[Code of Federal Regulations]
[Title 26, Volume 9]
[Revised as of April 1, 2002]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.860G-1]

[Page 106-112]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1--INCOME TAXES--Table of Contents
 
Sec. 1.860G-1  Definition of regular and residual interests.

    (a) Regular interest--(1) Designation as a regular interest. For 
purposes of section 860G(a)(1), a REMIC designates an interest as a 
regular interest by providing to the Internal Revenue Service the 
information specified in Sec. 1.860D-1(d)(2)(ii) in the time and manner 
specified in Sec. 1.860D-1(d)(2).
    (2) Specified portion of the interest payments on qualified 
mortgages--(i) In general. For purposes of section 860G(a)(1)(B)(ii), a 
specified portion of the interest payments on qualified mortgages means 
a portion of the interest payable on qualified mortgages, but only if 
the portion can be expressed as--
    (A) A fixed percentage of the interest that is payable at either a 
fixed rate or at a variable rate described in paragraph (a)(3) of this 
section on some or all of the qualified mortgages;
    (B) A fixed number of basis points of the interest payable on some 
or all of the qualified mortgages; or
    (C) The interest payable at either a fixed rate or at a variable 
rate described in paragraph (a)(3) of this section on some or all of the 
qualified mortgages in excess of a fixed number of basis points or in 
excess of a variable

[[Page 107]]

rate described in paragraph (a)(3) of this section.
    (ii) Specified portion cannot vary. The portion must be established 
as of the startup day (as defined in section 860G(a)(9) and Sec. 1.860G-
2(k)) and, except as provided in paragraph (a)(2)(iii) of this section, 
it cannot vary over the period that begins on the startup day and ends 
on the day that the interest holder is no longer entitled to receive 
payments.
    (iii) Defaulted or delinquent mortgages. A portion is not treated as 
varying over time if an interest holder's entitlement to a portion of 
the interest on some or all of the qualified mortgages is dependent on 
the absence of defaults or delinquencies on those mortgages.
    (iv) No minimum specified principal amount is required. If an 
interest in a REMIC consists of a specified portion of the interest 
payments on the REMIC's qualified mortgages, no minimum specified 
principal amount need be assigned to that interest. The specified 
principal amount can be zero.
    (v) Specified portion includes portion of interest payable on 
regular interest. (A) The specified portions that meet the requirements 
of paragraph (a)(2)(i) of this section include a specified portion that 
can be expressed as a fixed percentage of the interest that is payable 
on some or all of the qualified mortgages where--
    (1) Each of those qualified mortgages is a regular interest issued 
by another REMIC; and
    (2) With respect to that REMIC in which it is a regular interest, 
each of those regular interests bears interest that can be expressed as 
a specified portion as described in paragraph (a)(2)(i)(A), (B), or (C) 
of this section.
    (B) See Sec. 1.860A-1(a) for the effective date of this paragraph 
(a)(2)(v).
    (vi) Examples. The following examples, each of which describes a 
pass-thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(2).

