Cottage Sav. Ass'n v. Comm'r of Internal Revenue, Docket No. 27487-83.
| Decision Date | 14 March 1988 |
| Docket Number | Docket No. 27487-83. |
| Citation | 90 T.C. 372,56 USLW 2538,90 T.C. No. 28 |
| Parties | COTTAGE SAVINGS ASSOCIATION, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner, a regulated savings and loan institution, entered into reciprocal sales and purchases of loan participations with four other unrelated savings and loan institutions. These transfers were at then current fair market values, substantially below petitioner's bases in the loans. Although the transfers were bona fide, they were made solely to produce losses for Federal income tax purposes, in amounts great enough to result in net operating loss carrybacks which generated substantial Federal income tax refunds. Pursuant to a ruling of the Federal Home Loan Bank Board (Memorandum R-49), petitioner did not recognize the claimed losses for regulatory accounting purposes.
HELD: Petitioner realized losses on the transfers; these losses are recognized for Federal income tax purposes and are deductible. Secs. 1001, 165, I.R.C. 1954. Dennis L. Manes, Scott M. Slovin, and Richard M Schwartz, for the petitioner.*
Joseph R. Goeke and Mary Helen Weber, for the respondent.
Respondent determined deficiencies in Federal corporate income tax against petitioner for 1974 through 1980, as follows:
+----------------+
¦Year¦Deficiency ¦
+----+-----------¦
¦1974¦$47,029.09 ¦
+----+-----------¦
¦1975¦62,889.23 ¦
+----+-----------¦
¦1976¦102,014.57 ¦
+----+-----------¦
¦1977¦154,520.26 ¦
+----+-----------¦
¦1978¦185,427.59 ¦
+----+-----------¦
¦1979¦54,187.23 ¦
+----+-----------¦
¦1980¦73,752.53 ¦
+----------------+
After a concession by petitioner, 1 the issue for decision 2 is whether petitioner realized recognizable losses from sales of 90- percent participations in loan portfolios to other savings and loan institutions, from which petitioner simultaneously acquired 90- percent participations of approximately equal aggregate value and, if so, whether petitioner may deduct those losses.
Some of the facts have been stipulated; the stipulations and the stipulated exhibits are incorporated herein by this reference.
When the petition was filed in the instant case, petitioner's principal place of business was in Cincinnati, Ohio.
Since 1883, petitioner has been in the business of receiving savings deposits from the public and in turn making loans secured by residential and commercial real estate. Petitioner profited by making loans from deposits at interest rates higher than petitioner paid to depositors, and from charging points for the origination of such loans. Petitioner, a State-chartered mutual savings association, was a federally insured savings and loan institution subject to the regulations of the Federal Home Loan Bank Board (hereinafter sometimes referred to as ‘the FHLBB‘). Petitioner was required to file semiannual financial reports to the FHLBB reporting petitioner's financial condition in conformity with accounting principles adopted by the FHLBB and commonly referred to are regulatory accounting principles (hereinafter sometimes referred to as ‘RAP‘).
For 1980 and all the other years in issue (see n. 6, infra), petitioner filed its income tax returns on a calendar-year basis and used the accrual method of accounting for all purposes.
In 1980, savings and loan deposits were declining because funds were being diverted to higher-yielding money market funds. Earnings of savings and loan institutions declined as interest paid on deposits exceeded the interest earned on loan portfolios. In addition, because of the increases in market interest rates, the market values of existing fixed-interest loan portfolios held by savings and loan institutions were substantially less than the book values of these loan portfolios.
In 1980, petitioner began to offer adjustable-rate mortgages, which would allow interest rates to be adjusted to meet changes in the market. The number and dollar volume of loans made by petitioner dropped, however. Petitioner experienced a shortage of funds because of the loss of deposits to money market mutual funds and because high interest rates charged by the FHLBB eliminated the FHLBB as a source of funds that petitioner could use to make profitable loans. Petitioner expected the decline in deposits to continue.
FHLBB regulations required petitioner (and other federally insured savings and loan institutions) to meet certain net worth requirements. These requirements were revised by amendments published on November 6, 1980, with an effective date of November 17, 1980.
If petitioner had sold the loan participations described infra, and had been required by the FHLBB's RAP to reduce its net worth by the amounts of the losses that it would have sustained (in table 4, infra, compare the last two columns; in table 5, infra, compare column (3) with column (4)), then petitioner's net worth would have been reduced to such a level that it would barely exceed the FHLBB's minimum requirements.
On June 27, 1980, the Director of the Office of Examination and Supervision (OES) of the FHLBB issued Memorandum R-49 relating to ‘reciprocal sales‘ of mortgage loans, with the following stated synopsis: ‘A LOSS NEED NOT BE RECORDED FROM 'RECIPROCAL SALES' OF SUBSTANTIALLY IDENTICAL MORTGAGE LOANS ‘. The body of Memorandum R-49 states as follows:
The purpose of this memorandum is to advise OES staff on 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 [under RAP]. Mortgage loans are considered substantially identical only when each of the following criteria is met. The loans involved must:
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 purchaser should reduce its loan account. The difference between the reduction in loans and the amount of cash received should be charged to 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 the FHLBB's response to a desire of the savings and loan industry to structure exchanges of mortgage loans to create losses for income tax reporting purposes which would not be reported under RAP or under generally accepted accounting principles (hereinafter sometimes referred to as ‘GAAP‘).
The criteria selected in Memorandum R-49 represented an attempt by the FHLBB, OES, to maintain the regulated institution's position with respect to three types of risk in a loan portfolio. These risks related to credit or collectibility, rate or future earnings potential, and repayment or extent of principal repayments and prepayments. In the opinion of the OES, a change in any of these risks would change the economic factors underlying a savings and loan institution's loan portfolio and, as a result, require recording the resulting gain or loss under RAP.
A memorandum dated August 10, 1981, from the Director of the OES to the Executive Staff Director of the FHLBB, sets forth the following explanation with respect to the criteria listed in Memorandum R-49.
When developing the criteria contained in Memorandum R-49, we worked closely with the AICPA Committee on Savings and Loan Associations. In addition to communication with this committee, we also obtained agreement with our stance from prominent CPAs serving the industry. * * * Our objective at that time was to structure a transaction which was as close as possible to the IRS ‘materially different‘ definition which would still not change the economic position of the association after it engaged in the swap. It was and remains our opinion that Memorandum R-49 represents a transaction which is on a fine line between ‘substantially identical‘ and ‘materially different‘.
These criteria represented our attempt to maintain the association's position with respect to the three types of risks in a loan portfolio. These risks relate to credit (collectibility), rate (future earnings potential), and repayment (extent of principal repayments and prepayments). In our opinion, a change in any of these risks would change the economic factors underlying an association's loan portfolio and, as a result, require recording the resulting gain or loss.
The following schedule relates the ten criteria for non- recognition, as outlined in Memorandum R-49, to these types of risks.
+--------------------------------------------------------------+
¦ ¦ ¦Risk ¦
+----+-----------------------------------+---------------------¦
¦ ¦Criteria ¦Credit¦Rate¦Repayment¦...To continue reading
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