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 They were withdrawn, with no explanation, almost 20 months after they were issued.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.

The IRS’s decision to overturn such settled law, on the other hand, was based on its conclusion that treating the making of a loan as the rendition of a service “strained the language of the statute” and was inconsistent with Congressional intent. According to the IRS, Congress’s purpose in enacting Section 1221(a)(4), was a limited one. The service said that the section was enacted to insure that a taxpayer receiving an account or note receivable for services it rendered — or from the sale of inventory or other property held primarily for sale to customers in the ordinary course of business — would report ordinary gain or loss on the disposition of the receivable. Of course, to achieve an ordinary gain or loss, the taxpayer had to report the fair value of the receivable as ordinary income, and the receivable had to be later disposed of for an amount which differed from the amount the taxpayer reported upon the receipt of the instrument.

Despite the IRS’s clear conviction that Section 1221(a)(4) had been interpreted too broadly — and that the 2006 regulations were necessary to restore Section 1221(a)(4) to its historic, limited function — the agency, on April 22, 2008, and for unspecified reasons, withdrew its proposed regulations.

Moreover, it announced that “…it will not challenge tax return reporting positions of taxpayers, under Section 1221(a)(4), that apply existing law including Burbank Liquidating Corp. v. Commissioner, Federal National Mortgage Association v. Commissioner and Bielfeldt v. Commissioner.” That means, for the time being anyway, that any losses sustained by Fannie Mae (and by most mortgage originators) with respect to their mortgage paper will be ordinary in nature.

The IRS will not attempt, as LTR 200651033 suggested it might, to characterize the losses as capital in nature. The IRS did say, however, that it will continue to study this area and may issue guidance in the future with respect to this topic.

It is difficult to believe that the change of heart at the agency is based upon a view that the position it took in the proposed regulations is incorrect as a matter of law. Instead, the IRS may have been influenced by the fact that many other federal agencies are taking steps to assist participants in the mortgage lending business, rather than make their lives more difficult. And accordingly, the IRS did not want to be accused of insensitivity to the travails of such participants.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com. This extra column was written in response to the subprime mortgage crisis.

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