating that the originator of the obligation typically made mortgage loans in accordance with an established set of parameters, and that any mortgage loan originated in accordance with those parameters would satisfy at least one of the tests set out in paragraph (a)(1) of this section.

(iii) LATER DISCOVERY THAT AN OBLIGATION IS NOT PRINCIPALLY SECURED. If, despite the sponsor's reasonable belief concerning an obligation at the time it contributed the obligation to the REMIC, the REMIC later discovers that the obligation is not principally secured by an interest in real property, the obligation is a defective obligation and loses its status as a qualified mortgage 90 days after the date of discovery. See paragraph (f) of this section, relating to defective obligations.

(4) INTERESTS IN REAL PROPERTY; REAL PROPERTY. The definition of "interests in real property" set out in section 1.856-3(c), and the definition of "real property" set out in section 1.856-3(d), apply to define those terms for purposes of section 860G(a)(3) and paragraph (a) of this section.

(5) OBLIGATIONS SECURED BY AN INTEREST IN REAL PROPERTY. Obligations secured by interests in real property include the following: mortgages, deeds of trust, and installment land contracts; mortgage pass-thru certificates guaranteed by GNMA, FNMA, FHLMC, or CMHC (Canada Mortgage and Housing Corporation); other investment trust interests that represent undivided beneficial ownership in a pool of obligations principally secured by interests in real property and related assets that would be considered to be permitted investments if the investment trust were a REMIC, and provided the investment trust is classified as a trust under section 301.7701-4(c) of this chapter; and obligations secured by manufactured housing treated as single family residences under section 25(e)(10) (without regard to the treatment of the obligations or the properties under state law).

(6) OBLIGATIONS SECURED BY OTHER OBLIGATIONS; RESIDUAL INTERESTS. Obligations (other than regular interests in a REMIC) that are secured by other obligations are not principally secured by interests in real property even if the underlying obligations are secured by interests in real property. Thus, for example, a collateralized mortgage obligation issued by an issuer that is not a REMIC is not an obligation principally secured by an interest in real property. A residual interest (as defined in section 860G(a)(2)) is not an obligation principally secured by an interest in real property.

(7) CERTAIN INSTRUMENTS THAT CALL FOR CONTINGENT PAYMENTS ARE OBLIGATIONS. For purposes of section 860G(a)(3) and (4), the term "obligation" includes any instrument that provides for total noncontingent principal payments that at least equal the instrument's issue price even if that instrument also provides for contingent payments. Thus, for example, an instrument that was issued for $100x and that provides for noncontingent principal payments of $100x, interest payments at a fixed rate, and contingent payments based on a percentage of the mortgagor's gross receipts, is an obligation.

(8) DEFEASANCE. If a REMIC releases its lien on real property that secures a qualified mortgage, that mortgage ceases to be a qualified mortgage on the date the lien is released unless --

(i) The mortgagor pledges substitute collateral that consists solely of government securities (as defined in section 2(a)(16) of the Investment Company Act of 1940 as amended (15 U.S.C. 80a-1));

(ii) The mortgage documents allow such a substitution;

(iii) The lien is released to facilitate the disposition of the property or any other customary commercial transaction, and not as part of an arrangement to collateralize a REMIC offering with obligations that are not real estate mortgages; and

(iv) The release is not within 2 years of the startup day.

(9) STRIPPED BONDS AND COUPONS. The term "qualified mortgage" includes stripped bonds and stripped coupons (as defined in section 1286(e)(2) and (3)) if the bonds (as defined in section 1286(e)(1)) from which such stripped bonds or stripped coupons arose would have been qualified mortgages.

(b) ASSUMPTIONS AND MODIFICATIONS -- (1) SIGNIFICANT MODIFICATIONS ARE TREATED AS EXCHANGES OF OBLIGATIONS. If an obligation is significantly modified in a manner or under circumstances other than those described in paragraph (b)(3) of this section, then the modified obligation is treated as one that was newly issued in exchange for the unmodified obligation that it replaced. Consequently --

(i) If such a significant modification occurs after the obligation has been contributed to the REMIC and the modified obligation is not a qualified replacement mortgage, the modified obligation will not be a qualified mortgage and the deemed disposition of the unmodified obligation will be a prohibited transaction under section 860F(a)(2); and

(ii) If such a significant modification occurs before the obligation is contributed to the REMIC, the modified obligation will be viewed as having been originated on the date the modification occurs for purposes of the tests set out in paragraph (a)(1) of this section.

