Mortgage settlement payment preserves REMIC qualification

Plain-English summary

A REMIC in a residential mortgage securitization trust was entitled to a settlement payment resolving claims that mortgage loans breached representations and warranties. The payment did not exceed alleged losses and would be distributed as principal under the trust's existing waterfall, including restoration of previously written-down certificate balances. The IRS ruled that entering the settlement, acquiring the payment right, and receiving the payment would not cause the REMIC to fail its asset test. The payment would be treated as received on qualified mortgages, and its distribution would not disqualify the regular or residual interests. Receipt also would not be a prohibited transaction or a post-startup contribution subject to the 100-percent tax.

Ruling snapshot

• Question: What REMIC consequences follow from receiving and distributing the mortgage representation-and-warranty settlement payment?
• Outcome: approved
• Key authorities: IRC §§ 860D(a)(4), 860F(a), 860G(a) and (d); Treas. Reg. §§ 1.860D-1, 1.860G-1, 1.860G-2

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201742007                                              Third Party Communication: None
Release Date: 10/20/2017                                       Date of Communication: Not Applicable
Index Number: 860D.00-00
                                                               Person To Contact:
------------------------ ----------------------                --------------------------, --------------------------
-------------------------------------------                    -----------------
--------------------------------------------                   Telephone Number:
----------------------------------------                       ----------------------
------------------------------                                 Refer Reply To:
                                                               CC:FIP:B06
                                                               PLR-104889-17
                                                               Date:
                                                               July 25, 2017

Legend:

Taxpayer          =        ------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------
                           ------------------------

Trustee           =        -------------------------------------------
                           ------------------------

State             =        --------------

Year              =        -------

Company A =                --------------------------------------

Company B =                -----------------------------------------------

Company C =                ---------------------------------------

Company D =                -------------------

Exchange          =        -------------------------------------

Date 1            =        -------------------

A                 =        ----------------



Dear ----------------:
PLR-104889-17                                  2

This letter is in reply to a letter dated February 2, 2017, in which Trustee, solely in its
capacity as trustee of Taxpayer, a real estate mortgage investment conduit ("REMIC"),
requests certain rulings in connection with Taxpayer's qualification as a REMIC under
§§ 860A-860G of the Internal Revenue Code. Specifically, you have asked for the
following rulings:

        1.     In the case of Taxpayer, for which a timely, valid and continuing
        REMIC election has been made in accordance with the Governing
        Agreements (as defined below), none of (i) the execution of the Settlement
        Agreement (as defined below), (ii) the right to receive the Settlement
        Payment (as defined below), or (iii) the receipt of the Settlement Payment,
        will cause Taxpayer to fail to meet the requirements of § 860D(a)(4).

        2.     In the case of Taxpayer, for which a timely, valid and continuing
        REMIC election has been made in accordance with the Governing
        Agreements, the receipt of the Settlement Payment will be treated as a
        payment received on qualified mortgages within the meaning of § 1.860G-
        2(g)(1)(ii) of the Income Tax Regulations.

        3.     In the case of Taxpayer, for which a timely, valid and continuing
        REMIC election has been made in accordance with the Governing
        Agreements, the distribution of the Settlement Payment in accordance
        with the Governing Agreements and the Settlement Agreement will not
        cause any regular interest in Taxpayer to fail to qualify as a "regular
        interest" as defined in § 860G(a)(1) or the sole class of residual interest in
        Taxpayer to fail to qualify as a "residual interest" as defined in
        § 860G(a)(2).

        4.     In the case of Taxpayer, for which a timely, valid and continuing
        REMIC election has been made in accordance with the Governing
        Agreements, the receipt of the Settlement Payment will not be treated as a
        "prohibited transaction" within the meaning of § 860F(a)(2) or as a
        contribution that is subject to the tax imposed under § 860G(d)(1).

