Cottage Savings Association v. Commissioner, , was an
income taxThe federal government of the United States imposes a progressive tax on the taxable income of individuals, partnerships, companies, corporations, trusts, decedents' estates, and certain bankruptcy estates. Some state and municipal governments also impose income taxes. The first Federal income tax...
case before the
Supreme Court of the United StatesThe Supreme Court of the United States is the highest judicial body in the United States, and leads the federal judiciary. It consists of the Chief Justice of the United States and eight Associate Justices, who are nominated by the President and confirmed with the "advice and consent" of the Senate...
.
The Court was asked to determine whether the exchange of different
participation interestsIn finance, "participation" is an ownership interest in a mortgage or other loan. In particular, loan participation is a cooperation of multiple lenders to issue a loan to one borrower...
in home
mortgageA mortgage is the transfer of an interest in property to a lender as a security for a debt - usually a loan of money. While a mortgage in itself is not a debt, it is the lender's security for a debt...
s by a
savings and loan associationA savings and loan association , also known as a thrift, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans...
was a "disposition of property" under
Internal Revenue CodeThe Internal Revenue Code is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax , payroll taxes, gift taxes, estate taxes and statutory excise taxes...
(since this was the requirement for them to realize, and deduct, their losses on these mortgages).
The court determined that it was a "disposition of property" by making the following three holdings:
- Under § 1001(a), exchange of property gives rise to realization (a "disposition of property") only if the exchanged properties are "materially different."
- This concept of "material difference" is not defined by an economic substitute test (whether various would consider their differences to be "material"); rather, two properties are materially different if their respective possessors enjoy legal entitlements that are different in kind or extent.
- The S&L's 90% participation interest in its mortgages embodied legally distinct entitlements (and so was "materially different" from) the 90% mortgage participation interest it received from the other savings associations.
Cottage Savings Association v. Commissioner, , was an
income taxThe federal government of the United States imposes a progressive tax on the taxable income of individuals, partnerships, companies, corporations, trusts, decedents' estates, and certain bankruptcy estates. Some state and municipal governments also impose income taxes. The first Federal income tax...
case before the
Supreme Court of the United StatesThe Supreme Court of the United States is the highest judicial body in the United States, and leads the federal judiciary. It consists of the Chief Justice of the United States and eight Associate Justices, who are nominated by the President and confirmed with the "advice and consent" of the Senate...
.
The Court was asked to determine whether the exchange of different
participation interestsIn finance, "participation" is an ownership interest in a mortgage or other loan. In particular, loan participation is a cooperation of multiple lenders to issue a loan to one borrower...
in home
mortgageA mortgage is the transfer of an interest in property to a lender as a security for a debt - usually a loan of money. While a mortgage in itself is not a debt, it is the lender's security for a debt...
s by a
savings and loan associationA savings and loan association , also known as a thrift, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans...
was a "disposition of property" under
Internal Revenue CodeThe Internal Revenue Code is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax , payroll taxes, gift taxes, estate taxes and statutory excise taxes...
(since this was the requirement for them to realize, and deduct, their losses on these mortgages).
The court determined that it was a "disposition of property" by making the following three holdings:
- Under § 1001(a), exchange of property gives rise to realization (a "disposition of property") only if the exchanged properties are "materially different."
- This concept of "material difference" is not defined by an economic substitute test (whether various would consider their differences to be "material"); rather, two properties are materially different if their respective possessors enjoy legal entitlements that are different in kind or extent.
- The S&L's 90% participation interest in its mortgages embodied legally distinct entitlements (and so was "materially different" from) the 90% mortgage participation interest it received from the other savings associations. Even if mortgages are "substantially identical" for purposes of Federal Home Loan Bank Board "Memorandum R-49" on reporting losses, they can still exhibit "material difference" for the purposes of finding a "disposition of property."
Facts and procedural history
Cottage Savings Association was a savings & loan association (S&L) serving the
Greater CincinnatiThe Cincinnati-Northern Kentucky metropolitan area is a metropolitan area that includes counties in the U.S. states of Ohio, Kentucky and Indiana. The United States Census defines the metropolitan area as the Cincinnati-Middletown Metropolitan Statistical Area...
area. Like many other S&L’s, Cottage Savings had a large number of long-term, low-
interestInterest is a fee paid on borrowed assets. It is the price paid for the use of borrowed money, or, money earned by deposited funds. Assets that are sometimes lent with interest include money, shares, consumer goods through hire purchase, major assets such as aircraft, and even entire factories in...
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
regulationRegulation is "controlling human or societal behaviour by rules or restrictions." Regulation can take many forms: legal restrictions promulgated by a government authority, self-regulation, social regulation , co-regulation and market regulation. One can consider regulation as actions of conduct...
s of the Federal Home Loan Bank Board (FHLBB) would have required them to report these losses on their books, possibly putting them into
insolvencyInsolvency means the inability to pay one's debts as they fall due. Usually used in Business terms, insolvency refers to the inability for a company to pay off its debts.Business insolvency is defined in two different ways:...