    Example 1. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The Class A 
certificate holders are entitled to all principal payments on the 
mortgages and to interest on outstanding principal at a variable rate 
based on the current value of One-Month LIBOR, subject to a lifetime cap 
equal to the weighted average rate payable on the mortgages. The Class B 
certificate holders are entitled to all interest payable on the 
mortgages in excess of the interest paid on the Class A certificates. 
The Class B certificates are subordinate to the Class A certificates so 
that cash flow shortfalls due to defaults or delinquencies on the 
mortgages will be borne first by the Class B certificate holders.
    (ii) The Class B certificate holders are entitled to all interest 
payable on the pooled mortgages in excess of a variable rate described 
in paragraph (a)(3)(vi) of this section. Moreover, the portion of the 
interest payable to the Class B certificate holders is not treated as 
varying over time solely because payments on the Class B certificates 
may be reduced as a result of defaults or delinquencies on the pooled 
mortgages. Thus, the Class B certificates provide for interest payments 
that consist of a specified portion of the interest payable on the 
pooled mortgages under paragraph (a)(2)(i)(C) of this section.
    Example 2. (i) A sponsor transferred a pool of variable rate 
mortgages to a trustee in exchange for two classes of certificates. The 
mortgages call for interest payments at a variable rate based on the 
current value of the One-Year Constant Maturity Treasury Index 
(hereinafter ``CMTI'') plus 200 basis points, subject to a lifetime cap 
of 12 percent. Class C certificate holders are entitled to all principal 
payments on the mortgages and interest on the outstanding principal at a 
variable rate based on the One-Year CMTI plus 100 basis points, subject 
to a lifetime cap of 12 percent. The interest rate on the Class C 
certificates is reset at the same time the rate is reset on the pooled 
mortgages.
    (ii) The Class D certificate holders are entitled to all interest 
payments on the mortgages in excess of the interest paid on the Class C 
certificates. So long as the One-Year CMTI is at 10 percent or lower, 
the Class D certificate holders are entitled to 100 basis points of 
interest on the pooled mortgages. If, however, the index exceeds 10 
percent on a reset date, the Class D certificate holders' entitlement 
shrinks, and it disappears if the index is at 11 percent or higher.
    (iii) The Class D certificate holders are entitled to all interest 
payable on the pooled mortgages in excess of a qualified variable rate 
described in paragraph (a)(3) of this section. Thus, the Class D 
certificates provide for interest payments that consist of a specified 
portion of the interest payable on the qualified mortgages under 
paragraph (a)(2)(i)(C) of this section.
    Example 3. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The fixed 
interest rate payable on the mortgages varies from mortgage to mortgage, 
but all rates are between 8 and 10 percent. The Class E certificate 
holders are entitled to receive

[[Page 108]]

all principal payments on the mortgages and interest on outstanding 
principal at 7 percent. The Class F certificate holders are entitled to 
receive all interest on the mortgages in excess of the interest paid on 
the Class E certificates.
    (ii) The Class F certificates provide for interest payments that 
consist of a specified portion of the interest payable on the mortgages 
under paragraph (a)(2)(i) of this section. Although the portion of the 
interest payable to the Class F certificate holders varies from mortgage 
to mortgage, the interest payable can be expressed as a fixed percentage 
of the interest payable on each particular mortgage.

    (3) Variable rate. A regular interest may bear interest at a 
variable rate. For purposes of section 860G(a)(1)(B)(i), a variable rate 
of interest is a rate described in this paragraph (a)(3).
    (i) Rate based on current interest rate. A qualified floating rate 
as defined in Sec. 1.1275-5(b)(1) (but without the application of 
paragraph (b)(2) or (3) of that section) set at a current value, as 
defined in Sec. 1.1275-5(a)(4), is a variable rate. In addition, a rate 
equal to the highest, lowest, or average of two or more qualified 
floating rates is a variable rate. For example, a rate based on the 
average cost of funds of one or more financial institutions is a 
variable rate.
    (ii) Weighted average rate--(A) In general. A rate based on a 
weighted average of the interest rates on some or all of the qualified 
mortgages held by a REMIC is a variable rate. The qualified mortgages 
taken into account must, however, bear interest at a fixed rate or at a 
rate described in this paragraph (a)(3). Generally, a weighted average 
interest rate is a rate that, if applied to the aggregate outstanding 
principal balance of a pool of mortgage loans for an accrual period, 
produces an amount of interest that equals the sum of the interest 
payable on the pooled loans for that accrual period. Thus, for an 
accrual period in which a pool of mortgage loans comprises $300,000 of 
loans bearing a 7 percent interest rate and $700,000 of loans bearing a 
9.5 percent interest rate, the weighted average rate for the pool of 
loans is 8.75 percent.
    (B) Reduction in underlying rate. For purposes of paragraph 
(a)(3)(ii)(A) of this section, an interest rate is considered to be 
based on a weighted average rate even if, in determining that rate, the 
interest rate on some or all of the qualified mortgages is first subject 
to a cap or a floor, or is first reduced by a number of basis points or 
a fixed percentage. A rate determined by taking a weighted average of 
the interest rates on the qualified mortgage loans net of any servicing 
spread, credit enhancement fees, or other expenses of the REMIC is a 
rate based on a weighted average rate for the qualified mortgages. 
Further, the amount of any rate reduction described above may vary from 
mortgage to mortgage.
    (iii) Additions, subtractions, and multiplications. A rate is a 
variable rate if it is--
    (A) Expressed as the product of a rate described in paragraph 
(a)(3)(i) or (ii) of this section and a fixed multiplier;
    (B) Expressed as a constant number of basis points more or less than 
a rate described in paragraph (a)(3)(i) or (ii) of this section; or
    (C) Expressed as the product, plus or minus a constant number of 
basis points, of a rate described in paragraph (a)(3)(i) or (ii) of this 
section and a fixed multiplier (which may be either a positive or a 
negative number).
    (iv) Caps and floors. A rate is a variable rate if it is a rate that 
would be described in paragraph (a)(3)(i) through (iii) of this section 
except that it is--
    (A) Limited by a cap or ceiling that establishes either a maximum 
rate or a maximum number of basis points by which the rate may increase 
from one accrual or payment period to another or over the term of the 
interest; or
    (B) Limited by a floor that establishes either a minimum rate or a 
maximum number of basis points by which the rate may decrease from one 
accrual or payment period to another or over the term of the interest.
    (v) Funds-available caps--(A) In general. A rate is a variable rate 
if it is a rate that would be described in paragraph (a)(3)(i) through 
(iv) of this section except that it is subject to a ``funds-available'' 
cap. A funds-available cap is a limit on the amount of interest to be 
paid on an instrument in any accrual or payment period that is based on 
the total amount available for the distribution, including both 
principal and interest received by an