Facts

Background

Taxpayer is one of five REMICs in a tiered REMIC structure comprising a residential
mortgage-backed securitization trust (the "Trust"), which Trust is evidenced by a pooling
and servicing agreement ("PSA"). In addition to the PSA, the rights of the parties
relating to the Trust are governed by the mortgage loan purchase agreement (each a
"Governing Agreement" and collectively, the "Governing Agreements"). Under the
Governing Agreements, Trustee serves as trustee for the Trust. The laws of State
PLR-104889-17                                 3

govern the rights and obligations of the parties to the Governing Agreements, including
Trustee. The annual accounting period for Taxpayer is the calendar year and Taxpayer
utilizes the accrual method of accounting for maintaining its accounting books and filing
its U.S. federal income tax return.

Trustee is a wholly owned subsidiary of Company D, a public company whose shares of
common stock are traded on the Exchange.

The Trust functions as a residential mortgage loan securitization vehicle. The Trust,
including Taxpayer, was established during Year for the primary purpose of raising
financing in the securitization market with respect to a pool of residential real estate
mortgage loans originated or acquired by Company C, the sponsor of the mortgage
securitizations.

The securitization process for the Trust occurred as follows:

       1.     Company A (the "Seller"), sold a portfolio of residential mortgage
       loans (the "Mortgage Loans") to a related party (the "Depositor").

       2.    The Depositor conveyed the Mortgage Loans to Company B (the
       predecessor to Trustee), to be held in trust pursuant to the PSA.

       3.     Several classes of RMBS certificates representing various
       entitlements to the underlying mortgage pool's cash flows then were
       issued and sold through an underwriter to investors ("Investors").

       4.     Company A acted as master servicer, charged with responsibility
       for, among other things, collecting debt service payments on the Mortgage
       Loans, taking any necessary enforcement action against borrowers, and
       remitting payments on a monthly basis for distribution to Investors.

In the securitization, an election was made to treat the Mortgage Loans and certain
related assets held by Taxpayer as a REMIC under the Code.

The Governing Agreements for Taxpayer contain a series of representations and
warranties made for the benefit of Taxpayer. In general, these include representations
that the Mortgage Loans had certain characteristics, such as loan-to-value ratio,
property condition and mortgagor credit metrics; that the Mortgage Loans were
underwritten in all material respects in accordance with certain underwriting guidelines;
that the Mortgage Loans conform in all material respects to their descriptions in the
investor disclosure documents; that the origination of the Mortgage Loans complied with
applicable laws; and that the Mortgage Loans were being serviced in accordance with
accepted servicing practices.
PLR-104889-17                                  4

The Dispute

On Date 1, pursuant to an agreement among Trustee and certain holders of certificates
of beneficial interests in the Trust (the “Institutional Investors”), Trustee filed a complaint
on behalf of the Trust in court seeking, among other things, to enforce Company C’s
(and its affiliates’) obligation to repurchase mortgage loans that allegedly breached
representations and warranties set forth in the Governing Agreements. Company C and
the Trustee ultimately entered into an agreement (the "Settlement Agreement") to settle
the litigation.

The Settlement Agreement

The Settlement Agreement has two principal terms. One, a settlement payment to be
paid to the Trust (the "Settlement Payment"), and two, a release of claims against
Company C that arise under or are based upon the Governing Agreements or that
relate to the origination, sale, delivery, servicing, and/or administration of Mortgage
Loans in the Trust. The Settlement Agreement also requires certain improvements in
servicing the Mortgage Loans.

The released claims include all claims against Company C or its affiliates concerning or
relating to any alleged breaches of representations and warranties made in connection
with the origination, sale, delivery, and/or servicing of Mortgage Loans to the Trust,
including breaches of any obligation to notify or to cure any such alleged breaches of
representations and warranties or to repurchase any Mortgage Loan (the “Rep and
Warranty Claims”).

The Settlement Payment consists of a fixed cash payment in the amount of A.
Taxpayer represents that the Settlement Payment does not exceed losses suffered by
Taxpayer allegedly as the result of the Rep and Warranty Claims.

Taxpayer represents that the distribution provisions of the Settlement Agreement do not
alter the rights or obligations of any of the REMICs comprising the Trust or REMIC
interests therein. The Settlement Agreement requires that the distribution of the
Settlement Payment to Investors be in accordance with the applicable provisions
contained in the PSA that provide for the distribution of subsequent recoveries. The
Settlement Agreement provides that the Trust's distribution of the Settlement Payment
to Investors be characterized as distributions of principal. Distributions to the Investors
who hold regular interest classes entitled to receive principal will be made in
accordance with the PSA.

