REMIC Impairments May Qualify as Worthless Bad Debts
In the September 2008 issue of TAXING TIMES we discussed the general tax rules that apply to write-downs of impaired investment assets. In the prior article, we explained the different tax treatment for instruments treated as securities versus other debt instruments. In summary, “securities” are not eligible for a worthlessness deduction until the security is wholly worthless, and the worthlessness deduction is capital in character. A “security” is defined as a stock, subscription right or bond, debenture, note or certificate or other evidence of indebtedness with interest coupons or in registered form issued by a corporation, government or a political subdivision thereof. Classification of an investment asset as a security is a double disadvantage, in that it delays the timing of the deduction and, in some instances, may limit the ability to realize any benefit because capital losses can be used only against capital gains and the carryover of capital losses is limited to five years. In the current economic environment, there is no certainty that capital gains will be available to offset capital losses. For these reasons, non-security treatment is preferable because the instruments potentially are eligible for partial bad debt deductions as the instruments become worthless and the deductions are ordinary in character, meaning they can be used to offset ordinary operating income and can be carried forward for a longer period of time.
The issues discussed in our prior article have come up frequently with respect to impairments of investments in Real Estate Mortgage Investment Conduits (“REMICs”). A regular interest in a REMIC entitles the certificate holder to a portion of the cash flows from underlying residential mortgages packaged as securities by financial institutions. Regular interest REMICs along with other asset types have experienced dramatic declines in value as the result of the mortgage crisis and insurance companies have recorded impairments for statutory accounting purposes. Many taxpayers assume that the contingent nature of the cash flows from REMIC regular interests suggests that they would be classified as securities and ineligible for bad debt treatment. However, for federal income tax purposes, REMIC regular interests are treated as debt instruments under section 860B of the Internal Revenue Code. Importantly, moreover, they typically are issued by a trust rather than a corporation or government entity. This means that REMIC regular interests should not be treated as “securities” for purposes of the bad debt rules. Thus, statutory impairments of REMIC regular interests potentially may be eligible for a partial bad debt deduction under section 166 of the Code if the impairment satisfies the partial worthlessness standard for tax purposes. Taxpayers may be able to demonstrate that an impairment, or at least a portion of the impairment, represents a wholly worthless portion of the instrument under the tax standard (i.e., that collection of that portion is hopeless). To the extent the amount of partial worthlessness of a REMIC regular interest is difficult to prove, insurance companies may want to contend that the conclusive presumption of worthlessness under Treas. Reg. § 1.166-2(d) applies. For a company to take advantage of the presumption, its state regulators would need to provide a letter verifying that the impairment was required.
This issue will become increasingly important in tax year 2009, when Statement of Statutory Accounting Principles (SSAP) 98 is adopted. SSAP 98 amends SSAP 43, essentially requiring statutory impairments for structured securities similar to the GAAP impairments. As the impairments become more common, it will be important for companies to be able to evaluate each impairment to determine the portion that satisfies the tax standard of worthlessness and, moreover, to keep in contact with their state regulators in the annual statement examination process if reliance on the conclusive presumption is contemplated.
T3: Taxing Times Tidbits, 50 Taxing Times, Vol. 5, Issue 2 (May 2009)