[[Page 109]]

issuing entity on some or all of its qualified mortgages as well as 
amounts held in a reserve fund. The term ``funds-available cap'' does 
not, however, include any cap or limit on interest payments used as a 
device to avoid the standards of paragraph (a)(3)(i) through (iv) of 
this section.
    (B) Facts and circumstances test. In determining whether a cap or 
limit on interest payments is a funds-available cap within the meaning 
of this section and not a device used to avoid the standards of 
paragraph (a)(3)(i) through (iv) of this section, one must consider all 
of the facts and circumstances. Facts and circumstances that must be 
taken into consideration are--
    (1) Whether the rate of the interest payable to the regular interest 
holders is below the rate payable on the REMIC's qualified mortgages on 
the start-up day; and
    (2) Whether, historically, the rate of interest payable to the 
regular interest holders has been consistently below that payable on the 
qualified mortgages.
    (C) Examples. The following examples, both of which describe a pass-
thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(3)(v).

    Example 1. (i) A sponsor transferred a pool of mortgages to a 
trustee in exchange for two classes of certificates. The pool of 
mortgages has an aggregate principal balance of $100x. Each mortgage in 
the pool provides for interest payments based on the eleventh district 
cost of funds index (hereinafter COFI) plus a margin. The initial 
weighted average rate for the pool is COFI plus 200 basis points. The 
trust issued a Class X certificate that has a principal amount of $100x 
and that provides for interest payments at a rate equal to One-Year 
LIBOR plus 100 basis points, subject to a cap described below. The Class 
R certificate, which the sponsor designated as the residual interest, 
entitles its holder to all funds left in the trust after the Class X 
certificates have been retired. The Class R certificate holder is not 
entitled to current distributions.
    (ii) At the time the certificates were issued, COFI equalled 4.874 
percent and One-Year LIBOR equalled 3.375 percent. Thus, the initial 
weighted average pool rate was 6.874 percent and the Class X certificate 
rate was 4.375 percent. Based on historical data, the sponsor does not 
expect the rate paid on the Class X certificate to exceed the weighted 
average rate on the pool.
    (iii) Initially, under the terms of the trust instrument, the excess 
of COFI plus 200 over One-Year LIBOR plus 100 (excess interest) will be 
applied to pay expenses of the trust, to fund any required reserves, and 
then to reduce the principal balance on the Class X certificate. 
Consequently, although the aggregate principal balance of the mortgages 
initially matched the principal balance of the Class X certificate, the 
principal balance on the Class X certificate will pay down faster than 
the principal balance on the mortgages as long as the weighted average 
rate on the mortgages is greater than One-Year LIBOR plus 100. If, 
however, the rate on the Class X certificate (One-Year LIBOR plus 100) 
ever exceeds the weighted average rate on the mortgages, then the Class 
X certificate holders will receive One-Year LIBOR plus 100 subject to a 
cap based on the current funds that are available for distribution.
    (iv) The funds available cap here is not a device used to avoid the 
standards of paragraph (a)(3) (i) through (iv) of this section. First, 
on the date the Class X certificates were issued, a significant spread 
existed between the weighted average rate payable on the mortgages and 
the rate payable on the Class X certificate. Second, historical data 
suggest that the weighted average rate payable on the mortgages will 
continue to exceed the rate payable on the Class X certificate. Finally, 
because the excess interest will be applied to reduce the outstanding 
principal balance of the Class X certificate more rapidly than the 
outstanding principal balance on the mortgages is reduced, One-Year 
LIBOR plus 100 basis points would have to exceed the weighted average 
rate on the mortgages by an increasingly larger amount before the funds 
available cap would be triggered. Accordingly, the rate paid on the 
Class X certificates is a variable rate.
    Example 2. (i) The facts are the same as those in Example 1, except 
that the pooled mortgages are commercial mortgages that provide for 
interest payments based on the gross profits of the mortgagors, and the 
rate on the Class X certificates is 400 percent on One-Year LIBOR (a 
variable rate under paragraph (a)(3)(iii) of this section), subject to a 
cap equal to current funds available to the trustee for distribution.
    (ii) Initially, 400 percent of One-Year LIBOR exceeds the weighted 
average rate payable on the mortgages. Furthermore, historical data 
suggest that there is a significant possibility that, in the future, 400 
percent of One-Year LIBOR will exceed the weighted average rate on the 
mortgages.
    (iii) The facts and circumstances here indicate that the use of 400 
percent of One-Year LIBOR with the above-described cap is a device to 
pass through to the Class X certificate holder contingent interest based 
on mortgagor profits. Consequently, the rate