In the event the distribution waterfall provisions in the PSA and the Settlement Payment
would combine to result in a distribution of any amount on or in respect of the
Taxpayer’s residual interest class, whether on the date of the distribution of the
Settlement Payment or on any subsequent distribution date that is not the final
PLR-104889-17                                  5

distribution date under the PSA, such amount shall not be paid on or distributed to such
residual class. Instead, the Trustee would retain this amount in the Trust's distribution
account, and on the next distribution date, the Trustee would distribute the retained
amount to the regular interest Investors entitled to receive a principal distribution of
subsequent recoveries.

Consistent with the Governing Agreements, the Settlement Agreement provides for the
application of an amount equal to the Settlement Payment to the Trust’s issued
certificates, in order to restore the outstanding principal balance of such certificates
attributable to the prior write down of previously incurred realized losses on Mortgage
Loans. Specifically, an amount equal to the Settlement Payment will be applied to
increase the class certificate balance of the class or classes of certificates with the
highest payment priority to which realized losses have been previously allocated. An
increase to the principal balance of any class of certificates cannot exceed the
aggregate amount of realized losses previously allocated to such class under the
Governing Agreements. In addition, holders of certificates whose class principal
balances are restored will not be entitled to any payment in respect of interest on the
restored amount for any interest accrual period relating to the distribution date on which
such increase occurs or on any prior distribution date.

Law and Analysis

Issue #1 and #2: Qualified Mortgages, Permitted Investments, and Payments Received
on Qualified Mortgages

Section 860D(a) provides that the terms "real estate mortgage investment conduit" and
"REMIC" mean any entity that meets several requirements including that as of the close
of the third month beginning after the startup day and at all times thereafter,
substantially all of the assets of the entity consist of qualified mortgages and permitted
investments.

Section 860G(a)(3)(A) defines qualified mortgage to include any obligation (including
any participation or certificate of beneficial ownership therein) which is principally
secured by an interest in real property and which (i) is transferred to the REMIC on the
startup day in exchange for regular or residual interests in the REMIC, (ii) is purchased
by the REMIC within the 3-month period beginning on the startup day if, except as
provided in regulations, such purchase is pursuant to a fixed-price contract in effect on
the startup day, or (iii) represents an increase in the principal amount under the original
terms of an obligation described in clause (i) or (ii) if such increase (I) is attributable to
an advance made to the obligor pursuant to the original terms of a reverse mortgage
loan or other obligation, (II) occurs after the startup day, and (III) is purchased by the
REMIC pursuant to a fixed price contract in effect on the startup day.
PLR-104889-17                                6

Section 860G(a)(5) defines "permitted investments" to mean any cash flow investment,
qualified reserve asset, or foreclosure property. Section 860G(a)(6) defines "cash flow
investment" to mean any investment of amounts received under qualified mortgages for
a temporary period before distribution to holders of interests in the REMIC.

Section 1.860D-1(b)(3)(i) provides that, for purposes of the asset test of § 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. Section 1.860D-1(b)(3)(ii) sets forth a safe harbor rule which provides that 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.

Section 1.860G-2(g)(1)(ii) states that, in determining what is a cash flow investment, the
term "payments received on qualified mortgages" includes, among other payments,
payments by a sponsor or prior owner in lieu of the sponsor's or prior owner's
repurchase of a defective obligation, as defined in § 1.860G-2(f), that was transferred to
the REMIC in breach of a customary warranty.

Section 1.860G-2(f)(1) defines a defective obligation as a mortgage subject to certain
defects including that 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.

Taxpayer's right to receive the Settlement Payment under the Settlement Agreement
arises from the Mortgage Loans. The right to receive the Settlement Payment for
Taxpayer is a contract claim that stems directly from the rights held by the Trustee on
behalf of Taxpayer and its status as a REMIC. Therefore, Taxpayer's right to receive
the Settlement Payment does not constitute an asset that is newly acquired by a REMIC
after its startup date. The execution of the Settlement Agreement and the receipt of the
Settlement Payment by Taxpayer, arise from Taxpayer's interest in the Mortgage Loans
and its status as a REMIC, and, therefore, will not cause Taxpayer to fail to meet the
requirements under § 860D(a)(4).

