JUSTICE MARSHALL delivered the opinion of the Court.
The issue in this case is whether a financial institution realizes tax-deductible losses when it exchanges its interests in one group of residential mortgage loans for another lender's interests in a different group of residential mortgage loans. We hold that such a transaction does give rise to realized losses.
Petitioner Cottage Savings Association (Cottage Savings) is a savings and loan association (S & L) formerly regulated by the Federal Home Loan Bank Board (FHLBB).
The FHLBB responded to this situation by relaxing its requirements for the reporting of losses. In a regulatory directive known as "Memorandum R-49," dated June 27, 1980, the FHLBB determined that S & L's need not report losses associated with mortgages that are exchanged for "substantially identical" mortgages held by other lenders.
This case involves a typical Memorandum R-49 transaction. On December 31, 1980, Cottage Savings sold "90% participation interests" in 252 mortgages to four S & L's. It simultaneously purchased "90% participation interests" in 305 mortgages held by these S & L's.
On its 1980 federal income tax return, Cottage Savings claimed a deduction for $2,447,091, which represented the adjusted difference between the face value of the participation interests that it traded and the fair market value of the participation interests that it received. As permitted by Memorandum R-49, Cottage Savings did not report these losses to the FHLBB. After the Commissioner of Internal Revenue disallowed Cottage Savings' claimed deduction, Cottage Savings sought a redetermination in the Tax Court. The Tax Court held that the deduction was permissible. See 90 T.C. 372 (1988).
On appeal by the Commissioner, the Court of Appeals reversed. 890 F.2d 848 (CA6 1989). The Court of Appeals agreed with the Tax Court's determination that Cottage Savings had realized its losses through the transaction. See id., at 852. However, the court held that Cottage Savings was not entitled to a deduction because its losses were not "actually" sustained during the 1980 tax year for purposes of 26 U. S. C. § 165(a). See 890 F. 2d, at 855.
Because of the importance of this issue to the S & L industry and the conflict among the Circuits over whether Memorandum R-49 exchanges produce deductible tax losses,
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. The realization requirement is implicit in § 1001(a) of the Code, 26 U. S. C. § 1001(a), which defines "[t]he gain [or loss] from the sale or other disposition of property" as the difference between "the amount realized" from the sale or disposition of the property and its "adjusted basis." As this Court has recognized, the concept of realization is "founded on administrative convenience." Helvering v. Horst, 311 U.S. 112, 116 (1940). Under an appreciation-based system of taxation, taxpayers and the Commissioner would have to undertake the "cumbersome, abrasive, and unpredictable administrative task" of valuing assets on an annual basis to determine whether the assets had appreciated or depreciated in value. See 1 B. Bittker & L. Lokken, Federal Taxation of Income, Estates and Gifts ¶ 5.2, p. 5-16 (2d ed. 1989). In contrast, "[a] change in the form or extent of an investment is easily detected by a taxpayer or an administrative officer." R. Magill, Taxable Income 79 (rev. ed. 1945).
Section 1001(a)'s language provides a straightforward test for realization: to realize a gain or loss in the value of property, the taxpayer must engage in a "sale or other disposition of [the] property." The parties agree that the exchange of participation interests in this case cannot be characterized as a "sale" under § 1001(a); the issue before us is whether the transaction constitutes a "disposition of property." The Commissioner argues that an exchange of property can be treated as a "disposition" under § 1001(a) only if the properties exchanged are materially different. The Commissioner further submits that, because the underlying mortgages
We must therefore determine whether the realization principle in § 1001(a) incorporates a "material difference" requirement. If it does, we must further decide what that requirement amounts to and how it applies in this case. We consider these questions in turn.
Neither the language nor the history of the Code indicates whether and to what extent property exchanged must differ to count as a "disposition of property" under § 1001(a). Nonetheless, we readily agree with the Commissioner that an exchange of property gives rise to a realization event under § 1001(a) only if the properties exchanged are "materially different." The Commissioner himself has by regulation construed § 1001(a) to embody a material difference requirement:
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 U. S. C. § 7805(a), we must defer to his regulatory interpretations
We conclude that Treasury Regulation § 1.1001-1 is a reasonable interpretation of § 1001(a). Congress first employed the language that now comprises § 1001(a) of the Code in § 202(a) of the Revenue Act of 1924, ch. 234, 43 Stat. 253; that language has remained essentially unchanged through various reenactments.
