Can anyone point me to the tax law underlying this rule?

You can look at code section 221 and Proposed Reg 1.221-1.

You're looking at the first 60 months that payments are required. I assume payments were required or you would not have defaulted. So I'm pretty sure those months count toward the 60 month limit.

The pain may not be too bad, as the 60 month limit is scheduled to go away for 2002.

--Peter