The Arizona Department of Revenue (the Department) issued an Individual Income Tax Ruling describing the treatment of Real Estate Mortgage Investment Conduits (REMICs). Ariz. ITR 11-6 (Aug. 8, 2011). The ruling affirms the Department’s longstanding positions regarding the sourcing of income received from REMICs and whether simply holding an interest in an Arizona REMIC creates nexus. Ariz. ITR 91-2 (Apr. 2, 1991).
For federal tax purposes, the IRS treats REMICs as flow-through entities and does not tax the entity itself on its income. Rather, the REMIC’s interest holders are taxed on the REMIC’s income. Generally, REMICs will have two types of holders: regular interest holders and residual interest holders. Regular interest holders are taxed as if their interests were debt instruments, whereas residual interest holders report the REMIC’s taxable income or loss in proportion to their percentage ownership, similar to partners in a partnership.
Expanding on this federal scheme, the Arizona ruling reaffirms several determinations the Department made in 1991. First, the REMIC itself is not subject to Arizona income tax, since it is not engaged in a trade or business. However, if the REMIC is managed or administered in Arizona or owns real property in Arizona (e.g., foreclosure property), it must file annual information returns with Arizona similar to those required for federal purposes. A REMIC that is not managed or administered in Arizona presumably is not required to file the Arizona reports, as the ruling makes clear that a REMIC will not have income from Arizona sources solely by owning mortgages secured by Arizona property or in which the debtors are Arizona residents, or by having interest holders who are Arizona residents.
Holders are subject to Arizona tax on the income they receive from the REMIC if: (1) they are residents of Arizona; (2) the REMIC owns real property in Arizona; or (3) the holder employs the REMIC investment in a business in Arizona. Residents, of course, are subject to Arizona tax on all of their income, regardless of source, including their income from a REMIC. Nonresidents are subject to tax on their REMIC income only if the income has an Arizona source. The ruling clarifies that income received by the residual interest holders in a REMIC will be considered income from Arizona sources only if: (1) the REMIC owns any real property in Arizona at any time during the taxable year, including foreclosure property; or (2) the holder carries on a business, trade, profession, or occupation in Arizona, and the REMIC investment is employed in such business. However, the ruling does not address how much of the nonresident holder’s income from such a REMIC would be considered Arizona source income. Presumably, only a portion of the REMIC income could have an Arizona source if the REMIC owned real property in more than one state.
A nonresident holder whose only connection with Arizona is the receipt of income from a REMIC that is managed or administered in Arizona and does not own any real property in Arizona would not be subject to Arizona income tax, as the ruling treats such income as intangible income generally sourced to the individual’s state of residence. The ruling states, however, that corporate holders who are otherwise subject to Arizona tax must include their REMIC income as apportionable income. Several states reach similar conclusions regarding nexus in the context of financial institutions as REMIC interest holders, providing that simply holding an interest in a REMIC will not establish nexus with the state, nor be taken into account for purposes of calculating a nexus threshold. See, e.g., Ky. Rev. Stat. Ann. § 136.520(a); Tenn. Code Ann. § 67-4-2105(e).
The ruling is a welcome reminder that REMICs may expand their mortgage holdings to Arizona without the risk of incurring an income tax obligation. REMICs take note—Arizona wants you!