IIS 7.5 Basic Authentication does not seem to work with virtual directories

IIS 7.5 is running in this server. I have configured IIS Manager User "someuser". On virtual directory "virtdir", which is also an IIS7.5 "app" I have set user "someuser" to allowed (in IIS Manager Permissions" (and yes, I selected the "virtdir" and switched to "Features View" first.) Also with "virtdir" selected I have configured Authentication, and turned off Anonymous Authentication and enabled Basic Authentication.

When I navigate to "virtdir" using the browser, I expected to get Basic Auth Challenge pop up to enter userid and password. Instead I receive only an error page with the following info:

HTTP Error 401.2 - Unauthorized
You are not authorized to view this page due to invalid authentication headers.
Detailed Error Information
Module  UrlAuthorizationModule
Notification    AuthorizeRequest
Handler ExtensionlessUrlHandler-Integrated-4.0
Error Code  0x80070005
Requested URL   http://www.xxxx.org:80/virtdir
Physical Path   d:\xxx\xx
Logon Method    Anonymous
Logon User  Anonymous

This same set up with a normal directory (and declared as an "app") works successfully.

Anyone have any experience with this?