## Facts

- Cottage Savings Association, a federally chartered savings and loan, held long-term, low-interest home mortgages whose market values declined as interest rates rose.
- In 1980, it entered a “mortgage swap” with four other thrifts.
- Cottage Savings transferred participation interests in 252 mortgages and simultaneously received participation interests in 305 different mortgages; all were secured by single-family homes.
- The properties exchanged had roughly equal fair market values (about $4.5 million), but Cottage Savings’ adjusted basis in the interests it relinquished exceeded the value received, producing an asserted loss of about $2.5 million.
- For regulatory accounting purposes, the mortgages were treated as “substantially identical.”
- On its 1980 federal income tax return, Cottage Savings deducted the loss as the difference between adjusted basis in the interests transferred and the fair market value of the interests received.
- The IRS disallowed the deduction, asserting there was no realization event under I.R.C. § 1001(a), or alternatively that any loss was not “actually sustained” and thus not deductible under I.R.C. § 165(a).

## Issues

1. Whether exchanging mortgage participation interests constituted a “sale or other disposition of property” that realizes gain or loss under I.R.C. § 1001(a).
2. What “materially different” means for realization purposes under Treasury Regulation § 1.1001-1.
3. Whether a realized loss from the exchange was an “actually sustained” bona fide loss deductible under I.R.C. § 165(a), notwithstanding regulatory treatment of the mortgages as “substantially identical.”

## Decision

- The Supreme Court reversed the court of appeals and held for Cottage Savings.
- The exchange was a “disposition of property” under § 1001(a) because the participation interests received differed materially from those relinquished.
- Property differs materially when the owners’ legal entitlements are different in kind or extent, not merely when economic characteristics differ.
- Because the exchange satisfied § 1001(a)’s realization requirement, the decline from adjusted basis to fair market value was an “actually sustained” loss deductible under § 165(a).
- Regulatory accounting treatment of the mortgages as “substantially identical” did not control the tax realization and loss-deduction analysis.

## Legal Principles

- Under Treasury Regulation § 1.1001-1, gain or loss is realized upon an exchange of property for other property “differing materially either in kind or in extent.”
- For § 1001(a), “materially different” turns on whether the exchanged properties embody different legal entitlements; a focus on economic substitutability is not required.
- Realization serves administrative manageability by tying tax consequences to observable transactions rather than ongoing valuation changes.
- Mortgage participation interests tied to different obligors and different collateral can be materially different even if they have comparable market value and similar economic features.
- Once a loss is realized under § 1001(a), the decline from adjusted basis to fair market value can constitute a loss “sustained during the taxable year” under § 165(a); tax motivation or economic similarity alone does not negate bona fide loss treatment.

## Conclusion

The Court held that Cottage Savings realized a deductible loss when it exchanged mortgage participation interests tied to different borrowers and collateral, because the exchanged properties were materially different based on the legal entitlements they conveyed; the realized loss was deductible under § 165(a) despite regulatory accounting characterizations of similarity.


Cottage Savings Ass’n v. Comm’r, 499 U.S. 554 (1991)