(2) SIGNIFICANT MODIFICATION DEFINED. For purposes of paragraph (b)(1) of this section, a "significant modification" is any change in the terms of an obligation that would be treated as an exchange of obligations under section 1001 and the related regulations.

(3) EXCEPTIONS. For purposes of paragraph (b)(1) of this section, the following changes in the terms of an obligation are not significant modifications regardless of whether they would be significant modifications under paragraph (b)(2) of this section --

(i) Changes in the terms of the obligation occasioned by default or a reasonably foreseeable default;

(ii) Assumption of the obligation;

(iii) Waiver of a due-on-sale clause or a due on encumbrance clause; and

(iv) Conversion of an interest rate by a mortgagor pursuant to the terms of a convertible mortgage.

(4) MODIFICATIONS THAT ARE NOT SIGNIFICANT MODIFICATIONS. If an obligation is modified and the modification is not a significant modification for purposes of paragraph (b)(1) of this section, then the modified obligation is not treated as one that was newly originated on the date of modification.

(5) ASSUMPTION DEFINED. For purposes of paragraph (b)(3) of this section, a mortgage has been assumed if --

(i) The buyer of the mortgaged property acquires the property subject to the mortgage, without assuming any personal liability;

(ii) The buyer becomes liable for the debt but the seller also remains liable; or

(iii) The buyer becomes liable for the debt and the seller is released by the lender.

(6) PASS-THRU CERTIFICATES. If a REMIC holds as a qualified mortgage a pass-thru certificate or other investment trust interest of the type described in paragraph (a)(5) of this section, the modification of a mortgage loan that backs the pass-thru certificate or other interest is not a modification of the pass-thru certificate or other interest unless the investment trust structure was created to avoid the prohibited transaction rules of section 860F(a).

(c) TREATMENT OF CERTAIN CREDIT ENHANCEMENT CONTRACTS -- (1) IN GENERAL. A credit enhancement contract (as defined in paragraph (c)(2) and (3) of this section) is not treated as a separate asset of the REMIC for purposes of the asset test set out in section 860D(a)(4) and section 1.860D-1(b)(3), but instead is treated as part of the mortgage or pool of mortgages to which it relates. Furthermore, any collateral supporting a credit enhancement contract is not treated as an asset of the REMIC solely because it supports the guarantee represented by that contract. See paragraph (g)(1)(ii) of this section for the treatment of payments made pursuant to credit enhancement contracts as payments received under a qualified mortgage.

(2) CREDIT ENHANCEMENT CONTRACTS. For purposes of this section, a credit enhancement contract is any arrangement whereby a person agrees to guarantee full or partial payment of the principal or interest payable on a qualified mortgage or on a pool of such mortgages, or full or partial payment on one or more classes of regular interests or on the class of residual interests, in the event of defaults or delinquencies on qualified mortgages, unanticipated losses or expenses incurred by the REMIC, or lower than expected returns on cash flow investments. Types of credit enhancement contracts may include, but are not limited to, pool insurance contracts, certificate guarantee insurance contracts, letters of credit, guarantees, or agreements whereby the REMIC sponsor, a mortgage servicer, or other third party agrees to make advances described in paragraph (c)(3) of this section.

(3) ARRANGEMENTS TO MAKE CERTAIN ADVANCES. The arrangements described in this paragraph (c)(3) are credit enhancement contracts regardless of whether, under the terms of the arrangement, the payor is obligated, or merely permitted, to advance funds to the REMIC.

(i) ADVANCES OF DELINQUENT PRINCIPAL AND INTEREST. An arrangement by a REMIC sponsor, mortgage servicer, or other third party to advance to the REMIC out of its own funds an amount to make up for delinquent payments on qualified mortgages is a credit enhancement contract.

