COTTAGE SAVINGS ASSOCIATION, PETITIONER V. COMMISSIONER OF INTERNAL
REVENUE

   No. 89-1965

   In The Supreme Court Of The United States

   October Term, 1990

   On Petition For A Writ Of Certiorari To The United States Court Of
Appeals For The Sixth Circuit

   Brief For The Respondent

            TABLE OF CONTENTS
   Question Presented
   Opinions below
   Jurisdiction
   Statement
   Discussion
   Conclusion

                            OPINIONS BELOW

   The opinion of the court of appeals (Pet. App. 1a-15a) is reported
at 890 F.2d 848.  The opinion of the Tax Court (Pet. App. 16a-56a) is
reported at 90 T.C. 372.

                             JURISDICTION

   The judgment of the court of appeals (Pet. App. 57a) was entered on
December 4, 1989.  A petition for rehearing was denied on March 14,
1990 (Pet. App. 58a).  The petition for a writ of certiorari was filed
on June 11, 1990.  The jurisdiction of this Court is invoked under 28
U.S.C. 1254(1).

                          QUESTION PRESENTED

   Whether a financial institution realizes a deductible loss for
income tax purposes when it exchanges a group of mortgage loans for a
substantially identical group of mortgage loans held by another
financial institution.

                               STATEMENT

   1. Petitioner is a mutual savings and loan association formerly
regulated by the Federal Home Loan Bank Board.  In 1980, petitioner's
mortgage loan portfolio was partially comprised of fixed-rate,
long-term mortgage loans that had been issued previously at interest
rates significantly lower than those charged on more recent loans.  As
a result of the high interest rates of the early 1980s, the fair
market value of these older, low-interest loans fell far below their
face amount.  Pet. App. 2a, 18a.

   For petitioner, like other savings institutions holding older,
low-interest loans, this situation created a tax incentive for
disposing of its depreciated mortgage loans.  A disposition of the
loans would enable petitioner to realize for tax purposes the loss
that resulted from these market changes;  it could then utilize the
resulting loss deductions to offset current taxable income and produce
loss carrybacks that would generate tax refunds from prior years.
There was, however, a catch.  Many of these institutions were in such
precarious financial condition that a sale of the loans and consequent
recognition of the losses -- however beneficial for tax purposes --
would for regulatory accounting purposes have caused them to fail to
meet the Bank Board's minimum reserve and liquidity requirements,
raising the prospect of closure by the Bank Board.  See Pet. App.
18a-19a;  San Antonio Savings Ass'n v. Commissioner, 887 F.2d 577, 579
(5th Cir. 1989), petition for cert. pending, No. 89-1928.

   On June 27, 1980, the Bank Board's Office of Examination and
Supervision (OES) issued Memorandum R-49, a regulatory accounting
principle that adopted the rule that savings institutions could make
"reciprocal sales" of depreciated "substantially identical mortgage
loans" without having a record a loss for regulatory accounting
purposes.  Memorandum R-49 established a list of criteria that would
render loans "substantially identical," including that the mortgages
be of similar type with the same terms and interest rates.  /1/ The
admitted objective of Memorandum R-49 was to allow savings
institutions to engage in transactions that would generate deductible
losses for federal income tax purposes, but that would not be treated
as giving rise to losses for financial reporting and regulatory
purposes.  Pet. App. 19a-20a.  /2/

   2. On December 31, 1980, petitioner entered into four separate
transactions with four other savings institutions designed to exchange
interests in mortgages that satisfied the requirements of Memorandum
R-49.  In each transaction, petitioner effectively exchanged a package
of 90% participation interests in a group of mortgage loans for a
package of 90% participation interests in a group of mortgage loans
held by the other institution.  Pet. App. 24a-27a, 32a-33a.  /3/ In
each transaction, the participation interests exchanged were in loan
packages having almost identical face and market value (id. at 25a),
and the loans involved were "substantially identical" according to the
criteria set forth in Memorandum R-49 (id. at 30a).  In selecting
loans to be exchanged, petitioner and its trading partners did not
investigate the credit ratings of any of the borrowers on the loans it
received and did not investigate the value of the real estate that
secured the loans.  Id. at 4a, 28a.  The pricing or valuation of all
the loans was established by using one common discount factor based on
the then-current interest rate of 14.863%.  Id. at 3a, 25a.

   Each transaction was consummated in the form of a "reciprocal sale"
by conveyance of the 90% participation interests together with a
simultaneous transfer of checks by both parties in the amount of the
fair market value of the interests acquired (Pet. App. 3a, 24a-25a).
Petitioner paid a total of $4,456,912 and received a total of
$4,458,855 in the four transactions (id. at 25a).  The participation
interests that it transferred had a face value of $6,907,208 (id. at
27a).  On its 1980 federal income tax return, petitioner claimed a
deduction for a loss on the transaction in the amount of the
difference between the face value of the participation interests
transferred and the amount received for them.  Pursuant to Memorandum
R-49, petitioner did not report any loss for financial and regulatory
accounting purposes.  Id. at 2a, 30a.

