On November 24, 2023, the IRS released PLR 202347001, ruling that certificates issued from an "exchange trust" qualify as stripped bonds or stripped coupons within the meaning of Code Section 1286.
The taxpayer in the PLR issues mortgage-backed securities in which mortgage loans are deposited into a trust that is structured as either a grantor trust or a real estate mortgage investment conduit ("REMIC"). The grantor trust issues pass-through certificates that represent ownership of the underlying mortgage loans, and the REMIC issues REMIC regular interests that are treated as debt instruments for tax purposes. In each case, holders of trust certificates are entitled to receive income and principal from the mortgage loans.
The PLR describes an exchange trust mechanism in which holders of the trust certificates are permitted to exchange their certificates for certain "exchange certificates" that have terms that vary from the terms of the initial certificates. For example, a holder of a trust certificate entitled to $100 of principal and interest at a rate of 6% may exchange the initial certificate for two new exchange certificates—one entitled to $100 of principal and interest at a rate of 4%, and the other entitled to interest that accrues on $100 at a rate of 2%. These exchange certificates are stripped bonds and stripped coupons because they represent a "strip" off the initial certificate that is equal to a fixed number of basis points.
The PLR also rules favorably for the taxpayer in the more analytically challenging case when an initial certificate with a fixed rate is exchanged for two new exchange certificates that represent an inverse floater pair whose rates are based on a benchmark (e.g., SOFR) such that the "strips" are not fixed. For example, the holder of the trust certificate with a fixed rate of 6% may exchange it for two new certificates—one with an interest rate equal to SOFR plus 2% (with a cap of 6%) and the other with an interest rate equal to 6% minus the sum of SOFR plus 2% (with a floor of 0%). When paired together, the two exchange certificates always have a combined rate of 6%. The PLR confirms that these exchange certificates qualify as stripped bonds and stripped coupons—even though these "strips" vary based on a benchmark—and that the exchange trust in this example qualifies as a fixed investment trust.
The IRS has now privately ruled favorably on the use of exchange trusts for inverse floater pairs a few times (e.g., PLR 201229003 and PLR 200624005). It would certainly be helpful if the IRS would issue formal, precedential guidance on these exchange trusts considering their desired use in mortgage securitizations.
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