Treasury Regulation § 1.001-1 is also consistent with our landmark precedents on realization. In a series of early decisions involving the tax effects of property exchanges, this Court made clear that a taxpayer realizes taxable income
Precisely what constitutes a "material difference" for purposes of § 1001(a) of the Code is a more complicated question. The Commissioner argues that properties are "materially different" only if they differ in economic substance. To determine whether the participation interests exchanged in this case were "materially different" in this sense, the Commissioner argues, we should look to the attitudes of the parties, the evaluation of the interests by the secondary mortgage market, and the views of the FHLBB. We conclude that § 1001(a) embodies a much less demanding and less complex test.
Unlike the question whether § 1001(a) contains a material difference requirement, the question of what constitutes a material difference is not one on which we can defer to the Commissioner. For the Commissioner has not issued an authoritative, prelitigation interpretation of what property
We start with the classic treatment of realization in Eisner v. Macomber, supra. In Macomber, a taxpayer who owned 2,200 shares of stock in a company received another 1,100 shares from the company as part of a pro rata stock dividend meant to reflect the company's growth in value. At issue was whether the stock dividend constituted taxable income. We held that it did not, because no gain was realized. See id., at 207-212. We reasoned that the stock dividend merely reflected the increased worth of the taxpayer's stock, see id., at 211-212, and that a taxpayer realizes increased worth of property only by receiving "something of exchangeable value proceeding from the property," see id., at 207.
In three subsequent decisions — United States v. Phellis, supra; Weiss v. Stearn, supra; and Marr v. United States, supra—we refined Macomber's conception of realization in the context of property exchanges. In each case, the taxpayer owned stock that had appreciated in value since its acquisition.
The question in these cases was whether the taxpayers realized the accumulated gain in their shares in the old corporation when they received in return for those shares stock representing an equivalent proportional interest in the new corporations. In Phellis and Marr, we held that the transactions were realization events. We reasoned that because a company incorporated in one State has "different rights and powers" from one incorporated in a different State, the taxpayers in Phellis and Marr acquired through the transactions property that was "materially different" from what they previously had. United States v. Phellis, 257 U. S., at 169-173; see Marr v. United States, supra, at 540-542 (using phrase "essentially different"). In contrast, we held that no realization occurred in Weiss. By exchanging stock in the predecessor corporation for stock in the newly reorganized corporation, the taxpayer did not receive "a thing really different from what he theretofore had." Weiss v. Stearn, supra, at 254. As we explained in Marr, our determination that the reorganized company in Weiss was not "really different" from its predecessor turned on the fact that both companies were incorporated in the same State. See Marr v. United States, supra, at 540-542 (outlining distinction between these cases).
Obviously, the distinction in Phellis and Marr that made the stock in the successor corporations materially different from the stock in the predecessors was minimal. Taken together,
In contrast, we find no support for the Commissioner's "economic substitute" conception of material difference. According to the Commissioner, differences between properties are material for purposes of the Code only when it can be said that the parties, the relevant market (in this case the secondary mortgage market), and the relevant regulatory body (in this case the FHLBB) would consider them material. Nothing in Phellis, Weiss, and Marr suggests that exchanges of properties must satisfy such a subjective test to trigger realization of a gain or loss.
Moreover, the complexity of the Commissioner's approach ill serves the goal of administrative convenience that underlies the realization requirement. In order to apply the Commissioner's test in a principled fashion, the Commissioner and the taxpayer must identify the relevant market, establish whether there is a regulatory agency whose views should be taken into account, and then assess how the relevant market
Finally, the Commissioner's test is incompatible with the structure of the Code. Section 1001(c) of Title 26 provides that a gain or loss realized under § 1001(a) "shall be recognized" unless one of the Code's nonrecognition provisions applies. One such nonrecognition provision withholds recognition of a gain or loss realized from an exchange of properties that would appear to be economic substitutes under the Commissioner's material difference test. This provision, commonly known as the "like kind" exception, withholds recognition of a gain or loss realized "on the exchange of property held for productive use in a trade or business or for investment . . . for property of like kind which is to be held either for productive use in a trade or business or for investment." 26 U. S. C. § 1031(a)(1). If Congress had expected that exchanges of similar properties would not count as realization events under § 1001(a), it would have had no reason to bar recognition of a gain or loss realized from these transactions.