(ii) ADVANCES OF TAXES, INSURANCE PAYMENTS, AND EXPENSES. An arrangement by a REMIC sponsor, mortgage servicer, or other third party to pay taxes and hazard insurance premiums on, or other expenses incurred to protect the REMIC's security interest in, property securing a qualified mortgage in the event that the mortgagor fails to pay such taxes, insurance premiums, or other expenses is a credit enhancement contract.

(iii) ADVANCES TO EASE REMIC ADMINISTRATION. An agreement by a REMIC sponsor, mortgage servicer, or other third party to advance temporarily to a REMIC amounts payable on qualified mortgages before such amounts are actually due to level out the stream of cash flows to the REMIC or to provide for orderly administration of the REMIC is a credit enhancement contract. For example, if two mortgages in a pool have payment due dates on the twentieth of the month, and all the other mortgages have payment due dates on the first of each month, an agreement by the mortgage servicer to advance to the REMIC on the fifteenth of each month the payments not yet received on the two mortgages together with the amounts received on the other mortgages is a credit enhancement contract.

(4) DEFERRED PAYMENT UNDER A GUARANTEE ARRANGEMENT. A guarantee arrangement does not fail to qualify as a credit enhancement contract solely because the guarantor, in the event of a default on a qualified mortgage, has the option of immediately paying to the REMIC the full amount of mortgage principal due on acceleration of the defaulted mortgage, or paying principal and interest to the REMIC according to the original payment schedule for the defaulted mortgage, or according to some other deferred payment schedule. Any deferred payments are payments pursuant to a credit enhancement contract even if the mortgage is foreclosed upon and the guarantor, pursuant to subrogation rights set out in the guarantee arrangement, is entitled to receive immediately the proceeds of foreclosure.

(d) TREATMENT OF CERTAIN PURCHASE AGREEMENTS WITH RESPECT TO CONVERTIBLE MORTGAGES -- (1) IN GENERAL. For purposes of sections 860D(a)(4) and 860G(a)(3), a purchase agreement (as described in paragraph (d)(3) of this section) with respect to a convertible mortgage (as described in paragraph (d)(5) of this section) is treated as incidental to the convertible mortgage to which it relates. Consequently, the purchase agreement is part of the mortgage or pool of mortgages and is not a separate asset of the REMIC.

(2) TREATMENT OF AMOUNTS RECEIVED UNDER PURCHASE AGREEMENTS. For purposes of sections 860A through 860G and for purposes of determining the accrual of original issue discount and market discount under sections 1272(a)(6) and 1276, respectively, a payment under a purchase agreement described in paragraph (d)(3) of this section is treated as a prepayment in full of the mortgage to which it relates. Thus, for example, a payment under a purchase agreement with respect to a qualified mortgage is considered a payment received under a qualified mortgage within the meaning of section 860G(a)(6) and the transfer of the mortgage is not a disposition of the mortgage within the meaning of section 860F(a)(2)(A).

(3) PURCHASE AGREEMENT. A purchase agreement is a contract between the holder of a convertible mortgage and a third party under which the holder agrees to sell and the third party agrees to buy the mortgage for an amount equal to its current principal balance plus accrued but unpaid interest if and when the mortgagor elects to convert the terms of the mortgage.

(4) DEFAULT BY THE PERSON OBLIGATED TO PURCHASE A CONVERTIBLE MORTGAGE. If the person required to purchase a convertible mortgage defaults on its obligation to purchase the mortgage upon conversion, the REMIC may sell the mortgage in a market transaction and the proceeds of the sale will be treated as amounts paid pursuant to a purchase agreement.

(5) CONVERTIBLE MORTGAGE. A convertible mortgage is a mortgage that gives the obligor the right at one or more times during the term of the mortgage to elect to convert from one interest rate to another. The new rate of interest must be determined pursuant to the terms of the instrument and must be intended to approximate a market rate of interest for newly originated mortgages at the time of the conversion.

