The Internal Revenue Service is checking out dozens of participants in a financial arrangement to see if they are reaping illegal tax benefits by underreporting income on mortgage-backed securities, which make up the bulk of the multitrillion-dollar market for asset-backed securities.
The inquiry, which an I.R.S. official said yesterday was in its early stages, concerns the use of arcane but powerful investment entities known as real estate mortgage investment conduits.
Remics, as they are called, are a complex legal entity through which the vast majority of mortgage-backed securities are sold.
The I.R.S. is looking at whether companies and firms that set up remics — including the giant housing agencies Fannie Mae and Freddie Mac, as well as Wall Street investment banks, commercial banks and other mortgage originators — have undervalued the interest earned on those securities and thus underpaid their federal taxes, according to a senior I.R.S. official, Barry Schott.
Mr. Schott oversees the financial services unit of the I.R.S. division devoted to scrutinizing large and midsize businesses.
Mr. Schott said the I.R.S. had looked “at a couple of cases and discovered some issues, and we’re expanding this to look at other cases.” He said he thought that “less than hundreds of billions of dollars” in interest income had been underreported, but he declined to be more specific.
He added that the I.R.S. did not want to suggest that abuses were widespread “because there’s a very sensitive market.” While he said that approximately 20 to 30 companies involved in remics were under scrutiny, he declined to give their names, citing taxpayer confidentiality rules.
Mr. Schott said that the scrutiny, which was first reported yesterday in Tax Analysts, a prominent trade publication, was not related to the recent turmoil in the mortgage markets. The issuance of mortgage-backed securities has been all but frozen because of those problems, and large banks and hedge funds have taken big losses on investments in the securities.
A remic is typically a tax-free trust set up to issue and sell pools of existing mortgages, both residential and commercial, to investors.
A trust is set up by a bank or other company — called a sponsor — which sells or transfers mortgage pools to the trust. That move is taxable to the sponsors.
They then use the remic to carve those pools into slices, bearing varying degrees of risk, for sale to institutional investors — typically other banks, hedge funds, insurance companies and pension funds.
The investors who buy the slices pay taxes on their investments. Often the sponsors themselves retain a slice of the mortgage pools in the remic.
First created in the 1980s, remics have ballooned in popularity in recent years, and now account for an estimated 50 to 70 percent of the multitrillion-dollar market for asset-backed securities.
Securitization has allowed home lenders over the last decade to vastly increase the amount of money available for home loans, by moving existing loans off their balance sheets and freeing up cash. The market for mortgage-backed securities now exceeds that for United States Treasury bills, one of the world’s largest markets.
Remics are a crucial component of that process. Their profits or losses flow through to the investors who buy the mortgage pool slices, and are taxable to those investors. Remics, which are themselves tax-free, thus allow investors and sponsors to avoid double taxation.
Remics that violate the tax code, however, can lose their tax-free status, potentially causing either their sponsors or their investors to face a big tax bill.
Mr. Schott said that the I.R.S. was looking at whether sponsors of remics were deliberately underreporting the income they earned from regular and residual interest on securitized mortgages sold through remics.
The sponsors typically set the value of the interest according to complex calculations involving when and how borrowers are likely to pay off their mortgages.
The inquiry stemmed from some of those interest calculations, which the I.R.S. believed estimated the interest to be paid over time incorrectly.
Any underreporting could also affect the buyers of the mortgage slices, because they could unwittingly be paying too little tax on their investments.
“If there is general noncompliance, it’s going to cut across all of those pockets,” Mr. Schott said.
A spokesman for Freddie Mac, which has issued tens of billions of securities through the remics that it sponsors, said yesterday only that “our remic program is a key component of our securitization business here.”
Fannie Mae, one of the largest issuers of mortgage-backed securities and users of remics, did not have a comment on the investigation.