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. Cottage Savings' transactions at issue here easily satisfy this test. Because the participation interests exchanged by Cottage Savings and the other S & L's derived from loans that were made to different obligors and secured by different homes, the exchanged interests did embody legally distinct entitlements. Consequently, we conclude that Cottage Savings realized its losses at the point of the exchange.
The Commissioner contends that it is anomalous to treat mortgages deemed to be "substantially identical" by the
Although the Court of Appeals found that Cottage Savings' losses were realized, it disallowed them on the ground that they were not sustained under § 165(a) of the Code, 26 U. S. C. § 165(a). Section 165(a) states that a deduction shall be allowed for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." Under the Commissioner's interpretation of § 165(a),
The Commissioner offers a minimal defense of the Court of Appeals' conclusion. The Commissioner contends that the losses were not sustained because they lacked "economic substance," by which the Commissioner seems to mean that the losses were not bona fide. We say "seems" because the Commissioner states the position in one sentence in a footnote
In Higgins, we held that a taxpayer did not sustain a loss by selling securities below cost to a corporation in which he was the sole shareholder. We found that the losses were not bona fide because the transaction was not conducted at arm's length and because the taxpayer retained the benefit of the securities through his wholly owned corporation. See Higgins v. Smith, supra, at 475-476. Because there is no contention that the transactions in this case were not conducted at arm's length, or that Cottage Savings retained de facto ownership of the participation interests it traded to the four reciprocating S & L's, Higgins is inapposite. In view of the Commissioner's failure to advance any other arguments in support of the Court of Appeals' ruling with respect to § 165(a), we conclude that, for purposes of this case, Cottage Savings sustained its losses within the meaning of § 165(a).
For the reasons set forth above, the judgment of the Court of Appeals is reversed, and the case is remanded for further proceedings consistent with this opinion.
JUSTICE BLACKMUN, with whom JUSTICE WHITE joins, concurring in part and dissenting in part in No. 89-1926, post, p. 573, and dissenting in No. 89-1965.
I agree that the early withdrawal penalties collected by Centennial Savings Bank FSB do not constitute "income by reason of the discharge . . . of indebtedness of the taxpayer," within the meaning of 26 U. S. C. § 108(a)(1) (1982 ed.), and that the penalty amounts are not excludable from Centennial's gross income. I therefore join Part III of the Court's opinion in No. 89-1926.
The exchanges, as the Court acknowledges, were occasioned by Memorandum R-49, Record, Exh. 72-BT, issued by the Federal Home Loan Bank Board (FHLBB) on June 27, 1980, and by that Memorandum's relaxation of theretofore-existing accounting regulations and requirements, a relaxation effected to avoid placement of "many S & L's at risk of closure by the FHLBB" without substantially affecting the "economic position of the transacting S & L's." Ante, at 557. But the Memorandum, the Court notes, also had as a purpose the "facilit[ation of] transactions that would generate tax losses." Ibid. I find it somewhat surprising that an agency not responsible for tax matters would presume to dictate what is or is not a deductible loss for federal income tax purposes. I had thought that that was something within the exclusive province of the Internal Revenue Service, subject to administrative and judicial review. Certainly, the FHLBB's opinion in this respect is entitled to no deference whatsoever. See United States v. Stewart, 311 U.S. 60, 70 (1940); Graff v. Commissioner, 673 F.2d 784, 786 (CA5 1982) (concurring opinion). The Commissioner, of course, took the opposing position. See Rev. Rul. 85-125, 1985-2 Cum. Bull. 180; Rev. Rul. 81-204, 1981-2 Cum. Bull. 157.