The Settlement Payment under the Settlement Agreement is the result of a dispute
between the Institutional Investors and Company C regarding whether the Mortgage
Loans conveyed to Taxpayer violated customary representations and warranties under
the Governing Agreements. For purposes of the REMIC rules, a defective obligation
includes a mortgage that 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. Taxpayer's right to the Settlement Payment under the Settlement Agreement is
akin to a payment received by Taxpayer from a sponsor or prior owner in lieu of the
PLR-104889-17                                 7

sponsor or prior owner's repurchase of such a defective obligation. Therefore, pursuant
to § 1.860G-2(g)(1)(ii), the Settlement Payment will be considered a payment received
on a qualified mortgage pursuant to § 1.860G-2(g)(1)(ii).

Issue #3: Regular and Residual Interests

Section 860G(a)(1) defines a "regular interest" in a REMIC to mean any interest in a
REMIC which is issued on the startup day with fixed terms and which is designated as a
regular interest if (A) such interest unconditionally entitles the holder to receive a
specified principal amount (or other similar amount), and (B) interest payments (or other
similar amount), if any, with respect to such interest at or before maturity (i) are payable
based on a fixed rate (or to the extent provided in regulations, at a variable rate), or
(ii) consist of a specified portion of the interest payments on qualified mortgages and
such portion does not vary during the period such interest is outstanding.

Section 860G(a)(2) defines a "residual interest" in a REMIC to mean an interest in a
REMIC which is issued on the startup day, which is not a regular interest, and which is
designated as a residual interest.

Section 860G(a)(9) defines the term "startup day" to mean the day on which the REMIC
issues all of its regular and residual interests.

Section 1.860G-1(a)(1) provides that, for purposes of § 860G(a)(1), a REMIC
designates an interest as a regular interest by providing to the Internal Revenue Service
the information specified in § 1.860D-1(d)(2)(ii) in the time and manner specified in
§ 1.860D-1(d)(2). Section 1.860G-1(c) provides that 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 § 1.860D-1(d)(2)(ii) at the time and in the
manner provided in § 1.860D-1(d)(2). A residual interest need not entitle the holder to
any distributions from the REMIC.

Section 1.860G-1(a)(4) provides that, for purposes of § 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.

A REMIC regular interest must be issued on the startup date with fixed terms. A REMIC
residual interest is an interest in the REMIC issued on the startup date that is not a
regular interest. Taxpayer represents that the distribution provisions of the Settlement
Agreement do not alter the rights or obligations of either Taxpayer or the Investors'
interests therein and that the distribution of the Settlement Payment to Investors is
consistent with the distribution provisions contained in the Governing Agreements that
PLR-104889-17                                  8

provide for the distribution of subsequent recoveries or unscheduled principal amounts
received. Distributions that are made pursuant to these provisions are treated as and
constitute distributions of underlying Mortgage Loan principal collections. The
Settlement Agreement also provides that should a principal payment become payable to
a class of REMIC residual interests on a distribution date that is not the final distribution
date under the applicable Governing Agreement, such payment will be maintained in
the distribution account and Trustee shall distribute the retained amount on the next
distribution date to the applicable regular interest Investors entitled to receive a principal
distribution of subsequent recoveries or unscheduled payments of principal.
Accordingly, the distribution of the Settlement Payment to Investors will not cause any
regular interest in Taxpayer to fail to qualify as a regular interest or the sole class of
residual interest in Taxpayer to fail to qualify as a residual interest.

Issue #4: Tax on Contributions after Startup Date and Prohibited Transaction

Except as provided in § 860G(d)(2), § 860G(d)(1) imposes on any amount that is
contributed to a REMIC after the startup day a tax equal to 100 percent of the amount
contributed. Section 860G(d)(2) provides that the tax on contributions after the startup
date shall not apply to any contribution which is made in cash and is (A) a contribution
to facilitate a cleanup call (as defined in regulations) or a qualified liquidation, (B) a
payment in the nature of a guarantee, (C) a contribution during the 3-month period
beginning on the startup day, (D) a contribution to a qualified reserve fund by any holder
of a residual interest in the REMIC, or (E) any other contribution permitted in
regulations.