(e) PREPAYMENT INTEREST SHORTFALLS. An agreement by a mortgage servicer or other third party to make payments to the REMIC to make up prepayment interest shortfalls is not treated as a separate asset of the REMIC and payments made pursuant to such an agreement are treated as payments on the qualified mortgages. With respect to any mortgage that prepays, the prepayment interest shortfall for the accrual period in which the mortgage prepays is an amount equal to the excess of the interest that would have accrued on the mortgage during that accrual period had it not prepaid, over the interest that accrued from the beginning of that accrual period up to the date of the prepayment.

(f) DEFECTIVE OBLIGATIONS -- (1) DEFECTIVE OBLIGATION DEFINED. For purposes of sections 860G(a)(4)(B)(ii) and 860F(a)(2), a defective obligation is a mortgage subject to any of the following defects.

(i) The mortgage is in default, or a default with respect to the mortgage is reasonably foreseeable.

(ii) The mortgage was fraudulently procured by the mortgagor.

(iii) The mortgage was not in fact principally secured by an interest in real property within the meaning of paragraph (a)(1) of this section.

(iv) The mortgage does not conform to a customary representation or warranty given by the sponsor or prior owner of the mortgage regarding the characteristics of the mortgage, or the characteristics of the pool of mortgages of which the mortgage is a part. A representation that payments on a qualified mortgage will be received at a rate no less than a specified minimum or no greater than a specified maximum is not customary for this purpose.

(2) EFFECT OF DISCOVERY OF DEFECT. If a REMIC discovers that an obligation is a defective obligation, and if the defect is one that, had it been discovered before the startup day, would have prevented the obligation from being a qualified mortgage, then, unless the REMIC either causes the defect to be cured or disposes of the defective obligation within 90 days of discovering the defect, the obligation ceases to be a qualified mortgage at the end of that 90 day period. Even if the defect is not cured, the defective obligation is, nevertheless, a qualified mortgage from the startup day through the end of the 90 day period. Moreover, even if the REMIC holds the defective obligation beyond the 90 day period, the REMIC may, nevertheless, exchange the defective obligation for a qualified replacement mortgage so long as the requirements of section 860G(a)(4)(B) are satisfied. If the defect is one that does not affect the status of an obligation as a qualified mortgage, then the obligation is always a qualified mortgage regardless of whether the defect is or can be cured. For example, if a sponsor represented that all mortgages transferred to a REMIC had a 10 percent interest rate, but it was later discovered that one mortgage had a 9 percent interest rate, the 9 percent mortgage is defective, but the defect does not affect the status of that obligation as a qualified mortgage.

(g) PERMITTED INVESTMENTS -- (1) CASH FLOW INVESTMENT -- (i) IN GENERAL. For purposes of section 860G(a)(6) and this section, a cash flow investment is an investment of payments received on qualified mortgages for a temporary period between receipt of those payments and the regularly scheduled date for distribution of those payments to REMIC interest holders. Cash flow investments must be passive investments earning a return in the nature of interest.

(ii) PAYMENTS RECEIVED ON QUALIFIED MORTGAGES. For purposes of paragraph (g)(1) of this section, the term "payments received on qualified mortgages" includes --

(A) Payments of interest and principal on qualified mortgages, including prepayments of principal and payments under credit enhancement contracts described in paragraph (c)(2) of this section;

(B) Proceeds from the disposition of qualified mortgages;

(C) Cash flows from foreclosure property and proceeds from the disposition of such property;

(D) A payment by a sponsor or prior owner in lieu of the sponsor's or prior owner's repurchase of a defective obligation, as defined in paragraph (f) of this section, that was transferred to the REMIC in breach of a customary warranty; and

(E) Prepayment penalties required to be paid under the terms of a qualified mortgage when the mortgagor prepays the obligation.

