Yes. The bank can claim the tax deduction. The tax law says you have a loss when you get rid of property. Swapping property counts if what you get is 'materially different' from what you gave up. The court decided 'materially different' simply means having different legal rights. Since the new loans were from different borrowers and for different houses, they were legally different. Even though the loans seemed economically the same, the change in legal rights was enough to make the swap a real event for tax purposes, allowing the bank to claim its loss.

No. The bank should not get a deduction. This was just a paper shuffle to get a tax break, and the bank's real financial situation didn't change. We should look at what really happened, not just legal technicalities. The whole point of the government rule was to treat these loans as being the same. It's common sense that if they are 'substantially identical' for banking rules, they can't be 'materially different' for tax rules. This was a fake loss, not a real one.

Yes, Cottage Savings can count the losses from the mortgage trade on its taxes. Even though the mortgages had similar economic value, they were legally different because they involved different borrowers and properties. For tax purposes, properties are considered 'materially different' if they involve different legal rights, not just different economic values. The Court said it's important to follow the tax rules reasonably interpreted by the IRS.

Justice Blackmun disagreed about letting Cottage Savings claim the losses. He said the traded mortgage interests weren't different in an important way, because the government's rules aimed to make sure any differences would be minor. He argued that in tax law, what matters is the real substance of the deal, not just the legal form. In this case, he thought the reality was that the mortgage interests weren't meaningfully different.

First, the Supreme Court has long held that "substance rather than form determines tax consequences."

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.

Under our interpretation of § 1001 (a), an exchange of property gives rise to a realization event so long as the exchanged properties are `materially different'—that is, so long as they embody legally distinct entitlements

"Because Congress has delegated to the Commissioner the power to promulgate `all needful rules and regulations for the enforcement of the Internal Revenue Code,'26 USC § 7805 (a),[I] must defer to his regulatory interpretations of the Code so long as they are reasonable. "

"Treasury regulations and interpretations long continued without substantial change, applying to unamended or substantially reenacted statutes, are deemed to have received congressional approval and have the effect of law."

—the Supreme Court respected a transaction that created different legal rights on paper—and tremendous tax losses—but didn't change the taxpayer's economic reality.

The Supreme Court recently reiterated Horst's statement that "the concept of realization is founded on administrative convenience,"

Since the term "reserve strengthening''is ambiguous, the task that confronts us is to decide, not whether the Treasury regulation represents the best interpretation of the statute, but whether it represents a reasonable one.

—stating that by leaving a statute "undisturbed through subsequent reenactments of the [Act]," the Court "may presume that Congress intended to codify [the related] principles" represented by the Court's contemporary decisions

For example, taxpayers motivated solely by tax considerations have been permitted by the courts to time their recognition of accrued economic losses, notwithstanding that the IRS attacked such tax-motivated transactions as lacking economic substance.

Yes. An exchange of mortgage participation interests for interests in different loans with different obligors and collateral is a 'disposition of property' under § 1001(a) that gives rise to a realized loss. To realize a gain or loss, a taxpayer must engage in a 'sale or other disposition' of property, which requires that the properties exchanged be 'materially different.' The Court rejects the Commissioner's proposed 'economic substitute' test and instead holds that properties are materially different so long as they embody legally distinct entitlements. Because the participation interests Cottage Savings exchanged were derived from loans made to different obligors and secured by different homes, they embodied legally distinct entitlements and were therefore materially different. The fact that the FHLBB deemed the mortgages 'substantially identical' for regulatory accounting purposes is irrelevant to their status under the Internal Revenue Code. The transaction was a bona fide disposition allowing Cottage Savings to realize and deduct its loss.

No. The exchange of substantially identical mortgage packages does not give rise to a recognizable loss because the properties are not materially different. Tax law should prioritize substance over form, and in substance, this transaction did not change the economic position of Cottage Savings. The criteria in Memorandum R-49 were designed to ensure the mortgage pools were practically and economically identical. To find a 'material difference' for tax purposes when the assets are 'substantially identical' for accounting purposes defies common sense and elevates form over the economic reality of the transaction. The parties' own actions, such as not performing credit checks on the new loans, demonstrated that they viewed the exchanged assets as fungible, confirming the lack of a material difference.

Yes, the exchange of participation interests in mortgage loans gives rise to realized losses because the exchanged properties are materially different, embodying legally distinct entitlements. The participation interests exchanged by Cottage Savings and the other S&Ls derived from loans made to different obligors and secured by different homes, thus satisfying the material difference requirement for a realization event under Section 1001(a) of the Internal Revenue Code. The Court emphasizes that properties are 'materially different' so long as their respective possessors enjoy legal entitlements that are different in kind or extent, not just because the properties are economically different. The Court also acknowledges the importance of deferring to the Commissioner's reasonable regulatory interpretations of the Code.

Justice Blackmun dissents on the issue of whether Cottage Savings realized deductible losses. He argues that the mortgage participation partial interests exchanged were not materially different because they were 'substantially identical' under the criteria set forth in Memorandum R-49. The purpose of these criteria was to ensure that any differences between the interests would be immaterial. Justice Blackmun emphasizes that in tax law, substance rather than form should determine tax consequences, and the realities of the transaction demonstrate that any differences were not material.

Cottage Savings Assn. v. Commissioner

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