[[Page 110]]

paid on the Class X certificate here is not a variable rate.

    (vi) Combination of rates. A rate is a variable rate if it is based 
on--
    (A) One fixed rate during one or more accrual or payment periods and 
a different fixed rate or rates, or a rate or rates described in 
paragraph (a)(3) (i) through (v) of this section, during other accrual 
or payment periods; or
    (B) A rate described in paragraph (a)(3) (i) through (v) of this 
section during one or more accrual or payment periods and a fixed rate 
or rates, or a different rate or rates described in paragraph (a)(3) (i) 
through (v) of this section in other periods.
    (4) Fixed terms on the startup day. For purposes of section 
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.
    (5) Contingencies prohibited. Except for the contingencies specified 
in paragraph (b)(3) of this section, the principal amount (or other 
similar amount) and the latest possible maturity date of the interest 
must not be contingent.
    (b) Special rules for regular interests--(1) Call premium. An 
interest in a REMIC does not qualify as a regular interest if the terms 
of the interest entitle the holder of that interest to the payment of 
any premium that is determined with reference to the length of time that 
the regular interest is outstanding and is not described in paragraph 
(b)(2) of this section.
    (2) Customary prepayment penalties received with respect to 
qualified mortgages. An interest in a REMIC does not fail to qualify as 
a regular interest solely because the REMIC's organizational documents 
provide that the REMIC must allocate among and pay to its regular 
interest holders any customary prepayment penalties that the REMIC 
receives with respect to its qualified mortgages. Moreover, a REMIC may 
allocate prepayment penalties among its classes of interests in any 
manner specified in the REMIC's organizational documents. For example, a 
REMIC could allocate all or substantially all of a prepayment penalty 
that it receives to holders of an interest-only class of interests 
because that class would be most significantly affected by prepayments.
    (3) Certain contingencies disregarded. An interest in a REMIC does 
not fail to qualify as a regular interest solely because it is issued 
subject to some or all of the contingencies described in paragraph 
(b)(3) (i) through (vi) of this section.
    (i) Prepayments, income, and expenses. An interest does not fail to 
qualify as a regular interest solely because--
    (A) The timing of (but not the right to or amount of) principal 
payments (or other similar amounts) is affected by the extent of 
prepayments on some or all of the qualified mortgages held by the REMIC 
or the amount of income from permitted investments (as defined in 
Sec. 1.860G-2(g)); or
    (B) The timing of interest and principal payments is affected by the 
payment of expenses incurred by the REMIC.
    (ii) Credit losses. An interest does not fail to qualify as a 
regular interest solely because the amount or the timing of payments of 
principal or interest (or other similar amounts) with respect to a 
regular interest is affected by defaults on qualified mortgages and 
permitted investments, unanticipated expenses incurred by the REMIC, or 
lower than expected returns on permitted investments.
    (iii) Subordinated interests. An interest does not fail to qualify 
as a regular interest solely because that interest bears all, or a 
disproportionate share, of the losses stemming from cash flow shortfalls 
due to defaults or delinquencies on qualified mortgages or permitted 
investments, unanticipated expenses incurred by the REMIC, lower than 
expected returns on permitted investments, or prepayment interest 
shortfalls before other regular interests or the residual interest bear 
losses occasioned by those shortfalls.

