Excess Business Loss Limitation and Tax Treatment of MSR Sales

The sale of originated mortgage servicing rights (OMSRs) gives rise to several types of income. Ordinary income, short term capital gain, long-term capital gain and possibly excess servicing.

The tax code requires that a determination be made as to whether any portion of the MSR should be considered excess servicing for tax reporting purposes. Excess servicing is defined as compensation received in excess of the normal servicing fee, which is the amount under the servicing contract that represents reasonable compensation for servicing the loans.

Reasonable compensation is the mortgage interest paid by the borrower that the servicer is entitled to receive in order to perform the servicing function, up to the safe harbor rates set forth by the IRS, plus any ancillary income (other income the servicer receives from servicing the loans).

For OMSRs, the normal servicing income is the right to receive compensation from the holder of the related mortgage note for servicing the mortgage under the contract therefore there is no tax basis for the servicing contract portion of the MSR relating to reasonable compensation therefore income is recognized as it is received for performing the services.

Many mortgage companies sold MSRs in 2022 and 2023 to generate cash to fund its operating losses.

The taxation on the sale becomes a bit more complicated because of the excess business loss limitation IRS Code Sec. 461(l).

The excess business loss limitation was put in place for tax years starting after 2017 but was postponed to tax years beginning after 2020 by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in response to the COVID-19 (coronavirus) crisis. The excess business loss limitation was extended through 2028 by the Inflation Reduction Act of 2022.

It is important to note that although MSR contracts are considered capital assets under IRS Code Sec 1231 and are originated in the ordinary course of a mortgage company’s business the income from the sale of these contracts can be offset with ordinary business losses despite the excess business loss limitation. CPAs and tax accountants who are not familiar with the tax treatment on the sale of MSRs will look to treat the capital gain income as non-business income and will not apply the operating loss against the capital gain.

Noncorporate taxpayers may not deduct excess business losses for tax years beginning after December 31, 2020, and before January 1, 2029. Instead, they must treat any excess business loss that is disallowed as a net operating loss (NOL) carryover to the following tax year.

For partnerships and Subchapter S corporations, the limit on excess business losses is applied at the partner or shareholder level. Each partner’s distributive share or each S corporation shareholder’s pro rate share of items of income, gain, deduction, or loss is taken into account by the partner or shareholder in applying the excess business loss rules to the partner’s or shareholder’s tax year with or within which the partnership’s or S corporation’s tax year ends.

An excess business loss is the excess, if any, of:

1. the taxpayer’s aggregate deductions for the tax year from the taxpayer’s trades or businesses, determined without regard to whether such deductions are disallowed for such tax year under the excess business loss limitation; over
2. the sum of—
3. the taxpayer’s aggregate gross income or gain for the tax year from such trades or businesses, plus
4. $250,000, adjusted annually for inflation in tax years after 2018. For 2021, the amount is $262,000 ($524,000 for joint returns). For 2022, the amount is $270,000 ($540,000 for joint returns).

In computing the excess business loss:

• Aggregate deductions in determining the loss are computed without regard to any deduction for net operating loss or the qualified business income deduction.
• Deductions for losses from sales or exchanges of capital assets are not considered as aggregate deductions in determining the loss.
• The amount of gains from sales or exchanges of capital assets considered in determining aggregate gross income or gain may not exceed the lesser of (1) the capital gain net income determined by taking into account only gains and losses attributable to a trade or business, or (2) the capital gain net income.

Example

For the year ended December 31, 2022, Carl, a single taxpayer owns 100% of ABC Mortgage Company (a subchapter S Corp.). The Company has $1 million of gain on sale income and $2 million of deductions resulting in a net loss of $1 million before the income received on the sale of MSRs. The Company sold MSRs that it originated for $500,000 (for purposes of this example $450,000 is capital gain and $50,000 is ordinary income and no excess servicing) Carl’s excess business loss would be calculated as follows: $1,000,000 of operating loss plus the MSR sale of $500,000 for a loss of $500,000. Carl is only able to deduct $270,000 of the $500,000 and must treat his excess business loss of $230,000 as an NOL carryforward to 2023.

Taxpayers calculate excess business losses on IRS Form 461 Limitation on Business Losses.