When a bank or financial services company originates a mortgage, it often will sell the originated mortgage and retain the servicing rights. With the retained servicing comes the right to earn a fee for collecting and remitting the monthly payments from the borrower. The proper tax treatment of these servicing fees can result in immediate tax benefits.
The Rise of Servicing Fees
With mortgage interest rates remaining low, many banks are seeing a significant increase in the number of new residential mortgages originated. In some cases, banks even have created mortgage company subsidiaries to take advantage of the increased volume.
The increase in originated mortgages has often resulted in a significant increase in mortgage servicing income, as many financial services companies opt to sell the mortgage and retain the servicing rights. The fees for servicing these loans are treated as compensation and can be “normal” or “excess,” with the distinction being important in determining tax treatment.
Treatment of “Normal” Servicing Fees
Reasonable compensation for services performed by a bank or financial services organization servicing mortgages is included in taxable income in accordance with the taxpayer’s overall method of accounting. For most banks, this would be under the accrual method, and the income would be recognized the earlier of when received or earned, not averaged over life of loan (IRS Revenue Ruling No. 70-142). This tax treatment for normal servicing fees often runs counter to book treatment, causing a difference between taxable income and book income. This difference is typically favorable, as the tax treatment will recognize servicing income as the monthly payments are received, while the book treatment recognizes the entire gain amount when the mortgage is sold.
Revenue Procedure 91-50 provides an elective safe harbor for determining what constitutes “reasonable compensation” for mortgage servicing. Fees that fall within the safe harbor are considered normal and are included in taxable income as received or earned under the bank’s overall method of accounting.
The revenue procedure defines the following annual fee rates as “safe harbor” rates for one-to-four unit residential mortgages:
- For a conventional, fixed rate mortgage: 0.25 percent of the outstanding principal
- For a mortgage less than one year old that is insured or guaranteed by the Federal Housing Administration, Department of Veterans Affairs, or U.S. Department of Agriculture Rural Development (formerly Farmers Home Administration): 0.44 percent of the outstanding principal
- For any other mortgage: 0.375 percent of the outstanding principal
If the original principal balance of any mortgage was $50,000 or less, the safe harbor rate for servicing the mortgage is 0.44 percent.
Note that banks must elect (or revoke) the safe harbor by attaching a statement to their timely filed federal income tax returns for the first taxable year for which the safe harbor is elected (or revoked). The attachment should state that the bank is electing (or revoking) the safe harbor for mortgage servicing contracts provided by Revenue Procedure 91-50.
Treatment of “Excess” Servicing Fees
If the servicing arrangement results in the bank receiving servicing fees in excess of normal, special tax calculations must be applied. Revenue Ruling 91-46, which addresses proper tax treatment for excess servicing fees, describes the fees as those received that exceed the reasonable compensation for the services – in other words, fees that exceed the safe harbor rates outlined in Revenue Procedure 91-50, which was issued in conjunction with Revenue Ruling 91-46.
According to Revenue Ruling 91-46, the “stripped bond” rules in IRC Section 1286 apply when a bank sells a mortgage and at the same time enters a contract to service that mortgage that results in excess servicing fees. Under those rules, the bank must allocate the tax basis in the originated loan between the loan and the excess servicing right retained, based on the relative fair market values of each.
The basis allocation is made immediately before the loan is sold. Thus, the basis allocated to the excess servicing right will reduce the basis of the loan and increase the taxable gain (typically considered to be ordinary for banks) on the sale of the loan. The basis allocated to the excess servicing right is then amortized into taxable income over the life of the servicing agreement. Note that no basis allocation is required for normal servicing fees.
If a taxpayer acquires mortgage servicing rights in a taxable acquisition, the portion of the purchase price allocated to the servicing rights establishes the tax basis that can be amortized. The recovery period typically is either nine years or 15 years, depending on whether the servicing rights were purchased separately or as part of a larger asset acquisition.
Worth the Trouble
Understanding the difference between normal and excess servicing rights is an important distinction in correctly reporting taxable income and identifying opportunities. Most community banks engage only in normal servicing related to standard mortgage loans, thus not falling under the stripped bond rules and thereby allowing a deferral of income. When excess servicing fees are not an issue, simply following book basis will result in banks reporting income for tax purposes earlier than necessary. If a bank is using an improper tax method to account for the retained servicing fees, Revenue Procedure 91-51 provides procedures for taxpayers to change their tax accounting method from a method that does not comply with Section 1286 and Revenue Ruling 91-46 to a method that does comply. These rules can be complex but often beneficial to taxpayers.