It long has been established that gain or loss in the value of property is taken into account for income tax purposes only if and when the gain or loss is "realized," that is, when it is tied to a realization event, such as the sale, exchange, or other disposition of the property. Mere variation in value—
In applying the realization requirement to an exchange, the properties involved must be materially different in kind or in extent. Treas. Reg. § 1.1001-1(a), 26 CFR § 1.1001-1(a) (1990). This has been the rule recognized administratively at least since 1935, see Treas. Regs. 86, Art. 111-1, issued under the Revenue Act of 1934, and by judicial decision. See, e. g., Mutual Loan & Savings Co. v. Commissioner, 184 F.2d 161 (CA5 1950). See also Marr v. United States, 268 U.S. 536, 541 (1925); Weiss v. Stearn, 265 U.S. 242, 254 (1924); United States v. Phellis, 257 U.S. 156 (1921). This makes economic as well as tax sense, for the parties obviously regard the exchanged properties as having equivalent values. In tax law, we should remember, substance rather than form determines tax consequences. Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945); Gregory v. Helvering, 293 U.S. 465, 469-470 (1935); Shoenberg v. Commissioner, 77 F.2d 446, 449 (CA8), cert. denied, 296 U.S. 586 (1935). Thus, the resolution of the exchange issue in these cases turns on the "materially different" concept. The Court recognizes as much. Ante, at 559-560.
That the mortgage participation partial interests exchanged in these cases were "different" is not in dispute. The materiality prong is the focus. A material difference is one that has the capacity to influence a decision. See, e. g., Kungys v. United States, 485 U.S. 759, 770-771 (1988); Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
The application of this standard leads, it seems to me, to only one answer—that the mortgage participation partial interests released were not materially different from the mortgage participation partial interests received. Memorandum R-49, as the Court notes, ante, at 557, n. 2, lists 10 factors that, when satisfied, as they were here, serve to classify the
This should suffice and be the end of the analysis. Other facts, however, solidify the conclusion: The retention by the transferor of 10% interests, enabling it to keep on servicing its loans; the transferor's continuing to collect the payments due from the borrowers so that, so far as the latter were concerned, it was business as usual, exactly as it had been; the obvious lack of concern or dependence of the transferor with the "differences" upon which the Court relies (as transferees, the taxpayers made no credit checks and no appraisals of collateral, see 890 F.2d 848, 849 (CA6 1989)); 90 T.C. 372, 382 (1988); 682 F.Supp. 1389, 1392 (ND Tex. 1988); the selection of the loans by a computer programmed to match mortgages in accordance with the Memorandum R-49 criteria; the absence of even the names of the borrowers in the closing schedules attached to the agreements; Centennial's receipt of loan files only six years after its exchange, id., at 1392, n. 5; the restriction of the interests exchanged to the same State; the identity of the respective face and fair market values; and the application by the parties of common discount factors to each side of the transaction—all reveal that any differences that might exist made no difference whatsoever and were not material. This demonstrates the real nature of the transactions, including nonmateriality of the claimed differences.
I respectfully dissent on this issue.
"The loans involved must:
"1. involve single-family residential mortgages,
"2. be of similar type (e. g., conventionals for conventionals),
"3. have the same stated terms to maturity (e. g., 30 years),
"4. have identical stated interest rates,
"5. have similar seasoning (i. e., remaining terms to maturity),
"6. have aggregate principal amounts within the lesser of 2½% or $100,000 (plus or minus) on both sides of the transaction, with any additional consideration being paid in cash,
"7. be sold without recourse,
"8. have similar fair market values,
"9. have similar loan-to-value ratios at the time of the reciprocal sale, and
"10. have all security properties for both sides of the transaction in the same state." Record, Exh. 72-BT.
"Except as hereinafter provided in this section, the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis provided in subdivision (a) or (b) of section 204, and the loss shall be the excess of such basis over the amount realized."
The essence of this provision was reenacted in § 111(a) of Revenue Act of 1934, ch. 277, 48 Stat. 703; and then in § 111(a) of the Internal Revenue Code of 1939, ch. 1, 53 Stat. 37; and finally in § 1001(a) of the Internal Revenue Code of 1954, Pub. L. 591, 68A Stat. 295.
"Except as otherwise provided, the Act regards as income or as loss sustained, the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent" (emphasis added).