How do states apportion REMIC excess inclusion income?

What the federal statute does

A real estate mortgage investment conduit passes its income through to interest holders, and the residual interest absorbs the conduit's taxable income phantom and otherwise. Excess inclusion income is the portion of the residual holder's REMIC income that Congress decided must bear tax no matter what: under IRC Section 860E, the holder's taxable income for the year cannot be less than its excess inclusion, which means net operating losses, current losses, and most other attributes cannot offset it. The policy is anti-abuse, aimed at residual interests parked in loss entities, and the practical result is a taxpayer that may owe federal tax in a year it is otherwise in losses. Every state question about excess inclusion inherits this structure: the amount arrives in federal taxable income, it resists offset, and it derives from a pool of mortgages spread across the country with no natural situs.

California's answer

California conforms to the REMIC provisions (Rev. & Tax. Code sections 17088 and 24870), and the Franchise Tax Board addressed the mechanics in Legal Ruling 2009-01. The ruling applies the excess inclusion floor on a post-apportioned basis: the holder includes the excess inclusion in its measure and applies its California apportionment percentage to the amount, so that California taxes only its apportioned share of the floor rather than the entire federal amount. A corollary this article draws, rather than a point the ruling states in terms, is that the excess inclusion does not generate its own factor representation; the receipts do not enter the numerator or denominator of the sales factor, and the apportionment percentage that gets applied is the one produced by the taxpayer's other activity. The logic is sound in both directions: the income reflects a nationwide mortgage pool rather than a California activity, so giving it factor representation would distort the formula, while taxing the full unapportioned amount would reach income with no California connection.

The silent states

Most states offer nothing on point, and the practitioner's task is to build a method from the materials the state does have. The components are usually available. First, confirm conformity: a state that adopts IRC Sections 860A through 860G includes the excess inclusion in its base, and the floor concept comes with it. Second, look for the state's treatment of intangible income that cannot be attributed to an income producing activity. Florida is the clean example: its sales factor rule provides that business income from intangible property that cannot readily be attributed to any particular income producing activity is excluded from the numerator for every state and from the denominator as well (Florida Administrative Code Rule 12C-1.0155(1)(f)2), citing dividends, bond interest, and royalties from mere holding as illustrations. Excess inclusion income from a residual interest fits that description as well as anything does, and the rule then produces the same result the post-apportionment method implies: income in the base, no factor representation, the taxpayer's apportionment percentage applied. Third, apply the same method in every silent state rather than optimizing state by state, because a consistent multistate methodology is both administratively coherent and more persuasive on examination than a patchwork.

The disclosure statement

Where a state has no explicit guidance, the return should say what was done. A brief statement attached to the return, identifying the amount of excess inclusion income included in the base, noting the absence of state guidance, and describing the method as consistent with the taxpayer's other state filings and with the state's own treatment of unattributable intangible income, converts a silent position into a disclosed one. The comfort level in a silent state is realistically substantial authority rather than certainty. Disclosure is not strictly required to support a position at that level, but it removes any argument that the position was concealed, protects against penalty exposure if an examiner rates the authority lower, and frames the discussion if the return is examined. The statement costs a paragraph. Reconstructing the rationale three years later, in front of an auditor holding a return that says nothing, costs considerably more.

Practice notes

The floor deserves separate attention from the apportionment. In a loss year, a state that conforms to Section 860E can produce tax on the apportioned excess inclusion even though the state return otherwise shows no income, and state NOL schedules should be built so the excess inclusion never leaks into the carryover computation. Residual interests acquired in structured finance portfolios are easy to overlook at the state level because the amounts are often modest and the K-1 reporting cryptic; a standing question in the state compliance checklist, does any entity in the group hold a REMIC residual, is the cheap control. And where the amounts are material, the state-by-state conformity check is worth doing properly, because a minority of states decouple from pieces of the federal REMIC regime or compute the base in ways that alter the floor, and the consistent multistate method should be built on the actual conformity map rather than an assumption. G&G State Tax Group provides multistate apportionment analysis for structured finance and mortgage investment income alongside its state and local tax practice.