. 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 valueFair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the real estate market. An estimate of fair market value may be founded either on precedent or...
of the interests exchanged by each side was approximately $4.5 million. The
face valueThe Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
of the interests which Cottage Savings relinquished was approximately $6.9 million. On its 1980 federal income
tax returnTax returns in the United States are reports filed with the Internal Revenue Service or with the state or local tax collection agency containing information used to calculate income tax or other taxes....
, 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 RevenueThe Commissioner of Internal Revenue is the head of the Internal Revenue Service , a bureau within the United States Department of the Treasury.The office of Commissioner was created by Congress. See the Revenue Act of 1862...
disallowed Cottage Savings’ deduction, so the S&L filed a petition for redetermination in the
United States Tax CourtThe United States Tax Court is a federal trial court of record established by Congress under Article I of the U.S. Constitution, section 8 of which provides that the Congress has the power to "constitute Tribunals inferior to the supreme Court"...
, which reversed the Commissioner’s decision and permitted the deduction. The Commissioner appealed to the
United States Court of Appeals for the Sixth CircuitThe United States Court of Appeals for the Sixth Circuit is a federal court with appellate jurisdiction over the district courts in the following districts:* Eastern District of Kentucky* Western District of Kentucky...
, 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. The U.S. Supreme Court then granted
certiorariCertiorari is a legal term in Roman, English, and American law referring to a type of writ seeking judicial review. Certiorari is the present passive infinitive of Latin certiorare,...
.
Issues
§1001(a) of the
Internal Revenue CodeThe Internal Revenue Code is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax , payroll taxes, gift taxes, estate taxes and statutory excise taxes...
requires that the tax consequences a gain or loss in property value be deferred until it is realized by “the sale or other disposition of property”. Since the transaction was certainly not a sale,
Justice MarshallThurgood Marshall was an American jurist and the first African American to serve on the Supreme Court of the United States. Before becoming a judge, he was a lawyer who was best remembered for his high success rate in arguing before the Supreme Court and for the victory in Brown v. Board of...
identified the main legal issue to be whether the exchange was a "disposition of
propertyProperty is any physical or intangible entity that is owned by a person or jointly by a group of persons. Depending on the nature of the property, an owner of property has the right to consume, sell, rent, mortgage, transfer, exchange or destroy his or her property, and/or to exclude others from...
."
- 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
A security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets...
by different real propertyIn the common law, real property refers to one of the two main classes of property, the other being personal property. Real property generally encompasses land, land improvements resulting from human effort including buildings and machinery sited on land, and various property rights over the...
.
Thus, in order to determine whether the exchange was a "disposition of
propertyProperty is any physical or intangible entity that is owned by a person or jointly by a group of persons. Depending on the nature of the property, an owner of property has the right to consume, sell, rent, mortgage, transfer, exchange or destroy his or her property, and/or to exclude others from...
," the court first had to determine whether §1001 incorporated a "material difference" requirement, and if so, what that requirement involved.
Majority Opinion
Material difference is a requirement for a disposition under §1001. Marshall cited Treasury Regulation §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 RegulationsThe Code of Federal Regulations is the codification of the general and permanent rules and regulations published in the Federal Register by the executive departments and agencies of the Federal Government of the United States...
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 lawCase law is the reported decisions of selected appellate and other courts which make new interpretations of the law and, therefore, can be cited as precedents in a process known as stare decisis...
.
Material difference defined. 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. MacomberEisner v. Macomber, , was a tax case before the United States Supreme Court. It is notable for the following holdings:*a pro rata stock dividend, where a shareholder received no actual cash or other property, and retained the same proportionate share of ownership of the corporation as was held...
, which dealt with exchange of
stockIn the investment world, a share of stock represents a share of ownership in a corporation ....
in
corporationA corporation is a legal entity separate from the shareholders and employees. In British tradition it is the term designating a body corporate, where it can be either a corporation sole or a corporation aggregate...
s. 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 ruleThe black letter law refers to the basic standard elements for a particular field of law, which are generally known and free from doubt or dispute...
, 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." 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.
Dissent
Justice BlackmunHarold Andrew Blackmun was an Associate Justice of the Supreme Court of the United States from 1970 until 1994. He is best known as the author of Roe v. Wade.-Early years and professional career:...
dissented, joined by
Justice WhiteByron Raymond "Whizzer" White won fame both as a football running back and as an associate justice of the Supreme Court of the United States. Appointed to the court by President John F. Kennedy in 1962, he served until his retirement in 1993...
.
- First, Blackmun wanted to define “material difference” with reference to how the term “materiality” was defined. In TSC Industries, Inc. v. Northway, Inc.
TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 , was a case in which the Supreme Court of the United States articulated the requirement of materiality in securities fraud cases.-Facts and procedural history:...
, Justice Marshall himself had stated, in the context of securities fraud, that an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. By implication, a material difference is a difference capable of influencing the decision made by the parties to the transaction.
- Second, Blackmun pointed out that the majority created something of an anomaly by allowing the property interests exchanged here to be “identical” for accounting purposes but “different” for tax purposes.
- Finally, he explained the he felt the substance of the transactions, including the fact that Cottage Savings retained a 10% interest in loans it traded away so it could continue servicing them, did not point to any real difference that should permit the allowance of a deduction.
Academic Commentary
The emphasis in
Cottage Savings on realization as an administrative requirement makes evident the capricious role that realization plays in the tax field.
- 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.