(iii) TEMPORARY PERIOD. For purposes of section 860G(a)(6) and this paragraph (g)(1), a temporary period generally is that period from the time a REMIC receives payments on qualified mortgages and permitted investments to the time the REMIC distributes the payments to interest holders. A temporary period may not exceed 13 months. Thus, an investment held by a REMIC for more than 13 months is not a cash flow investment. In determining the length of time that a REMIC has held an investment that is part of a commingled fund or account, the REMIC may employ any reasonable method of accounting. For example, if a REMIC holds mortgage cash flows in a commingled account pending distribution, the first-in, first-out method of accounting is a reasonable method for determining whether all or part of the account satisfies the 13 month limitation.

(2) QUALIFIED RESERVE FUNDS. The term qualified reserve fund means any reasonably required reserve to provide for full payment of expenses of the REMIC or amounts due on regular or residual interests in the event of defaults on qualified mortgages, prepayment interest shortfalls (as defined in paragraph (e) of this section), lower than expected returns on cash flow investments, or any other contingency that could be provided for under a credit enhancement contract (as defined in paragraph (c)(2) and (3) of this section).

(3) QUALIFIED RESERVE ASSET -- (i) IN GENERAL. The term "qualified reserve asset" means any intangible property (other than a REMIC residual interest) that is held both for investment and as part of a qualified reserve fund. An asset need not generate any income to be a qualified reserve asset.

(ii) REASONABLY REQUIRED RESERVE -- (A) IN GENERAL. In determining whether the amount of a reserve is reasonable, it is appropriate to consider the credit quality of the qualified mortgages, the extent and nature of any guarantees relating to either the qualified mortgages or the regular and residual interests, the expected amount of expenses of the REMIC, and the expected availability of proceeds from qualified mortgages to pay the expenses. To the extent that a reserve exceeds a reasonably required amount, the amount of the reserve must be promptly and appropriately reduced. If at any time, however, the amount of the reserve fund is less than is reasonably required, the amount of the reserve fund may be increased by the addition of payments received on qualified mortgages or by contributions from holders of residual interests.

(B) PRESUMPTION THAT A RESERVE IS REASONABLY REQUIRED. The amount of a reserve fund is presumed to be reasonable (and an excessive reserve is presumed to have been promptly and appropriately reduced) if it does not exceed --

(1) The amount required by a nationally recognized independent rating agency as a condition of providing the rating for REMIC interests desired by the sponsor; or

(2) The amount required by a third party insurer or guarantor, who does not own directly or indirectly (within the meaning of section 267(c)) an interest in the REMIC (as defined in section 1.860D-1(b)(1)), as a condition of providing credit enhancement.

(C) PRESUMPTION MAY BE REBUTTED. The presumption in paragraph (g)(3)(ii)(B) of this section may be rebutted if the amounts required by the rating agency or by the third party insurer are not commercially reasonable considering the factors described in paragraph (g)(3)(ii)(A) of this section.

(h) OUTSIDE RESERVE FUNDS. A reserve fund that is maintained to pay expenses of the REMIC, or to make payments to REMIC interest holders is an outside reserve fund and not an asset of the REMIC only if the REMIC's organizational documents clearly and expressly --

(1) Provide that the reserve fund is an outside reserve fund and not an asset of the REMIC;

(2) Identify the owner(s) of the reserve fund, either by name, or by description of the class (e.g., subordinated regular interest holders) whose membership comprises the owners of the fund; and

(3) Provide that, for all Federal tax purposes, amounts transferred by the REMIC to the fund are treated as amounts distributed by the REMIC to the designated owner(s) or transferees of the designated owner(s).

(i) CONTRACTUAL RIGHTS COUPLED WITH REGULAR INTERESTS IN TIERED ARRANGEMENTS -- (1) IN GENERAL. If a REMIC issues a regular interest to a trustee of an investment trust for the benefit of the trust certificate holders and the trustee also holds for the benefit of those certificate holders certain other contractual rights, those other rights are not treated as assets of the REMIC even if the investment trust and the REMIC were created contemporaneously pursuant to a single set of organizational documents. The organizational documents must, however, require that the trustee account for the contractual rights as property that the trustee holds separate and apart from the regular interest.

