DATE:             April 1, 2004

TO:                  The FFELP Community

FROM:            The Ad Hoc TRA Workgroup

RE:                   Update on the TRA Regulations

Under the terms of the Taxpayer Relief Act of 1997 and the regulatory guidance (both final and proposed) issued thereunder, student loan providers must report interest paid on qualified education loans.  Under a transition rule, reporting of origination fees and capitalized interest was not required for any loans made prior to January 1, 2004.  The industry has raised several questions regarding the reporting of capitalized interest and fees; we have sought guidance from the IRS, as well as an extension of the transition rule.  To date, we have not received any additional guidance or an extension, although we believe both to be in the works.  We anticipate that the extension will be for a fairly short period of time.

The Ad Hoc TRA Workgroup was created several months ago to analyze the existing regulations issued under §6050S of the Internal Revenue Code (IRC), as well as what we know of the IRS’ position on the not-yet-issued final regulations under §221.  We had hoped to come up with reasonable interim guidance on which the industry could agree until such time as the final regulations are issued.

This update attempts to identify the various positions that the IRS may adopt in issuing the final §221 regulations, and to assess their viability.  Informal discussions with the IRS have muddied the waters somewhat, and made the guidance less clear and specific than it might have been otherwise.  However, we believe that the attached at least lays out the issues on which the IRS is focusing, as well as the positions that they are most likely to take, based on our discussions with them.

We hope that the attached document is helpful to you as you plan how to capture capitalized interest and origination fees. 

The Ad Hoc TRA Workgroup

Background:

The Taxpayer Relief Act of 1997 (TRA 97) and Economic Growth and Tax Relief Reconciliation Act of 2001 allow certain taxpayers who pay interest on qualified education loans to claim a Federal income tax deduction for their interest payments.  The TRA 97 added §221 of the Internal Revenue Code (IRC) to allow a deduction from gross income for certain interest paid on qualified education loans.  TRA 97 also added to the IRC §6050S, reporting requirements by certain persons who receive payments of interest that may be deductible as interest on a qualified education loan.  The Economic Growth and Tax Relief Reconciliation Act of 2001 amended §221 to eliminate the limitation on the number of months (60) during which interest paid on a qualified education loan is deductible, and to allow a deduction for voluntary payments of interest.

The Internal Revenue Service (IRS) issued a NPRM January 21, 1999 relating to the borrower’s eligibility to deduct interest paid on qualified education loans (§221).  Additionally, the IRS issued a NPRM on June 16, 2000 and a subsequent Final Rule on April 29, 2002 relating to the information reporting requirements under §6050S of the IRC for the payments of interest on qualified education loans.  Final regulations for §221 of the IRC have not yet been published.

The reporting requirements contained in the Final Rule dated April 29, 2002 were applicable for information to be furnished after December 31, 2003 (for interest payments received during calendar year 2003).  However, in order to give payees additional time to implement reporting of origination fees and capitalized interest, the reporting regulation contains a special transitional rule under which reporting of such items is not required for any loan made before January 1, 2004.

Issues:

Without final guidance from the IRS on a few issues we have questioned, most people in the student loan industry believe it is difficult to begin programming changes. These questions relate to:

·         Allocation of payments;

·         treatment of origination fees and insurance premiums paid by the borrower at time of disbursement; and

·         treatment of outstanding fees and interest on loans paid through consolidation.

In the preamble section of the April 29, 2002 Final Rule, the IRS acknowledged that questions had been raised concerning the reporting of payments of capitalized interest and loan origination fees, and stated that these questions would be considered in the final regulations under §221.  The Ad Hoc TRA Workgroup has attempted to analyze these questions, including reviewing alternative positions and supporting rationales. A summary of our analysis is set forth below. This analysis is intended to summarize the issues involved, and is not intended to constitute programmatic or legal advice. Each student loan participant needs to reach its own conclusions on the proper action to take and is encouraged to consult tax counsel as appropriate.

1.      Allocation of Payments

The proposed rule, dated January 21, 1999, in §1.221-1(h)(iii), incorporates existing IRS regulations regarding payment allocation which treats a payment first as a payment of accrued interest, second as a payment of loan origination fees or capitalized interest, until such amounts have been reduced to zero, and third as a payment of principal.  As a result, a taxpayer may deduct the portion of a principal payment that is treated as the payment of any loan origination fee or capitalized interest.

Under the terms of the HEA, borrower fees and interest, once capitalized, are added to and treated as principal.  To date, current FFELP lender and guarantor servicing systems have not had a need to track and report payments of capitalized interest and/or fees separately.  Since the changes necessary to develop such capability are extensive, the industry requested confirmation via a letter to IRS dated March 3, 2003 that the payment allocation methodology set forth in the January 21, 1999 proposed rule would be adopted in the final rule.

