What are the tax benefits of mortgage servicing rights?
The mortgage servicing rights (MSRs) market is booming right now. By some estimates, , as financial institutions and other investors surveying an uncertain economic climate look for assets that issue a relatively stable return.
However, MSRs don’t just offer a largely predictable revenue stream but also certain appealing tax benefits. For example, in most cases, any tax liability is deferred, which can be a useful tool to advance your institution’s tax strategy.
If you’re thinking about making an investment in the MSR asset class, consider the implications from a tax and accounting perspective. Here’s a short rundown on what you need to know.
What are mortgage servicing rights?
MSRs are the contractual rights a lender or servicer retains when it sells a mortgage but continues to handle the day-to-day duties. The seller continues servicing the loan, which includes collecting principal, interest, taxes, managing escrow accounts and handling delinquencies.
In other words, when an originator decides to sell a loan but keeps the servicing rights, an MSR is recognized. For sellers, this may offer a best-of-both-worlds balance between a short-term gain through the sale of the loan itself and recurring income via the MSR.
How does accounting handle mortgage servicing rights?
Once servicing is retained and the loan is sold, generally accepted accounting principles (GAAP) require the servicer to capitalize MSRs at fair value. At the initial recognition, an asset is recorded on the balance sheet equal to the MSR’s fair value.
However, while income equal to fair value is recognized, it isn’t yet taxable. This is because the asset carries zero tax basis.
After the initial recognition of the mortgage servicing rights, there are two methods to measure the asset: the amortization method and the fair value method.
With the amortization method, the MSR balance is amortized over the expected life of the loan. Meanwhile, the fair value method requires you to mark-to-market the MSR each reporting period.
Depending on your specific circumstances, one of these methods will usually make more sense than the other. More information on these two valuation methods can be found in .
What is tax vs. book treatment for MSRs?
MSRs are a classic example of what’s called a book-tax timing difference. This is a situation where the amount of income reported on a company’s books is different than the number reported for tax purposes — essentially as a result of reasons related to timing.
For book purposes, you have two options for how to handle MSRs. GAAP requires that you either mark them to fair value or amortize them over the life of the loan. Whichever method you choose, the result will appear on your books.
However, for tax purposes, an MSR is not realized until it is sold. This difference in treatment creates a temporary divergence between book and taxable income, as your books could show value for an MSR today that may not appear on your taxes for years to come.
This can be a useful tool from a tax perspective. Practically, the change in the mortgage servicing right asset on the balance sheet represents the book-tax temporary timing difference on the tax return.
These timing differences create a deferred tax liability that can be leveraged during tax planning, either by timing sales or selecting the most tax-advantageous accounting convention.
How long should you hold onto an MSR?
If your financial institution is considering investing in MSRs, how long should you plan to hold? Deciding on if or when to sell them often comes down to weighing a few key trade-offs.
Holding an MSR as a long-term asset gives you a built-in cushion. When rates go up, borrowers tend to hold onto their loans longer, which means more servicing income and a chance to deepen your customer relationships, which could lead to additional origination in the future.
However, those benefits also come with challenges. While MSRs are less risky than some asset types, they can be volatile. Tighter regulations have also led to a rise in servicing costs.
Meanwhile, selling an MSR gives you immediate cash and takes the servicing burden off your hands. But it also means giving up future revenue streams — and potentially, even sending your customers to a competitor.
The tax liability element can be a major factor here. From a tax perspective, MSRs get recognized for books upfront but aren’t taxed until they’re sold. That creates a deferred tax liability, which can be a smart lever to pull if you’re planning your tax position strategically.
Ultimately, whether you’re holding or selling, it all boils down to knowing what works best for your balance sheet, your operations and your long-term goals.
How Wipfli can help
We help you maximize tax benefits for your financial institution or business. Work with our team of tax advisors and accountants to plan your strategy, reduce liability and strengthen your overall financial position to meet the challenges of today. Learn more here.
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