Section 860F(a)(1) imposes a tax equal to 100 percent of the net income derived from
prohibited transactions. Section 860F(a)(2) defines prohibited transaction to mean one
of the following: (A) disposition of any qualified mortgage transferred to the REMIC
other than a disposition pursuant to (i) the substitution of a qualified replacement
mortgage for a qualified mortgage (or the repurchase in lieu of substitution of a
defective obligation), (ii) a disposition incident to the foreclosure, default, or imminent
default of the mortgage, (iii) the bankruptcy or insolvency of the REMIC, or (iv) a
qualified liquidation, (B) the receipt of any income attributable to any asset which is
neither a qualified mortgage nor a permitted investment, (C) the receipt by the REMIC
of any amount representing a fee or other compensation for services, or (D) gain from
the disposition of any cash flow investment other than pursuant to any qualified
liquidation.

As discussed above, the receipt of the Settlement Payment by Taxpayer arises from the
Mortgage Loans and Taxpayer's status as a REMIC. The Settlement Payment arises in
connection with Taxpayer's interest in the Mortgage Loans and is neither a contribution
of cash to the REMIC nor is it listed as a prohibited transaction in § 860F(a)(2). As a
result, the receipt of the Settlement Payment by Taxpayer will not be treated as a
PLR-104889-17                                  9

prohibited transaction within the meaning of § 860F(a)(2) or as a contribution subject to
tax under § 860G(d)(1).

Conclusion

We hereby rule as follows:

       1.     In the case of Taxpayer, for which a timely, valid and continuing
       REMIC election has been made in accordance with the applicable
       Governing Agreement, none of (i) the execution of the Settlement
       Agreement, (ii) the right to receive the Settlement Payment, or (iii) the
       receipt of the Settlement Payment will cause Taxpayer to fail to meet the
       requirements of § 860D(a)(4).

       2.     In the case of Taxpayer, for which a timely, valid and continuing
       REMIC election has been made in accordance with the applicable
       Governing Agreement, the receipt of the Settlement Payment will be
       treated as a payment received on qualified mortgages within the meaning
       of § 1.860G-2(g)(1)(ii).

       3.     In the case of Taxpayer, for which a timely, valid and continuing
       REMIC election has been made in accordance with the applicable
       Governing Agreement, the distribution of the Settlement Payment in
       accordance with the applicable Governing Agreement and the Settlement
       Agreement will not cause any regular interest in Taxpayer to fail to qualify
       as a "regular interest" as defined in § 860G(a)(1) or the sole class of
       residual interest in the Taxpayer to fail to qualify as a "residual interest" as
       defined in § 860G(a)(2).

       4.     In the case of Taxpayer, for which a timely, valid and continuing
       REMIC election has been made in accordance with the applicable
       Governing Agreement, the receipt of the Settlement Payment will not be
       treated as a "prohibited transaction" within the meaning of § 860F(a)(2) or
       as a contribution that is subject to the tax imposed under § 860G(d)(1).

This ruling's application is limited to the facts, representations, Code sections, and
regulations cited herein. Except as specifically ruled upon above, no opinion is
expressed concerning any federal income tax consequences related to the facts herein
under any other provisions of the Code. Specifically, we do not rule whether Taxpayer
qualifies as a REMIC under §§ 860A-860G or whether any Mortgage Loan qualifies as a
qualified mortgage as defined in § 860G(a)(3).

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3)
provides that it may not be used or cited as precedent. In accordance with the
PLR-104889-17                                 10

provisions of a Power of Attorney on file, we are sending a copy of this ruling letter to
your authorized representative.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                          Sincerely,


                                          John W. Rogers III
                                          John W. Rogers III
                                          Senior Technician Reviewer, Branch 6
                                          Office of Associate Chief Counsel
                                          (Financial Institutions & Products)