[[Page 111]]

    (iv) Deferral of interest. An interest does not fail to qualify as a 
regular interest solely because that interest, by its terms, provides 
for deferral of interest payments.
    (v) Prepayment interest shortfalls. An interest does not fail to 
qualify as a regular interest solely because the amount of interest 
payments is affected by prepayments of the underlying mortgages.
    (vi) Remote and incidental contingencies. An interest does not fail 
to qualify as a regular interest solely because the amount or timing of 
payments of principal or interest (or other similar amounts) with 
respect to the interest is subject to a contingency if there is only a 
remote likelihood that the contingency will occur. For example, an 
interest could qualify as a regular interest even though full payment of 
principal and interest on that interest is contingent upon the absence 
of significant cash flow shortfalls due to the operation of the Soldiers 
and Sailors Civil Relief Act, 50 U.S.C. app. 526 (1988).
    (4) Form of regular interest. A regular interest in a REMIC may be 
issued in the form of debt, stock, an interest in a partnership or 
trust, or any other form permitted by state law. If a regular interest 
in a REMIC is not in the form of debt, it must, except as provided in 
paragraph (a)(2)(iv) of this section, entitle the holder to a specified 
amount that would, were the interest issued in debt form, be identified 
as the principal amount of the debt.
    (5) Interest disproportionate to principal--(i) In general. An 
interest in a REMIC does not qualify as a regular interest if the amount 
of interest (or other similar amount) payable to the holder is 
disproportionately high relative to the principal amount or other 
specified amount described in paragraph (b)(4) of this section 
(specified principal amount). Interest payments (or other similar 
amounts) are considered disproportionately high if the issue price (as 
determined under paragraph (d) of this section) of the interest in the 
REMIC exceeds 125 percent of its specified principal amount.
    (ii) Exception. A regular interest in a REMIC that entitles the 
holder to interest payments consisting of a specified portion of 
interest payments on qualified mortgages qualifies as a regular interest 
even if the amount of interest is disproportionately high relative to 
the specified principal amount.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes. In determining the tax under chapter 1 of the 
Internal Revenue Code, a REMIC regular interest (as defined in section 
860G(a)(1)) is treated as a debt instrument that is an obligation of the 
REMIC. Thus, sections 1271 through 1288, relating to bonds and other 
debt instruments, apply to a regular interest. For special rules 
relating to the accrual of original issue discount on regular interests, 
see section 1272(a)(6).
    (c) Residual interest. 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 Sec. 1.860D-
1(d)(2)(ii) at the time and in the manner provided in Sec. 1.860D-
1(d)(2). A residual interest need not entitle the holder to any 
distributions from the REMIC.
    (d) Issue price of regular and residual interests--(1) In general. 
The issue price of any REMIC regular or residual interest is determined 
under section 1273(b) as if the interest were a debt instrument and, if 
issued for property, as if the requirements of section 1273(b)(3) were 
met. Thus, if a class of interests is publicly offered, then the issue 
price of an interest in that class is the initial offering price to the 
public at which a substantial amount of the class is sold. If the 
interest is in a class that is not publicly offered, the issue price is 
the price paid by the first buyer of that interest regardless of the 
price paid for the remainder of the class. If the interest is in a class 
that is retained by the sponsor, the issue price is its fair market 
value on the pricing date (as defined in Sec. 1.860F-2(b)(3)(iii)), if 
any, or, if none, the startup day, regardless of whether the property 
exchanged therefor is publicly traded.
    (2) The public. The term ``the public'' for purposes of this section 
does not include brokers or other middlemen, nor does it include the 
sponsor who acquires all of the regular and residual

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interests from the REMIC on the startup day in a transaction described 
in Sec. 1.860F-2(a).

[T.D. 8458, 57 FR 61306, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995]