Cottage Savings Ass'n v. Commissioner

Cottage Savings Association was a savings & loan association (S&L) serving the Greater Cincinnati area. Like many other S&L's, Cottage Savings had a large number of long-term, low-interest mortgages on its books, which declined in value as interest rates increased during the late 1970s.

These S&Ls could have achieved a tax savings from selling these mortgages at a loss, but they were dissuaded from doing so because the accounting regulations of the Federal Home Loan Bank Board (FHLBB) would have required them to report these losses on their books, possibly putting them into insolvency. Hoping to find another way for these S&Ls to realize their tax losses, the FHLBB promulgated a new regulation called "Memorandum R-49", under which the S&Ls would not have to show a loss on their books if they exchanged their mortgages for "substantially identical" mortgages held by other lenders.

Cottage Savings made a transaction pursuant to this regulation by exchanging 90% participation interests in 252 mortgages to four other S&Ls, receiving in return 90% participation interests in 305 mortgages. All the mortgages involved in the transaction were for homes in the Greater Cincinnati region. The fair market value of the interests exchanged by each side was approximately $4.5 million. The face value of the interests which Cottage Savings relinquished was approximately $6.9 million. On its 1980 federal income tax return, Cottage Savings claimed a loss of $2,447,091, the adjusted difference between the face value of the participation interests it gave up and fair market value of the interests it received.

The Commissioner of Internal Revenue disallowed Cottage Savings' deduction, so the S&L filed a petition for redetermination in the United States Tax Court, which reversed the Commissioner's decision and permitted the deduction. The Commissioner appealed to the United States Court of Appeals for the Sixth Circuit, which reversed the decision of the Tax Court, holding that even though Cottage Savings realized a loss in the transaction, it had not actually realized the loss during the 1980 tax year.[3] The U.S. Supreme Court then granted certiorari.

§ 1001(a) of the Internal Revenue Code requires that the tax consequences of a gain or loss in property value be deferred until it is realized by "the sale or other disposition of property".[2] Since the transaction was certainly not a sale, the Court identified the main legal issue to be whether the exchange was a "disposition of property."

• The Commissioner had argued that an exchange of properties can be a "disposition" only if the properties involved in the transaction are "materially different".
• Cottage Savings argued that "material difference" was not a requirement—that any exchange of property could be considered a disposition. Just in case, it also argued that the participation interests exchange were materially different because they were secured by different real property.

Thus, to determine whether the exchange was a "disposition of property," the court first had to determine whether §1001 incorporated a "material difference" requirement, and if so, what that requirement involved.

In an opinion by Justice Marshall, the Court came to three key findings:

Material difference is a requirement for a disposition under §1001. Justice Marshall cited Treasury Regulation §1.1001-1 (26 CFR 1.1001-1), which required that an exchange of materially different properties constitutes a realization under the Tax Code. Congress delegated to the Commissioner the authority to make rules and regulations to enforce the Internal Revenue Code. Because Title 26 of the Code of Federal Regulations represents the Commissioner's interpretation of the Code, the Court deferred to the Commissioner's judgment, holding that the regulation was a reasonable interpretation of the Code and consonant with prior case law.

Material difference defined. Justice Marshall defined what constituted a "material difference" in property under §1001 by examination at what point "realization" had been found in past case law. He started with Eisner v. Macomber (1920), which dealt with exchange of stock in corporations. In several cases after Eisner, the court held that an exchange of stock which occurred when a corporation reorganized in another state was a realization, because corporations have different rights and power in different states. Marshall reasoned that properties materially differ for tax purposes when their respective possessors enjoy different legal entitlements from each. As long as the properties being exchanged were not identical, a realization had taken place. This was a simpler, black letter rule, as compared to what the Commissioner was arguing for, which would have examined not just the underlying substance of the transaction, but also the market and other non-tax regulations.

The properties exchanged were "materially different." Justice Marshall held that the participation interests exchanged by Cottage Savings and the other S&Ls were "materially different" because the loans involved were made to different obligors and secured by different properties. Even though the interests were "substantially identical" for the FHLBB's purposes, that did not mean they were not materially different for taxation purposes. Therefore, the exchange was a "disposition of property," Cottage Savings had realized a loss, and their deduction was appropriate.

The Court agreed that "material difference" is the applicable test of realization under Code § 1001(a), but it did not agree that that test had been flunked merely because the properties exchanged were economic substitutes or equivalents. While the test for regulatory purposes might indeed be one of economic substance, for tax purposes the question was one of administrative convenience only. As the mortgages exchanged were secured by different homes and involved different mortgage borrowers, the banks on either side emerged with "legally distinct entitlements". More important, the swap itself sufficed to meet the administrative aims that underlie the realization requirement. The transaction was an arms-length deal between unrelated parties. As such, it "put both Cottage Savings and the Commissioner in a position to determine the change in the value of Cottage Savings' mortgages relative to their tax bases" and thus to reckon up gain or loss under § 1001(a).

— Marvin Chirelstein, Federal Income Taxation, A Law Student's Guide [4]

The emphasis in Cottage Savings on realization as an administrative requirement makes evident the capricious role that realization plays in the tax field.[5]

• If the realization requirement can be met at a very low threshold, as the decision implies, then "realization" virtually becomes elective with the taxpayer.
• The hazard of elective or voluntary realization arises in connection with much investment activity.
  • To prevent an investor from selling underwater assets to deduct realized losses from gross income without restriction, the Code permits the investor to offset so-called capital losses only against his realized capital gains. (Unused losses may be carried forward to subsequent years.) Investment losses are thus confined by the Code to a separate schedule, and so isolated from other kinds of taxable income.

• List of United States Supreme Court cases, volume 499
• List of United States Supreme Court cases
• Lists of United States Supreme Court cases by volume
• List of United States Supreme Court cases by the Rehnquist Court

• Works related to Cottage Savings Association v. Commissioner of Internal Revenue at Wikisource
• Text of Cottage Savings Ass'n v. Commissioner, 499 U.S. 554 (1991) is available from:  Justia  Library of Congress  Oyez (oral argument audio)