IRS: Losses on Defaulted Mortgages = Ordinary, Not Capital

The IRS yesterday withdrew proposed regulations that treated mortgage loans as capital assets and thereby restricted the deductibility of losses caused by mortgage defaults:

On August 7, 2006, the Treasury Department and the IRS published ... proposed regulations § 1.1221-1(e) under § 1221(a)(4). These regulations sought to clarify the circumstances in which accounts or notes receivable are “acquired … for services rendered” within the meaning of § 1221(a)(4). ...  Most of the comments focused on the decisions in Burbank Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963), ... aff’d in part & rev’d in part on other grounds, 335 F.2d 125 (9th Cir. 1964), and Federal National Mortgage Ass'n v. Commissioner, 100 T.C. 541 (1993). The Treasury Department and the IRS considered the comments and have decided to withdraw the proposed regulations. The IRS will not challenge return reporting positions of taxpayers under § 1221(a)(4) that apply existing law ... The IRS and the Treasury Department will continue to study this area and may issue guidance in the future.

As a result, lenders will be able to deduct losses on defaulted loans against ordinary income for four years under the new NOL rules.  Bloomberg reports that although Fannie Maw and Freddie Mac are the biggest beneficiaries of this change, 70 of the world's biggest banks, securities firms, and mortgage companies have taken $290 billion in asset writedowns and credit losses since the beginning of 2007.  Fannie, Freddie Losses May Be Mitigated as IRS Cancels Rules, by Ryan J. Donmoyer & Dawn Kopecki.