Cottage Savings Association V. Commissioner - Facts and Procedural History

Facts and Procedural History

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. The U.S. Supreme Court then granted certiorari.