Many mortgage companies are facing the decision of whether to keep or sell their mortgage servicing rights (MSR) that have built up since the start of the Covid-19 pandemic. The impact on your liquidity, financial statements, and income taxes are major factors to consider.
As interest rates continue to increase and production falls off from historic highs, liquidity could be a concern. We are seeing a drop in prepayments which positively impacts MSR values. However, due to the complexities of valuing any future stream of cash flows, warehouse lenders may discount the MSR values on the company’s balance sheet for net worth purposes.
None the less, a cash infusion from the complete or partial sale of MSRs could solidify the company’s net worth and be just what the company needs to reinvest in new technology, retain key employees, and deal with other inflationary impacts on the company.
It’s important first to understand that MSRs are an appreciated asset marked-to-market for financial statement presentation under Generally Accepted Accounting Principles (GAAP) but realized for income tax purposes when the MSR is sold. The difference between the book asset under GAAP versus the tax asset is a significant tax planning opportunity. Although the tax rules can be overly complex considering Section 451 recognition, Section 1286 stripped bonds, amortization under section 167, and excess servicing “safe harbor” rules, the goal is to assess the impact of the overall tax strategy. To the extent that Originated Mortgage Servicing Rights (OSMRs) are held for greater than one year, a portion of the sale will be taxed at long-term capital gains rates. Companies will need to provide loan-level detail to determine the long-term gain treatment. Gains on the sale of Purchased Mortgage Servicing Rights (PSMRs) (net of amortization) are taxed at long-term capital gain rates after a one-year hold.
The tax consequences of the sale are a major factor to consider. For a company that reports as a pass-through entity where the ordinary income can be taxed up to 39 percent for an individual and the long-term capital gains rate are 20 percent, tax distributions would be substantially less.
If your company expects to incur a net operating loss, generating long-term capital gains from the sale of MSRs may lessen the tax benefit of a net operating loss because of the difference in long-term capital gain rates and ordinary tax rates. Be sure to track the impacts on book and tax losses throughout the year by paying special attention to the change in fair value of derivatives and MSRs. Also, keep an eye out for President Biden’s Build Back Better program or his budget calling for substantial increases in long-term capital gains rates.
Special thanks to the Mortgage Bankers Association (www.mba.com) and BKM Sowan Horan (www.bkmsh.com) Partner Brad Marckx (email@example.com) for their industry service on keeping the change in MSR values out of taxable income. There are many factors to consider in an MSR sale when evaluating a company’s liquidity needs, financial statement considerations and income taxes. Contact your accounting and tax advisors to make sure your evaluation is thoughtful and complete.
With over 23 years of experience in public accounting and as a founding Partner of BKM Sowan Horan, Mike provides exceptional client service for companies primarily in the mortgage banking, investment funds, real estate, and healthcare industries.
Mike is an experienced business partner who delivers value and solutions to help his clients achieve their goals. He is a Texas Mortgage Bankers Association board member and graduate of the Mortgage Bankers Association Future Leaders Class of 2016. Together with Brad Marckx, Mike leads the mortgage banking practice, which has become one of the largest industry practices of the firm.