Metropolitan Mortgage & Securities Co., the big Spokane-based financial-services company, is being challenged by the Internal Revenue Service over a $28 million tax benefit it claimed on an investment loss.


The company disclosed in its most recent annual report, filed in late December with the U.S. Securities and Exchange Commission, that it had received an audit notice from the IRS in connection with the claimed benefit. It says the IRS has taken the position that the tax benefits relative to the investment would be disallowed. It also notes that if the tax benefit were disallowed totally, the potential earnings effect would be a loss of $28 million plus applicable interest.


Erik Skaggs, Metropolitans vice president of production and market development, declines to elaborate on the significance of the matter or how the company is responding to it.


Everything thats material here we have disclosed and will continue to disclose as it develops out, he says.


An adverse IRS finding could mean a setback for the 50-year-old company, which has been working hard to rebuild profits since sharply revising its business strategy a little over two years ago and slashing its large work force here by more than half.


Metropolitan recorded net income of $3.9 million for its 2002 fiscal year ended Sept. 30, after posting net losses of $8.6 million and $7.6 million in 2001 and 2000, respectively, and net income of $16.6 million in 1999. It reported total revenues of $163.9 million for its 2002 fiscal year, up from $119.2 million in 2001, but still below the $172.4 million and $165 million in the two prior years.


The company says in its annual report that it recorded half of the disputed $28 million tax benefit in its 1999 fiscal year, when it made the investment that resulted in the loss, and the other half in 2001.


Metropolitan doesnt provide details about the investment in its latest annual report, but says, The objectives of the investment were to produce economic gains combined with favorable tax benefits. Similar investments were presented throughout the country to numerous individuals and companies as an investment and tax strategy. It also says that prior to, and in conjunction with, making the investment, it received two independent tax opinions relating to the investment.


Metropolitans 2001 annual report also included mention of the investment, saying it involved securities in a major financial institution and a separate foreign corporation, and that, Ultimately, an income tax loss resulted from the securities and warrants as the tax basis exceeded the sales receipts.


In the strategic shift it began in 2000, the company exited the high-volume, low-margin mortgage-banking and loan-securitization markets and redirected its resources to more profitable areas such as commercial lending, property development, and its longtime core focus of investing in seller-financed real estate contracts.


As a result of the shift, Metropolitan reduced its work force from about 635 employees to about 290 last September, although since then its work force has grown back to about 420.


During the latter 1990s, the company had used what are called securitizations to raise capital. Through a securitization, assetstypically receivables of some typeare pooled, and security interests in the pool then are sold to investors. Such transactions allow companies to receive upfront, lump-sum payments from institutional investors by issuing securities that pledge a future cash flow.


In Metropolitans case, that cash flow had come from mortgage loans that it and some of its subsidiaries amassed, then sold. The company raised a couple of billion dollars through a series of sales of mortgage-backed securities between 1996 and 2000, and during some of that period was reporting record net income figures.


However, it started suffering losses when the residential mortgage-lending market began to weaken, and global market conditions caused sub-prime securitization profit margins to dry up as investors demanded higher yields.


Skaggs said earlier this year that an intensified focus on commercial lending has been paying off for Metropolitan, with the company increasing its revenue in that area by 127 percent last year and expecting similar growth this year. He says it expects to fund about $500 million in commercial loans this year.