Cottage Savings Association v. Commissioner of Internal Revenue

• Decision Date: 17 April 1991
• Docket Number: No. 89-1965,89-1965
• Citation: 111 S.Ct. 1503,113 L.Ed.2d 589,499 U.S. 554
• Parties: COTTAGE SAVINGS ASSOCIATION v. COMMISSIONER OF INTERNAL REVENUE
• Court: U.S. Supreme Court

499 U.S. 554

111 S.Ct. 1503

113 L.Ed.2d 589

COTTAGE SAVINGS ASSOCIATION

v COMMISSIONER OF INTERNAL REVENUE.

No. 89-1965.

Argued Jan. 15, 1991.

Decided April 17, 1991.

Syllabus

Petitioner Cottage Savings Association simultaneously sold participation interests in 252 mortgages to four savings and loan associations and purchased from them participation interests in 305 other mortgages. All of the loans were secured by single-family homes. The fair market value of the package of participation interests exchanged by each side was approximately $4.5 million. The face value of the participation interests relinquished by Cottage Savings was $6.9 million. For Federal Home Loan Bank Board (FHLBB) accounting purposes, Cottage Savings' mortgages were treated as having been exchanged for "substantially identical" ones held by the other lenders. On its 1980 federal income tax return, Cottage Savings claimed a deduction for the adjusted difference between the face value of the interests it traded and the fair market value of the interests it received. Following the Commissioner's disallowance of the deduction, the Tax Court determined the deduction was permissible. The Court of Appeals reversed, finding that Cottage Savings had realized its losses through the transaction, but that it was not entitled to a deduction because its losses were not actually sustained for purposes of § 165(a) of the Internal Revenue Code, which allows deductions only for bona fide losses.

Held:

1. Cottage Savings realized a tax-deductible loss because the properties it exchanged were materially different. Pp. 559-567.

(a) In order to avoid the cumbersome, abrasive, and unpredictable administrative task of valuing assets annually to determine whether their value has appreciated or depreciated, § 1001(a) of the Code defers the tax consequences of a gain or loss in property until it is realized through the "sale or disposition of [the] property." This rule serves administrative convenience because a change in the investment's form or extent can be easily detected by a taxpayer or an administrative officer. P. 1507.

(b) An exchange of property constitutes a "disposition of property" under § 1001(a) only if the properties exchanged are materially different. Although the statute and its legislative history are silent on the subject, Treasury Regulation § 1.1001-1 includes a material difference- require ment for realization to occur through a disposition of property. Treasury Regulation § 1.1001-1 should be given deference as a reasonable interpretation of § 1001(a). Where, as here, a Treasury Regulation long continues without substantial change and applies to a substantially reenacted statute, it is deemed to have congressional approval. The regulation is also consistent with this Court's landmark precedents on realization, which make clear that a taxpayer realizes taxable income only if the properties exchanged are "materially" or "essentially" different. United States v. Phellis, 257 U.S. 156, 173, 42 S.Ct. 63, 67, 66 L.Ed. 180; Weiss v. Stearn, 265 U.S. 242, 253-254, 44 S.Ct. 490, 491-493, 68 L.Ed. 1001; Marr v. United States, 268 U.S. 536, 540-542, 45 S.Ct. 575, 576-577, 69 L.Ed. 1079. Since these cases were part of the contemporary legal context in which the substance of § 1001(a) was originally enacted, and since Congress has left their principles undisturbed through subsequent reenactments, it can be presumed that Congress intended to codify these principles in § 1001(a). Pp. 560-562.

(c) Properties are materially different if their respective possessors enjoy legal entitlements that are different in kind or extent. As long as the property entitlements are not identical, their exchange will allow both the Commissioner and the transacting taxpayer to fix the appreciated or depreciated values of the property relative to their tax bases. There is no support in Phellis, Weiss, or Marr for the Commissioner's "economic substitute" concept of material difference, under which differences would be material only when the parties, the relevant market, and the relevant regulatory body would consider them so. Moreover, the complexity of the Commissioner's approach both ill serves the goal of administrative convenience underlying the realization requirement and is incompatible with the Code's structure. Pp. 562-566.

(d) Cottage Savings' transactions easily satisfy the material difference test. Since the participation interests exchanged derived from loans that were made to different obligors and secured by different homes, the exchanged interests embodied legally distinct entitlements. Thus, Cottage Savings realized its losses at the point of the exchange, at which time both it and the Commissioner were in a position to determine the change in the value of its mortgages relative to their tax bases. The mortgages' status under the FHLBB's criteria has no bearing on this conclusion, since a mortgage can be "substantially identical" to the FHLBB and still exhibit "differences" that are "material" for purposes of the Code. Pp. 566-567.