Below is an excerpt from the letter of March 3^rd (please note that this letter was written when insurance premiums were thought to be included in the definition of “fees”, see page 5 for additional information)–

Before we make these changes to accommodate the different tax treatment, we want to confirm our understanding of how payments should be allocated for tax purposes.  With one additional clarification, we believe the payment allocation methodology set forth in the January 21, 1999 proposed rule on Section 221 should be carried over into the final rule.  See proposed   §1.221-1(h)(2)(iii).  Under this allocation methodology, a payment would be treated first as a payment of accrued interest, second as a payment of any loan origination fees or capitalized interest, until such amounts are reduced to zero, and third as a payment of principal.  Attached as Exhibit B, is an example showing how this payment methodology would work in the case of a hypothetical borrower account.

The additional payment allocation clarification we request pertains to late charges and collection costs (See item 3 in our original comments.).  The accounting of payments of these amounts can vary, but in most cases lenders allocate all payments to these charges first, and then to interest and principal.  In some instances, however, lenders allocate payments first to interest and then to late charges and collection costs.  We believe this treatment is consistent with existing IRS rules (§§1.1446-2(e) and 1.1275-2(a)).  We believe the final Section 221 regulation should repeat the allocation of payments section in the proposed rule, with the added clarification that lenders in all cases may allocate payments to late charges and collection costs according to their loan program terms and conditions.

Summary of Section 1.221-1(h)(2) of January 21, 1999 Proposed Rule

Proposed IRS regulations regarding student loan interest deductions state that loan origination fees and capitalized interest are to be treated as “interest” and are deductible.  The proposed rule incorporates existing IRS regulations regarding payment allocation which treats a payment first as a payment of accrued interest, second as a payment of loan origination fees or capitalized interest, until such amounts have been reduced to zero, and third as a payment of principal.  As a result, a taxpayer may deduct the portion of a principal payment that is treated as the payment of any loan origination fee or capitalized interest.

Example

An unsubsidized Stafford loan borrower has a $10,000 loan at a 5.00% interest rate.  The borrower is charged a 3% origination fee and 1% insurance fee.  Loan fees are deducted from the disbursement of funds to the borrower.  The borrower attends school for 12 months from January YR 0 through December YR 0, and receives a 6-month grace period from January YR 1 through June YR 1.  Unpaid interest of $750 is capitalized at the end of the grace period and the borrower begins repayment of $10,750 in July YR 1 at a monthly payment amount of $114.02.  At this time, the amount of capitalized interest and loan fees (cap/fee balance) is $1,150.00.

In the YR 1 tax year, the borrower pays $684.12, of which $264.40 is allocated to interest and $419.72 to principal.  Each principal portion of a payment reduces the cap/fee balance from $1,150 to $730.28 after the December YR 1 payment, which is carried to the YR 2 tax year.  The lender reports $684.12 ($264.40 interest + $419.72 of the cap/fee balance paid by principal) to the borrower and IRS for the YR 1 tax year.

In the YR 2 tax year, the borrower pays $1,368.25, of which $496.72 is allocated to interest and $871.52 to principal.  Each principal portion of a payment reduces the cap/fee balance from $730.28 to $0 after the November YR 2 payment.  The lender reports $1,227 ($496.72 interest + $730.28 of the cap/fee balance paid by principal) to the borrower and IRS for the YR 2 tax year.

Loan origination fees should be treated different from capitalized interest.  Payments of capitalized interest should be reported using the payment allocation methodology set forth in the proposed §221 regulations. Thus, borrower payments would be treated first as a payment of accrued interest, second as a payment of capitalized interest, and third as a payment of principal.  However, loan origination fees would be deductible over the entire life of the loan in accordance with the original issue discount (OID) regulations set forth in 26 CFR 1.1272-1 (general rules) and 1.1275-5 (special rules for variable rate debt instruments).

Conversations with Treasury last fall revealed a potential “new wrinkle” in the IRS’s treatment of the deduction of origination fees. Treasury officials stated that they were looking at whether two different “buckets” should be created – one for capitalized interest and one for the origination fee.  Capitalized interest would be reported as in our example of March 3, 2003, and applied against the principal portion of monthly payments until the capitalized interest “bucket” is empty.  However, the origination fee could be considered original issue discount (OID) and therefore subject to the provisions of the OID regulations (26 CFR 1.1272-1).  The OID formula is set forth in 1.1272-1(b) and examples are set forth in (j).  To oversimplify the OID regulations, the origination fee has to be deducted over the life of the loan. However, since student loans don’t qualify for the de minimis rule set forth in 26 CFR 1.1273-1, there is a complex calculation required for each year, which is made further complex by the fact that Stafford and PLUS loans are variable rate loans (see special rules for variable rate debt instruments at 26 CFR 1.1275-5). 