   3. On audit, the Commissioner determined that petitioner was not
entitled to its claimed deduction for a loss on the mortgage exchange
transactions.  Petitioner sought redetermination of the resulting
income tax deficiencies in the Tax Court.  After a trial, the Tax
Court held for petitioner (Pet. App. 16a-54a).

   The Commissioner's primary argument was that a loss is "realized"
for tax purposes under Section 1001 of the Internal Revenue Code (26
U.S.C.) on an exchange of property only if the exchanged properties
are "materially different" and that mortgages that were "substantially
identical" under the Memorandum R-49 criteria were not materially
different.  The Tax Court concluded that the loans taxpayer
transferred were "materially different" from the loans it received
because the loans had different borrowers and were secured by
different collateral (Pet. App. 40a-45a).  The Tax Court also rejected
the Commissioner's argument that, because the mortgage exchange lacked
economic substance, deduction of the loss was not authorized by
Section 165 of the Internal Revenue Code (id. at 51a-53a).

   4. The court of appeals reversed (Pet. App. 1a-15a).  The court
agreed with petitioner's position that a loss was "technically
realized" (id. at 10a) on an R-49 exchange of mortgages because, in
the court's view, Section 1001 of the Code does not require that
exchanged properties be "materially different" in order for an
exchange to constitute a realization event (id. at 9a-10a).  The court
held, however, that because the exchange of mortgages pursuant to
Memorandum R-49 did not result in any real change in petitioner's
economic position, petitioner had not "sustained" a loss on the
transactions that would permit it to take a loss deduction under
Section 165 of the Code (Pet. App. 10a-15a).  In particular, the court
stated that loss deductions are not allowed on "transactions in which
the taxpayer's economic position was not changed for the worse" (id.
at 12a-13a), and it concluded that petitioner's "economic position was
not changed" by an exchange of a pool of mortgages for "a
substantially identical pool of mortgages" (id. at 14a).

                              DISCUSSION

   This case presents the same question that is presented in three
petitions pending from decisions of the Fifth Circuit (United States
v. Centennial Savings Bank (Resolution Trust Corporation, Receiver),
No. 89-1926 (Question 1);  United States v. First Federal Savings and
Loan Ass'n, No. 89-1927;  Commissioner v. San Antonio Savings Ass'n
and Subsidiaries (Resolution Trust Corporation, Receiver), No.
89-1928), and in a petition pending from a decision of the District of
Columbia Circuit (Commissioner v. Federal National Mortgage Ass'n, No.
89-1987) -- namely, whether a financial institution realizes a
deductible loss for income tax purposes when it exchanges a group of
mortgage loans for a "substantially identical" group of mortgage
loans.  As we explain in detail in our petition in Centennial, review
of this question by this Court is warranted because there exists a
square conflict in the circuits between the decision below and the
decisions of the Fifth and District of Columbia Circuits (see
Centennial Pet. 11-13) and the issue is of considerable importance to
the administration of the federal tax laws.  /4/ We have accordingly
urged that the Court grant plenary review in Centennial and in First
Federal (see Centennial Pet. 13 n.10).  Because the question presented
here is the same as that already presented in First Federal and in
Centennial, we believe that there is no need for the Court to grant
plenary review in this case as well but that it would be appropriate
for the Court to hold this case pending the outcome in Centennial and
First Federal.

                              CONCLUSION

   The petition for a writ of certiorari should be disposed of as
appropriate in light of this Court's disposition of United States v.
Centennial Savings Bank (Resolution Trust Corporation, Receiver), No.
89-1926, and United States v. First Federal Savings & Loan Ass'n, No.
89-1927.

   Respectfully submitted.

   JOHN G. ROBERTS, JR.

      Acting Solicitor General /5/

   SHIRLEY D. PETERSON

      Assistant Attorney General

   RICHARD FARBER

   BRUCE R. ELLISEN

      Attorneys

   JULY 1990

   /1/ Memorandum R-49 specifically provided in part (Pet. App.
19a-20a):

         A loss resulting from a difference between market value and
      book value in connection with reciprocal sales of substantially
      identical mortgage loans need not be recorded.  Mortgage loans
      are considered substantially identical only when each of the
      following criteria is met.  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 2
      1/2% 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.

   /2/ A memorandum from the Director of OES to an officer of the Bank
Board described the "objective" of Memorandum R-49 as "to structure a
transaction which was as close as possible to the IRS 'materially
different' definition which would still not change the economic
position of the association after it engaged in the swap." Pet. App.
21a.

   /3/ Transactions designed to take advantage of Memorandum R-49
often involved exchanges of 90% participation interests, rather than
the entire loan, so that the original mortgagee could maintain its
relationship with the obligor on the loans.  Pet. App. 27a-28a.

   /4/ We are supplying petitioner's counsel with copies of our
petitions in Centennial, First Federal, San Antonio, and Federal
National Mortgage Ass'n.

   /5/ The Solicitor General is disqualified in this case.