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CCA 201507019 – Sec. 7701(g) Nonrecourse Debt Relevant for Sec. 475 Mark-to-Market, IRS Says
February 18, 2015
Administrative Actions
Here we have what appears to be a novel issue that could potentially resolve some confusion that various securitization financial players might have had in the past. The question CCA 201507019 answers is whether financial institutions who mark-to-market their portfolios under Sec. 475 must factor in their fair market value calculations any Sec. 7701(g) nonrecourse debt that encumbers the portfolio. Succinctly, the answer is yes. To those who do not recall what Sec. 7701(g) is about, it basically enacts the principles set forth in the famous Tufts case that most LLMs study in their first year. It stands for the proposition that for purposes of computing gain/loss on the sale of property, the FMV of the property cannot be less than the value of the nonrecourse debt encumbering the property.

In this ruling we have a financial institution (not clear whether a family of funds, bank subsidiary, or something else) that was in the business of originating mortgage-backed-securities. The financial institution bought mortgages and repackaged them as MBS. Any money the financial institution received from investors was treated as nonrecourse liabilities encumbering the mortgages.  The financial institution computed mark-to-market gain/loss but did not include the nonrecourse liabilities in those computations. Apparently, and we are surmising here, the institution’s position was that nothing in Sec. 475 implies that 7701(g) ought to apply. As a result, the institution’s computations lead to significant losses. When it calculated its annual MTM gain/loss, the institution did not treat the FMV of the securities as not being less than the nonrecourse debt. Thus, for example, if it bought the securities for 100 and issued MBS for 100, and if the FMV dropped to $80 it claimed a $20 loss instead of no gain/loss. In other words, it was piling on non-economic losses because it was not on the hook for the original $100 loan, which was secured solely by the underlying mortgages.

The IRS’ reasoning as to why Sec. 7701(g) applies to Sec. 475 was a few paragraphs long but the gist of it could be summarized as follows. The Service explained the issues in the Tuffts case and the reasons for the enactment of Sec. 7701(g) and it further pointed out that Sec. 475 was enacted nine years after 7701(g). The IRS pointed out that while other Code sections expressly provide that 7701(g) does not apply to FMV determinations, Sec. 475 contains no language that precludes the application of 7701(g). Lastly, it reasoned that it is generally assumed that Congress is aware of existing law when it passes legislation and that because section 475 was enacted nine years after section 7701(g), it should be assumed that Congress intended section 7701(g) to apply. The IRS buttressed all of this by concluding that even if section 7701(g) did not apply to section 475, the principles of Tufts nonetheless apply leading to the same result. The ruling can be found here.
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Tags: 7701(g), mark to market, section 475