Under this approach, lenders and servicers would have to capture capitalized interest and origination fees separately and report them to the borrower using two different methodologies.  If Treasury adopts this policy in their regulations, we have urged them to illustrate the guidance using our example and calculation previously provided for comparative purposes. 

1.  Ad Hoc Group Comments

Based on the most recent update from Treasury, work is in progress on the §221 Final Rules, but no publication date has been offered.

·         They appear to have retreated somewhat from the second position; therefore, we believe there is a good chance that the final regulations will reflect the approach on the proposed rules (Position 1A), or at least a less onerous alternative (such as treating the origination fee similarly to points on a mortgage where the lender’s reporting obligations are de minimis) (a modified version of Position 1B).

·         The primary reason for the final regulations to differ from the proposed is related to the treatment of origination fees.

·         The industry should continue to analyze applicable systems and procedures consistent with the proposed rules, with the caveat that modifications may be necessary if programming has been started prior to the publication of the §221 regulations.

1.  Ad Hoc Group Conclusion

Since the payment allocation for fees, capitalized interest, and accrued interest have not been clarified through the issuance of the §221 regulations, servicers, lenders, and guarantors should continue to evaluate their reporting schema.  At a minimum, loan holders should begin capturing capitalized interest as it occurs for all loan types as soon as they are able after January 1, 2004.  Further, industry participants should continue to evaluate the reporting requirements necessary to pass this information for events such as a loan assignment (claim or sale) or transfer.

2.      Treatment of origination fees and insurance premiums paid by the borrower at time of disbursement

Insurance premiums (guarantee fees) are not deductible as interest under the Internal Revenue Code.  Therefore, loan holders should not allocate loan payments to guarantee fees for interest reporting purposes.

Origination fees are treated as a payment for use of money and align fairly closely with the concept of mortgage points, which are deductible as prepaid interest.  Conversely, guarantee fees are viewed as a fee for service (e.g., the due diligence that is part of guaranty agency process) and not deductible.

The proposed §221 regulation issued on January 21, 1999 states, as a general rule, that “[l]loan origination fees (other than any fees for services) and capitalized interest are interest and are deductible under this section” (26 CFR 1.221-1(h)(2)(i)).  In the examples that follow, Example 3 is an example of capitalized interest (there isn’t an example involving an origination fee).

Likewise the reporting regulations under §6050S define interest as including “stated interest, loan origination fees (other than fees for services) and capitalized interest as described in the regulations under §221” (26 CFR 1.6050S-3(b)(1)).

Further, the IRS’s 2003 Publication 970 (dealing with various education tax benefits) has a section on student loans.  On page 22, it instructs the borrower to “[i]nclude as interest [l]oan origination fees (other than fees for services), capitalized interest,.... “  Just below the instruction it provides the following definition: “Loan origination fees.  These are the costs of getting the loan.”

A similar publication exists for the home mortgage interest deduction.  Publication 936 discusses interest, including those situations where “points” are deductible as interest.  On page 5 there is a discussion of “amounts charged for services.”  Amounts charged by the lender for specific services connected to the loan are not interest.  Examples of these charges are:

1)                  Appraisal fees;

2)                  Notary fees;

3)                  Preparation costs for the mortgage note or deed of trust;

4)                  Mortgage insurance premiums; and

5)                  VA funding fees.

Publication 530, which provides Tax Information for First-Time Homeowners, contains language identical to Publication 936 in its discussion of points.  In addition, it sets forth a general list of nondeductible payments: “You cannot deduct any of the following items:

Insurance, including fire and comprehensive coverage, and title and mortgage insurance . . .” 

Rev. Rul. 67-297, 1967-2 C.B. 87 concludes that certain VA loan origination fees are not deductible as interest.  It quotes the VA Lenders Handbook, which provides that a lender may charge “a flat charge not exceeding 1% of the amount of the loan, provided that such flat charge shall be in lieu of all other charges relating to costs of origination not expressly specified and allowed in this schedule.” Among the charges not expressly specified and allowed under the Handbook are items such as the lender appraisal fee, cost of preparing the mortgage note, settlement fee, notary fee, and cost of providing certain information concerning the property to the VA.  The 1% fee is actually made up of charges for services and, therefore, is not deductible as interest.

