April 23 (Bloomberg) -- Fannie Mae, Freddie Mac and other companies suffering as mortgage delinquencies rise won a two-year battle with the IRS yesterday, allowing them to use those losses to reduce their tax burden.

The Internal Revenue Service withdrew proposed regulations that had asserted that mortgage loans are capital assets and any losses from them could be used only to offset capital gains. The agency also said it wouldn't challenge companies that count such losses against ordinary income.

The action also clears the way for Fannie Mae, Freddie Mac and some other holders of defaulted loans ranging from auto lenders to credit card issuers to benefit from Senate-passed tax legislation that would allow companies to apply those losses against previous tax years to get immediate refunds. So far, 70 of the world's biggest banks, securities firms and mortgage companies have taken about $290 billion in asset writedowns and credit losses since the beginning of 2007.

``This is a serious windfall,'' said Christopher Whalen, managing director of Hawthorne, California-based Institutional Risk Analytics. ``Essentially, the Street gets a $290 billion tax shelter they did not have available'' under the earlier IRS position.

`Carry Back'

Tax law generally allows companies to ``carry back'' losses realized this year to previous years and get a refund for earlier taxes paid or apply them to later years, known as a ``carry forward'' to reduce future liability. Carry backs currently are limited to two years; the Senate legislation would temporarily expand that to four. A House panel passed a separate relief measure that doesn't contain the provision.

Winning the right to treat mortgage-loan losses as a loss against regular income is ``a great victory for Fannie Mae,'' which led lobbying efforts against the regulations, said Robert Willens, president of a New York tax-consulting firm and an expert on tax and accounting rules.

``It means that the losses they sustain on these instruments will be eligible for the four-year carry back, assuming that provision gets enacted,'' Willens said. The biggest beneficiaries of the IRS action will be Fannie, Freddie and mortgage originators, he said.

As the nation's two biggest mortgage investors, Fannie and Freddie both posted record mortgage losses during the fourth quarter, $3.55 billion at Fannie and $2.45 billion at Freddie.

`Billions of Dollars'

Pete Davis, president of Davis Capital Investment Ideas in Washington, told clients in an e-mail today that the IRS's action ``could easily be worth billions of dollars'' to the two government-sponsored enterprises.

Fannie Mae fell 39 cents to $26.74 and Freddie Mac fell 73 cents to $24.86 at 2:35 p.m. in trading on the New York Stock Exchange.

The Senate passed the provision earlier this month as part of legislation intended to alleviate the housing crisis.

For Fannie Mae, the withdrawal caps an almost two-year regulatory tussle with the IRS, which first issued the rules in August 2006. In comments to the tax agency later that year, the company called the proposed regulations ``not sound tax policy'' because they would force its effective tax rate to rise higher than the statutory 35 percent.

Congressional Testimony

The company testified against the rules at an August 2007 hearing along with the Mortgage Bankers Association, the American Bankers Association and McLean, Virginia-based Freddie Mac.

``There were a lot of concerns raised,'' said Andrew DeSouza, a Treasury spokesman for tax policy. ``In the course of examining this issue, we decided to withdraw the regulation and also let taxpayers know that the IRS will not challenge positions taken on tax returns that apply existing case law under that specific section of the tax code.''

Other companies and organizations called for the regulations' withdrawal, including the Association of International Automobile Manufacturers, HSBC Holdings Plc's North American unit, American Express Co., and the Federal Agricultural Mortgage Corp., or Farmer Mac.

The National Association of Home Builders warned in November 2006 that the proposed regulations would have increased costs for homebuyers.

Fannie Mae spokesman Brian Faith and Freddie Mac spokesman Michael Cosgrove declined to comment. The IRS said it would continue to study the issue.

Though Washington-based Fannie Mae took the lead in opposing the rule, the IRS decision would benefit Wall Street firms and other investors that have billions in mortgage losses piling up in their books.

The entire industry would benefit since most of its profits are derived from ordinary income, not capital gains.

To contact the reporters on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net; Dawn Kopecki in Washington at dkopecki@bloomberg.net.

Last Updated: April 23, 2008 14:54 EDT