Did Subprime Woes Cause a Change of Heart at the IRS?

Fannie Mae and other mortgage loan originators and buyers get an unexpected windfall from the tax man.

On August 7, 2006, the Treasury Department and the Internal Revenue Service published proposed rules ( Prop. Reg. Section 1.1221-1(e)) under Section 1221(a)(4) of the Internal Revenue Code. These potential regulations “sought to clarify the circumstances in which accounts or notes receivable are acquired for services rendered.” But the planned rules never saw the light of day. They were withdrawn, with no explanation, almost 20 months after they were issued. Here’s one theory of what happened.

The accounting and tax issue is of surpassing importance to entities which originate mortgage loans, and to those like Fannie Mae, which purchase such loans in the secondary market. If the loans are, in fact and in law, acquired (in the ordinary course of a trade or business) for services rendered, then these accounts or notes receivable should not be classified as “capital assets.” What’s more, the losses sustained with respect to these instruments would then be considered “ordinary” in nature.

Characterizing losses as ordinary, rather than capital, is more desirable because ordinary losses can be offset against any variety of income, whereas capital losses may only be offset against capital gains — a type of income that a corporation is ordinarily hard-pressed to generate. Moreover, net capital losses have a short “shelf life.” That is, capital net losses may only be carried back to the three taxable years preceding the taxable year in which the loss is sustained. Further, they can only be carried forward to the five taxable years following the year in which the net capital loss is incurred.

In the he proposed regulations, the IRS had taken the position that the making of a loan, or the purchase of loans in the secondary market, did not constitute the rendition of a service. Therefore, with respect to both mortgage originators and secondary market purchasers, these instruments constituted capital assets with the result that the losses would be capital in nature. In addition, although these proposed regulations were intended to be prospective in their application, the IRS had apparently been taking the position, in advance of the final rules, that the instruments, in the hands of originators and secondary market purchasers, would constitute capital assets. (See LTR 200651033, August 31, 2006. See also Bielfeldt v. Commissioner, 231 F.3d 1035, 7th Circuit 2000.)

Not surprisingly, the proposed regulations elicited much criticism from Fannie Mae and other affected parties. Most notably, the critics were dismayed by the fact that the IRS saw fit to use this new stance to overturn more than 40 years of “settled law.” Indeed, the courts had adopted the position that the making of a loan (and the purchase of loans in the secondary market by institution like Fannie Mae) was, in fact, the rendition of a service. Consider, for example, Burbank Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963) and Federal National Mortgage Association v. Commissioner, 100 T.C. 541 (1993). Also see, Revenue Rule 80-57, 1980-1 C.B. 157, which relates to a real estate investment trust engaged in the trade or business of originating and servicing short-term construction and development loans. In that case, the loans were made in the ordinary course of the REIT’s trade or business, and were acquired in exchange for services rendered. Accordingly, the notes, in the REIT’s hands, were not capital assets.

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