Based on existing regulations for the treatment of fees for non-education loans, the IRS has a well-documented history of denying the interest deductibility for many types of insurance premiums.  The guarantee fee is referred to in the statute as “a single insurance premium equal to not more than 1% of the principal amount of the loan...” HEA section 428(b)(1)(H).  Even though it is not risk-based, it most closely aligns with a fee for service.

For tax purposes, the full amount of fees, to the extent charged to the borrower but regardless of the label assigned to them, should be deemed an origination fee for purposes of the §221 regulation.  By providing for parallel tax treatment for payments of origination fees and insurance premiums, the IRS would be assuring that loans made under the FFELP and Direct Lending have the same terms, conditions, and benefits, as contemplated by the Congress.

There are two principal Federal education loan programs, the FFELP, where private lenders make loans that are insured by guarantors and reinsured by the U.S. Department of Education, and the Federal Direct Loan Program (FDLP), where the loans are directly funded by the Department of Education.  The authorizing legislation for the FDLP states that, as a general matter, “loans made to borrowers under this part [the part of the HEA authorizing the FDLP] shall have the same terms, conditions and benefits, and be available in the same amounts, as loans made to borrowers under sections 428, 428B, and 428H of this title [sections of the HEA authorizing the FFELP].”

The HEA specifies for the FDLP in §455 of the HEA –

(c) LOAN FEE.—The Secretary shall charge the borrower of a loan made under this part an origination fee of 4.0 percent of the principal amount of loan.

With respect to the FFELP, the HEA states in §438(c)(2)&(6) –

(c) ORIGINATION FEES FROM STUDENTS.—

(2) AMOUNT OF ORIGINATION FEES.— . . . each eligible lender under this part is authorized to charge the borrower an origination fee in an amount not to exceed 3.0 percent of the principal amount of the loan, to be deducted proportionately from each installment payment of the proceeds of the loan prior to payment to the borrower . . .

Section 438 (c)(6) provides for a correlating assessment for PLUS and SLS loans.

With respect to the FFELP, the HEA states in §428(b)(1)(H) –

(H) provides for collection of a single insurance premium equal to not more than 1.0 percent of the principal amount of the loan, by deduction proportionately from each installment payment of the proceeds of the loan to the borrower, and insures that the proceeds of the premium will not be used for incentive payments to lenders;

Because of the Congressional desire to make the programs parallel, and to treat borrowers in the two programs equally, the maximum amount of the upfront fees chargeable to the borrower is identical, even though, because of the nature of the programs, they are structured and named slightly differently.

This concept is further illustrated in the HEA when describing the costs incurred by a borrower in obtaining a loan in §472 of the HEA –

SEC. 472 COST OF ATTENDANCE.

For the purpose of this title, the term ‘‘cost of attendance’’ means—

(12) for a student who receives a loan under this or any other Federal law, or, at the option of the institution, a conventional student loan incurred by the student to cover a student’s cost of attendance at the institution, an allowance for the actual cost of any loan fee, origination fee, or insurance premium charged to such student or such parent on such loan, or the average cost of any such fee or premium charged by the Secretary, lender, or guaranty agency making or insuring such loan, as the case may be.

It would seem that one could make the argument that, since Congress has identified the insurance premium as a “cost of attendance”, the IRS should treat this amount as a cost of obtaining a loan. Under this approach, both origination fees and insurance premiums should be treated as deductible interest.

2.  Ad Hoc Group Comments

The Treasury has verbally stated many times that only the origination fee is eligible for deduction, and it seems unlikely that they will change their position. 

·         Senator Grassley, Chairman of the Senate Finance Committee, has been contacted to see if there is interest in helping on this issue.

·         The Department of Education has decided that negotiations with Treasury will be futile, and instead is recommending that the community look for a legislative fix, either to the Internal Revenue Code (IRC), or the HEA.

2.  Ad Hoc Group Conclusion

Pending receipt of definitive guidance from the IRS, but based on their informal 
advice, we believe it is safe to assume, in making programming changes, that 
only the origination fee, and not the guarantee fee, is considered to be interest, 
and therefore is eligible for the interest deduction and reportable on the 1098-E.

3.  Treatment of outstanding fees and interest on loans paid through consolidation

3.  Ad Hoc Group Comments

It is assumed that the §221 Final Rules will not address how to report interest as result of a loan paid in full through loan consolidation.  Our next steps will be determined once the regulations are issued and analyzed.

3.  Ad Hoc Group Conclusion

Pending guidance from the IRS, loan holders should continue their current process for the accrued interest on loans paid in full as a result of loan consolidation.