2. Cottage Savings sustained its losses within the meaning of § 165(a) of the Code. The Commissioner's apparent argument that the losses were not bona fide is rejected, since there is no contention that the transaction was not conducted at arm's length or that Cottage Savings retained de facto ownership of the participation interests it traded. Higgins v. Smith, 308 U.S. 473, 60 S.Ct. 355, 84 L.Ed. 406, distinguished. Pp. 567-568.

890 F.2d 848 (CA6 1989), reversed and remanded.

MARSHALL, J., delivered the opinion of the Court, in which REHNQUIST, C.J., and STEVENS, O'CONNOR, SCALIA, KENNEDY, and SOUTER, JJ., joined. BLACKMUN, J., filed a dissenting opinion, in which WHITE, J., joined, post, p. ----.

Dennis L. Manes, Cincinnati, Ohio, for petitioner.

John G. Roberts, Jr., Washington, D.C., for respondent.

Justice MARSHALL delivered the opinion of the Court.

The issue in this case is whether a financial institution realizes tax-deductible losses when it exchanges its interests in one group of residential mortgage loans for another lender's interests in a different group of residential mortgage loans. We hold that such a transaction does give rise to realized losses.

I

Petitioner Cottage Savings Association (Cottage Savings) is a savings and loan association (S & L) formerly regulated by the Federal Home Loan Bank Board (FHLBB).¹ Like many S & L's, Cottage Savings held numerous long-term, low-interest mortgages that declined in value when interest rates surged in the late 1970's. These institutions would have benefited from selling their devalued mortgages in order to realize tax-deductible losses. However, they were deterred from doing so by FHLBB accounting regulations, which required them to record the losses on their books. Reporting these losses consistent with the then-effective FHLBB accounting regulations would have placed many § & L's at risk of closure by the FHLBB.

The FHLBB responded to this situation by relaxing its requirements for the reporting of losses. In a regulatory directive known as "Memorandum R-49," dated June 27, 1980, the FHLBB determined that § & L's need not report losses associated with mortgages that are exchanged for "substantially identical" mortgages held by other lenders.² The FHLBB's acknowledged purpose for Memorandum R-49 was to facilitate transactions that would generate tax losses but that would not substantially affect the economic position of the transacting § & L's.

This case involves a typical Memorandum R-49 transaction. On December 31, 1980, Cottage Savings sold "90% participation" in 252 mortgages to four § & L's. It simultaneously purchased "90% participation interests" in 305 mortgages held by these § & L's.³ All of the loans in- volved in the transaction were secured by single-family homes, most in the Cincinnati area. The fair market value of the package of participation interests exchanged by each side was approximately $4.5 million. The face value of the participation interests Cottage Savings relinquished in the transaction was approximately $6.9 million. See 90 T.C. 372, 378-382 (1988).

On its 1980 federal income tax return, Cottage Savings claimed a deduction for $2,447,091, which represented the adjusted difference between the face value of the participation interests that it traded and the fair market value of the participation interests that it received. As permitted by Memorandum R-49, Cottage Savings did not report these losses to the FHLBB. After the Commissioner of Internal Revenue disallowed Cottage Savings' claimed deduction, Cottage Savings sought a redetermination in the Tax Court. The Tax Court held that the deduction was permissible. See 90 T.C. 372 (1988).

On appeal by the Commissioner, the Court of Appeals reversed. 890 F.2d 848 (CA6 1989). The Court of Appeals agreed with the Tax Court's determination that Cottage Savings had realized its losses through the transaction. See id., at 852. However, the court held that Cottage Savings was not entitled to a deduction because its losses were not "actually" sustained during the 1980 tax year for purposes of 26 U.S.C. § 165(a). See 890 F.2d, at 855.

Because of the importance of this issue to the § & L industry and the conflict among the Circuits over whether Memorandum R-49 exchanges produce deductible tax losses,⁴ we granted certiorari. 498 U.S. 808, 111 S.Ct. 40, 112 L.Ed.2d 17 (1990). We now reverse.

II

Rather than assessing tax liability on the basis of annual fluctuations in the value of a taxpayer's property, the Internal Revenue Code defers the tax consequences of a gain or loss in property value until the taxpayer "realizes" the gain or loss. The realization requirement is implicit in § 1001(a) of the Code, 26 U.S.C. § 1001(a), which defines "[t]he gain [or loss] from the sale or other disposition of property" as the difference between "the amount realized" from the sale or disposition of...