(2) EXAMPLE. The following example, which describes a tiered arrangement involving a pass-thru trust that is intended to qualify as a REMIC and a pass-thru trust that is intended to be classified as a trust under section 301.7701-4(c) of this chapter, illustrates the provisions of paragraph (i)(1) of this section.

EXAMPLE. (i) A sponsor transferred a pool of mortgages to a trustee in exchange for two classes of certificates. The pool of mortgages has an aggregate principal balance of $100x. Each mortgage in the pool provides for interest payments based on the eleventh district cost of funds index (hereinafter COFI) plus a margin. The trust (hereinafter REMIC trust) issued a Class N bond, which the sponsor designates as a regular interest, that has a principal amount of $100x and that provides for interest payments at a rate equal to One-Year LIBOR plus 100 basis points, subject to a cap equal to the weighted average pool rate. The Class R interest, which the sponsor designated as the residual interest, entitles its holder to all funds left in the trust after the Class N bond has been retired. The Class R interest holder is not entitled to current distributions.

(ii) On the same day, and under the same set of documents, the sponsor also created an investment trust. The sponsor contributed to the investment trust the Class N bond together with an interest rate cap contract. Under the interest rate cap contract, the issuer of the cap contract agrees to pay to the trustee for the benefit of the investment trust certificate holders the excess of One-Year LIBOR plus 100 basis points over the weighted average pool rate (COFI plus a margin) times the outstanding principal balance of the Class N bond in the event One-Year LIBOR plus 100 basis points ever exceeds the weighted average pool rate. The trustee (the same institution that serves as REMIC trust trustee), in exchange for the contributed assets, gave the sponsor certificates representing undivided beneficial ownership interests in the Class N bond and the interest rate cap contract. The organizational documents require the trustee to account for the regular interest and the cap contract as discrete property rights.

(iii) The separate existence of the REMIC trust and the investment trust are respected for all Federal income tax purposes. Thus, the interest rate cap contract is an asset beneficially owned by the several certificate holders and is not an asset of the REMIC trust. Consequently, each certificate holder must allocate its purchase price for the certificate between its undivided interest in the Class N bond and its undivided interest in the interest rate cap contract in accordance with the relative fair market values of those two property rights.

(j) CLEAN-UP CALL -- (1) IN GENERAL. For purposes of section 860F(a)(5)(B), a clean-up call is the redemption of a class of regular interests when, by reason of prior payments with respect to those interests, the administrative costs associated with servicing that class outweigh the benefits of maintaining the class. Factors to consider in making this determination include --

(i) The number of holders of that class of regular interests;

(ii) The frequency of payments to holders of that class;

(iii) The effect the redemption will have on the yield of that class of regular interests;

(iv) The outstanding principal balance of that class; and

(v) The percentage of the original principal balance of that class still outstanding.

(2) INTEREST RATE CHANGES. The redemption of a class of regular interests undertaken to profit from a change in interest rates is not a clean-up call.

(3) SAFE HARBOR. Although the outstanding principal balance is only one factor to consider, the redemption of a class of regular interests with an outstanding principal balance of no more than 10 percent of its original principal balance is always a clean-up call.

(k) STARTUP DAY. The term "startup day" means the day on which the REMIC issues all of its regular and residual interests. A sponsor may, however, contribute property to a REMIC in exchange for regular and residual interests over any period of 10 consecutive days and the REMIC may designate any one of those 10 days as its startup day. The day so designated is then the startup day, and all interests are treated as issued on that day.

SECTION 1.860G-3 TREATMENT OF FOREIGN PERSONS.

(a) TRANSFER OF A RESIDUAL INTEREST WITH TAX AVOIDANCE POTENTIAL -- (1) IN GENERAL. A transfer of a residual interest that has tax avoidance potential is disregarded for all Federal tax purposes if the transferee is a foreign person. Thus, if a residual interest with tax avoidance potential is transferred to a foreign holder at formation of the REMIC, the sponsor is liable for the tax on any excess inclusion that accrues with respect to that residual interest.

