Real Estate Mortgage Investment Conduit - The Limitations of REMICs

The Limitations of REMICs

Though REMICs provide relief from entity-level taxation, their allowable activities are quite limited “to holding a fixed pool of mortgages and distributing payments currently to investors.” A REMIC has some freedom to substitute qualified mortgages, declare bankruptcy, deal with foreclosures and defaults, dispose of and substitute defunct mortgages, prevent defaults on regular interests, prepay regular interests when the costs exceed the value of maintaining those interests, and undergo a qualified liquidation, in which the REMIC has 90 days to sell its assets and distribute cash to its holders. All other transactions are considered to be prohibited activities and are subject to a penalty tax of 100%, as are all nonqualifying contributions.

To avoid the 100% contributions tax, contributions to REMICs must be made on the startup day. However, cash contributions avoid this tax if they are given three months after the startup day, involve a clean-up call or qualified liquidation, are made as a guarantee, or are contributed by a residual interest holder to a qualified reserve fund. Additionally, states may tax REMICs under state tax laws. “Many states have adopted whole or partial tax exemptions for entities that qualify as REMICs under federal law.”

REMICs are subject to federal income taxes at the highest corporate rate for foreclosure income and must file returns through Form 1066. The foreclosure income that is taxable is the same as that for a real estate investment trust (REIT) and may include rents contingent on making a profit, rents paid by a related party, rents from property to which the REMIC offers atypical services, and income from foreclosed property when the REMIC serves as dealer.

The REMIC rules in some ways exacerbate problems of phantom income for residual interest holders, which occurs when taxable gain must be realized without a corresponding economic gain with which to pay the tax. Phantom income arises by virtue of the way that the tax rules are written. There are penalties for transferring income to non-taxpayers, so REMIC interest holders must pay taxes on gains that they do not yet have.