First Federal Sav. & Loan Ass'n of Temple v. US, Civ. A. No. W-86-CA-117.

• Decision Date: 26 July 1988
• Docket Number: Civ. A. No. W-86-CA-117.
• Parties: FIRST FEDERAL SAVINGS & LOAN ASSOCIATION OF TEMPLE, Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — Western District of Texas

694 F. Supp. 230

FIRST FEDERAL SAVINGS & LOAN ASSOCIATION OF TEMPLE, Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. No. W-86-CA-117.

United States District Court, W.D. Texas, Waco Division.

July 26, 1988.

Vester T. Hughes, Jr., Cynthia M. Ohlenforst, Dallas, Tex., H. Robert Powell, Austin, Tex., for plaintiff.

Walter B. Thurmond & Grover Hartt, III, Dept. of Justice, Tax Div., Dallas, Tex., for defendant.

MEMORANDUM OPINION AND ORDER

WALTER S. SMITH, Jr., District Judge.

This cause came on for trial April 25, 1988, before the Court without a jury. Having considered the pleadings, evidence, and arguments of counsel, the Court enters the following findings of fact and conclusions of law.

I. Introduction

This case presents the relatively novel issue of the tax treatment to be given to "reciprocal mortgage sales" conducted pursuant to the Federal Home Loan Bank Board's Memorandum R-49. The dispute concerns the deductibility of $3,715,132.00 in losses that Plaintiff, First Federal Savings and Loan of Temple, Texas ("Temple"), claims that it incurred through a "reciprocal sale" of mortgage "pools" with First Federal Savings and Loan of Waco, Texas on December 31, 1980. The Internal Revenue Service disallowed the claimed loss, and Temple brings this suit to recover a tax refund.

Temple is a savings and loan association organized under the laws of the State of Texas and has its principal place of business in Temple, Texas. In 1980, Temple was a federally insured mutual savings and loan association subject to review, supervision, and regulation of the Federal Home Loan Bank Board ("FHLBB") and the Federal Savings and Loan Insurance Corporation. Defendant, United States of America ("Government"), was duly served pursuant to Fed.R.Civ.P. 4(d)(4). Jurisdiction is proper pursuant to 28 U.S.C. §§ 1340 and 1346(a)(1) and 26 U.S.C. § 7422. Venue is proper pursuant to 28 U.S.C. § 1402(a)(2).

This is an action arising under the Internal Revenue Code of 1954, as amended,¹ for the refund of income taxes and interest assessed against Temple during its tax year 1980. On September 15, 1981, Temple filed a federal corporate income tax return for the tax year ending December 31, 1980, and paid the taxes reported due. Thereafter, Temple filed a Form 1139, Corporate Application for Tentative Refund, on which it applied for tentative allowance of refunds for the taxable years 1970, 1971, 1972, 1973, and 1974, resulting from the carryback of a claimed net operating loss for the taxable year 1980. Tentative allowances were granted and refunds of $733,179.00, exclusive of interest, were paid to Temple by the Government in accordance with the claims on the Form 1139. The net operating loss which constituted the basis for the carryback losses reported on Temple's Form 1139 resulted from a loss claimed by Temple on the "reciprocal sale" of two pools of mortgage loans transferred in accordance with an agreement with First Federal Savings and Loan Association of Waco ("Waco"). On its Form 1139, Temple also claimed a carryback of unused investment tax credit to the years 1968 and 1969 which arose as a result of the carryback to 1971 and 1972 of the claimed net operating loss in 1980 due to the "reciprocal sale" of mortgage pools. On February 20, 1985, the Government issued statutory notices of deficiency to Temple for tax years 1970-74, and 1980. This deficiency was based upon the Internal Revenue Service's determination that Temple was not entitled to deduct (and, therefore, not carryback) a loss of $3,715,132.00 from the "reciprocal sale" transaction with Waco on December 31, 1980.

The deficiency assessment amounted to $1,546,394.13 ($878,564.00 in taxes and $667,830.13 in interest), which Temple timely paid on July 22, 1985. Of the total deficiency, $363,431.17 was the amount assessed for tax year 1980 ($207,343.00 in taxes and $156,088.17 in interest). It is the deficiency assessment for tax year 1980 ($363,431.17) which is at issue in this suit. On September 23, 1985, Temple timely filed a Claim for Refund with the Internal Revenue Service for the $363,431.17 paid by Temple for the deficiency assessed for tax year 1980. The Internal Revenue Service did not render a decision on the Claim for Refund within six (6) months, and this suit was filed to recover the claimed refund on June 4, 1986. The Parties agree that the only contested issue is the deductibility, including the realization,² of the claimed loss of $3,715,132.00 from the "reciprocal sale" of mortgage loan pools between Temple and Waco on December 31, 1980.