(2) TAX AVOIDANCE POTENTIAL -- (i) DEFINED. A residual interest has tax avoidance potential for purposes of this section unless, at the time of the transfer, the transferor reasonably expects that, for each excess inclusion, the REMIC will distribute to the transferee residual interest holder an amount that will equal at least 30 percent of the excess inclusion, and that each such amount will be distributed at or after the time at which the excess inclusion accrues and not later than the close of the calendar year following the calendar year of accrual.

(ii) SAFE HARBOR. For purposes of paragraph (a)(2)(i) of this section, a transferor has a reasonable expectation if the 30-percent test would be satisfied were the REMIC's qualified mortgages to prepay at each rate within a range of rates from 50 percent to 200 percent of the rate assumed under section 1272(a)(6) with respect to the qualified mortgages (or the rate that would have been assumed had the mortgages been issued with original issue discount).

(3) EFFECTIVELY CONNECTED INCOME. Paragraph (a)(1) of this section will not apply if the transferee's income from the residual interest is subject to tax under section 871(b) or section 882.

(4) TRANSFER BY A FOREIGN HOLDER. If a foreign person transfers a residual interest to a United States person or a foreign holder in whose hands the income from a residual interest would be effectively connected income, and if the transfer has the effect of allowing the transferor to avoid tax on accrued excess inclusions, then the transfer is disregarded and the transferor continues to be treated as the owner of the residual interest for purposes of section 871(a), 881, 1441, or 1442.

(b) [Reserved]

Par. 8. Section 1.6041-1 is amended by redesignating the text of paragraph (b) as paragraph (b)(1) and adding a heading for new paragraph (b)(1), and adding a new paragraph (b)(2) to read as follows:

SECTION 1.6041-1 RETURN OF INFORMATION AS TO PAYMENTS OF $600 OR MORE.

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(b) PERSONS ENGAGED IN TRADE OR BUSINESS -- (1) IN GENERAL. * * *

(2) SPECIAL RULE FOR REMICs. For purposes of chapter 1 subtitle F, chapter 61A, part IIIB, the terms "all persons engaged in a trade or business" and "any service-recipient engaged in a trade or business" includes a real estate mortgage investment conduit or REMIC (as defined in section 860D).

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PART 301 -- PROCEDURE AND ADMINISTRATION

Par. 9. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 10. Section 301.7701-13A is amended by adding a new paragraph (e)(12) to read as follows:

SECTION 301.7701-13A POST-1969 DOMESTIC BUILDING AND LOAN ASSOCIATION.

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(e) * * *

(12) REGULAR OR RESIDUAL INTEREST IN A REMIC -- (i) IN GENERAL. If for any calendar quarter at least 95 percent of a REMIC's assets (as determined in accordance with section 1.860F-4(e)(1)(ii) or section 1.6049-7(f)(3) of this chapter) are assets defined in paragraph (e)(1) through (e)(11) of this section, then for that calendar quarter all the regular and residual interests in that REMIC are treated as assets defined in this paragraph (e). If less than 95 percent of a REMIC's assets are assets defined in paragraph (e)(1) through (e)(11) of this section, the percentage of each REMIC regular or residual interest treated as an asset defined in this paragraph (e) is equal to the percentage of the REMIC's assets that are assets defined in paragraph (e)(1) through (e)(11) of this section. See sections 1.860F-4(e)(1)(ii)(B) and 1.6049-7(f)(3) of this chapter for information required to be provided to regular and residual interest holders if the 95 percent test is not met.

(ii) LOANS SECURED BY MANUFACTURED HOUSING. For purposes of paragraph (e)(12)(i) of this section, a loan secured by manufactured housing treated as a single family residence under section 25(e)(10) is an asset defined in paragraph (e)(1) through (e)(11) of this section.

* * * * *

PART 602 -- OMB CONTROL NUMBER UNDER THE PAPERWORK REDUCTION ACT

Par. 11. The authority citation for part 602 continues to read:

Authority: 26 U.S.C. 7805.

Par. 12. Section 602.101(c) is amended by adding the following entries to the table:

SECTION 602.101 OMB CONTROL NUMBERS.

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(c) * * *

 CFR part or section                          Current OMB