Supreme Court approves reciprocal sales of mortgage pools.

The Supreme Court, in Cottage Savings Association v. Commissioner, ruled savings and loans realize deductible tax losses in connection with exchanges of mortgage pools that feature substantially the same effective interest rates and maturity dates.

In the early 1980s, most S&Ls possessed significant unrealized losses on their portfolios of fixed rate mortgages. To enable them to obtain tax deductions without a concurrent charge to regulatory capital, the Federal Home Loan Bank Board published guidelines (known as Memorandum R-49) allowing thrifts to avoid a capital charge when they undertook exchanges of "substantially identical" mortgage pools.

For tax purposes, these exchanges would give rise to deductible losses if the exchange constituted a "disposition" of the mortgages. The IRS argued, and the Court agreed, that a disposition could be found only if the mortgages exchanged were "materially different." Logically, the IRS contended that mortgages substantially identical (for regulatory accounting purposes) could not, by definition, be regarded as materially different.

Nevertheless, the Court was able to bridge the gap between the regulatory accounting and tax rules. It found that properties are materially different if they embody "legally distinct entitlements." In this case, therefore, the mortgages, even though "economic substitutes," were materially different because they were made to different borrowers and secured by different lenders.

Observation: Although the Court did not address wash sales restrictions (which disallow losses on sales of securities if substantially identical securities are acquired within 30 days before or after the sale), it has apparently relaxed them, sub silentio (that is, without comment). To the extent it is now easier to conclude that properties are materially different, they are less likely to be "substantially identical" within the meaning of Internal Revenue Code section 1091.