II. Background of "Reciprocal Mortgage Sales"

The "reciprocal sale" at issue in this case is the type of transaction that has become known in the savings and loan industry as an "R-49" transaction. This is because this type of "reciprocal sale" of mortgage loans is specifically designed to comport with the requirements of Memorandum R-49 published by the FHLBB.

"R Memoranda," such as Memorandum R-49, are publications issued by the Office of Examination and Supervision ("OES") of the FHLBB which have the force and effect of binding FHLBB regulations. FHLBB member institutions are required to comply with the R Memoranda as they would any other FHLBB regulation. Memorandum R-49, issued June 27, 1980, related to the regulatory accounting treatment³ to be given "reciprocal mortgage sales." Memorandum R-49 reads:

The purpose of this memorandum is to advise OES staff of the proper accounting for reciprocal sales of mortgage loans.

A loss resulting from a difference between market value and book value in connection with reciprocal sales of substantially identical mortgage loans need not be recorded. Mortgage loans are considered substantially identical only when each of the following criteria is met. The loans involved must:

1. involve single-family residential mortgages,

2. be of similar type (e.g., conventional for conventional),

3. have the same stated terms to maturity (e.g. 30 years),

4. have identical stated interest rates,

5. have similar seasoning (i.e. remaining terms to maturity),

6. have aggregate principal amounts within the less of 2½% or $100,000 (plus or minus) on both sides of the transaction, with any additional consideration being paid in cash,

7. be sold without recourse,

8. have similar fair market values,

9. have similar loan-to-value ratios at the time of the reciprocal sale, and

10. have all security properties for both sides of the transaction in the same state.

When the aggregate principal amounts are not the same and the principal amount of the mortgage loans purchased is greater than the principal amount of the mortgage loans sold, the purchaser should record the additional principal. The difference between the additional principal and the additional cost should be recorded as a discount and amortized over a period of not less than ten years. If the principal amount of the mortgage loans purchased is less than the principal amount of those originally sold, the difference should reduce its loan account. The difference between the reduction in loans and the amount of cash received should be charged to a loss on sale of mortgage loans.

If a reciprocal sale does not meet all of the above criteria, the institution must record losses resulting from the sale.

Memorandum R-49 was a product of the financial crunch that savings and loan institutions were experiencing in the middle to late 1970's and early 1980's. The financial downturn in the savings and loan industry was the result of the decrease in profits and liquidity these institutions were incurring due to the differential between the low interest rates on outstanding loans and the increasing interest rates being paid on savings accounts and other obligations to depositors. This decrease in liquidity became significant because the FHLBB requires its member institutions to maintain specified liquidity levels for regulatory and financial accounting purposes. Savings and loan institutions wanted to sell their low interest mortgage loans, recognize their accumulating "book" loss for tax purposes (thus generating income through tax refunds), and reinvest the funds generated in higher interest loans or in similar low interest loans purchased from other institutions at a discount (i.e. with a reduced basis). The problem with conducting such transactions was that the FHLBB required its member institutions to report and account for losses incurred on the outright sale of mortgage loans, and such sales as those contemplated (i.e. large enough to produce significant tax refund income) would at least temporarily reduce some savings and loans' liquidity levels below the minimum required by the FHLBB.

In 1980, representatives of the accounting profession, members of the FHLBB, and savings and loan industry experts held meetings to discuss potential solutions to the industry's problems — Memorandum R-49 was the result. Memorandum R-49 allows savings and loan institutions to "reciprocally sell" very particular types of mortgage loans and not record or recognize a loss for regulatory or financial accounting purposes. This would allow savings and loan institutions to maintain requisite liquidity levels while then reporting a loss on their tax returns which could be carried-back to prior years and generate revenues through tax refunds.

Indeed, this was the entire purpose of Memorandum R-49. The drafters intended to carefully structure a transaction which would involve the "reciprocal sale" of property which would be at the same time "substantially identical" for regulatory and financial accounting purposes, yet "materially different" for tax accounting purposes thereby creating a transaction that does not generate an actual regulatory and financial loss, but sufficient to generate an actual tax loss. The Director of the OES explained the purpose of Memorandum R-49 to the Executive Staff Director of the FHLBB in the context of R-49's ten criteria...