## Facts

- Federal Home Loan Mortgage Corporation (Freddie Mac) purchased residential mortgages in the secondary market and operated multifamily mortgage purchase programs.
- Under its Conventional Multifamily Prior Approval Purchase Program, mortgage originators entered into “prior approval purchase contracts” giving them the ability to deliver qualifying multifamily mortgages to Freddie Mac in the future.
- The contracts set a defined period for delivery and a formula to determine the purchase price if a qualifying mortgage was tendered.
- Originators paid Freddie Mac nonrefundable up-front “commitment fees” to enter into these contracts; the fees were not returned whether or not any mortgage was ultimately delivered.
- For tax years spanning the mid-1980s through early 1990s, Freddie Mac received substantial aggregate amounts of these commitment fees.
- The IRS determined deficiencies and, in this proceeding, disputed the characterization and timing of income from the nonrefundable commitment fees.

## Issues

1. Whether the prior approval purchase contracts were “options” for federal income tax purposes (economically, put options held by originators).
2. Whether the nonrefundable commitment fees were option premiums whose income recognition depends on whether the option is exercised or lapses, rather than ordinary income recognized upon receipt.

## Decision

- The Tax Court held the prior approval purchase contracts constituted options for federal income tax purposes.
- The court characterized the contracts as put options because the originators held the right, but not the obligation, to sell qualifying mortgages to Freddie Mac within a set period at a formula-determined price.
- The court treated the nonrefundable commitment fees as option premiums, rejecting the Commissioner’s position that the fees were fully includible in income when received.
- The court concluded the tax treatment and timing of income from the fees followed rules applicable to option premiums, turning on whether the originator exercised the right to deliver a mortgage or allowed it to lapse.

## Legal Principles

- Federal tax characterization depends on substantive rights and obligations, not labels used by the parties.
- A contract is treated as an option when it grants one party a unilateral right (without obligation) to compel a purchase or sale of property within a defined period at a fixed price or formula-based price.
- Consideration paid for the unilateral right is treated as an option premium.
- Nonrefundable “commitment fees” can be option premiums when paid to secure an election right against a counterparty that must stand ready to perform; premium recognition follows option-premium timing rules tied to exercise or lapse.

## Conclusion

The Tax Court held Freddie Mac’s nonrefundable prior-approval commitment fees were premiums for put options embedded in the purchase contracts, so the fees were not treated as ordinary income automatically recognized upon receipt but were governed by option-premium timing rules based on exercise or lapse.


Fed. Home Loan Mortg. Corp. v. Comm'r, 125 T.C. 248 (2005)