UNITED STATES OF AMERICA, PETITIONER V. FIRST FEDERAL SAVINGS AND LOAN ASSOCIATION OF TEMPLE No. 89-1927 In The Supreme Court Of The United States October Term, 1989 The Acting Solicitor General, on behalf of the United States of America, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Fifth Circuit in this case. Petition For A Writ Of Certiorari To The United States Court Of Appeals For The Fifth Circuit TABLE OF CONTENTS Question Presented Opinions below Jurisdiction Statutory provisions and regulation involved Statement Reasons for granting the petition Conclusion OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-3a) is reported at 887 F.2d 593. The opinion of the district court (App., infra, 4a-45a) is reported at 694 F. Supp. 230. JURISDICTION The judgment of the court of appeals was entered on November 2, 1989. A petition for rehearing was denied on January 19, 1990 (App., infra, 46a-47a). On April 10, 1990, Justice White extended the time within which to file a petition for a writ of certiorari to and including May 18, 1990. On May 4, 1990, Justice White further extended that time to and including June 8, 1990. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTORY PROVISIONS AND REGULATION INVOLVED The relevant portions of Sections 165 and 1001 of the Internal Revenue Code of 1954 (26 U.S.C. (1982)) and Section 1.1001-1(a) of the Treasury Regulations on Income Tax (26 C.F.R.) are set out in a statutory appendix (App., infra, 48a-50a). 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. Respondent is a mutual savings and loan association formerly regulated by the Federal Home Loan Bank Board. In 1980, respondent's mortgage loan portfolio was partially comprised of fixed-rate, long-term home mortgage loans that had been issued in the late 1960s 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. App., infra, 5a, 9a. For respondent, 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 respondent 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 App., infra, 9a. 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 to 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. See App., infra, 7a-12a. /2/ 2. On December 31, 1980, respondent entered into a transaction in which it effectively exchanged a group of residential mortgage loans for a group of residential mortgage loans held by First Federal Savings and Loan of Waco (Waco Savings). The two groups of loans exchanged had almost identical face and market value, and the loans involved were "substantially identical" according to the criteria set forth in the Bank Board's Memorandum R-49. Respondent selected the loans to be exchanged by running a computer analysis of its portfolio designed to assemble those of its loans that fit the Memorandum R-49 criteria. Respondent conducted no new credit checks, appraisals, or underwriting of the loans it was to receive, nor did it review any of the mortgage file documents related to these loans. The pricing or valuation of all of the loans was established by reference to the Federal National Mortgage Association's new money auction rate for December 31, 1980. To arrive at a price, a single common discount factor was applied to all of the loans on each side of the transaction. App., infra, 12a-13a. The transaction was styled a "reciprocal sale()" (App., infra, 13a) and was consummated by reciprocal conveyances of the mortgage pools together with delivery of checks by respondent and Waco Savings. Respondent thus "paid" Waco Savings $6,759,868 for loans with a face amount of $10,503,499. Waco Savings in turn "paid" respondent $6,801,607 for loans with a face amount of $10,516,739. In effect, respondent exchanged loans with a face amount (and cost basis) of $10,516,739, but a much lower value, for loans and a relatively small amount of cash of equal value. Id. at 12a. On its 1981 federal income tax return, respondent claimed a deduction for a loss on the transaction of $3,715,132, the difference between the face amount and value of the loans it transferred. Id. at 4a. Pursuant to Memorandum R-49, however, respondent did not report any loss for financial and regulatory accounting purposes. Doc. 55, at 8. 3. On audit, the IRS determined that respondent was not entitled to its claimed deduction for a loss on the mortgage exchange transaction. Respondent paid the resulting income tax deficiencies and filed this refund action in the United States District Court for the Western District of Texas. App., infra, 4a. After a bench trial, the district court held for respondent (id. at 4a-45a). The government's primary argument was that a loss is "realized" for tax purposes 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 district court agreed with the government that the mortgages respondent transferred to Waco Savings were not "materially different" from the mortgages respondent received (App., infra, 32a-36a). The court held, however, that neither the Internal Revenue Code nor the applicable regulations established material difference between exchanged properties as a prerequisite to the realization of gain or loss on an exchange; rather, the court ruled that any disposition of property in an exchange results in realization and recognition of gain or loss for tax purposes (id. at 21a-28a, 36a-41a). The district court also rejected the government'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 (26 U.S.C.) (id. at 41a-43a). 4. The court of appeals affirmed (App., infra, 1a-3a). This case was heard together with two other cases involving mortgage exchanges that satisfied the criteria of Memorandum R-49, and all three cases were decided by the same panel on the same day. See San Antonio Savings Ass'n v. Commissioner, 887 F.2d 577 (5th Cir. 1989); Centennial Savings Bank v. United States, 887 F.2d 595 (5th Cir. 1989). The court of appeals treated San Antonio as the lead case and analyzed the issue in detail there. The court agreed with the government's position that a loss is realized on an exchange only if the properties exchanged are "materially different" (887 F.2d at 581-587). The court then held, however, that the mortgages exchanged in an R-49 transaction are "materially different" because the mortgages have different borrowers and different collateral, even though the Bank Board had identified the mortgages as "substantially identical" (id. at 587-592). The San Antonio court also rejected the government's additional argument that the exchange lacked economic substance and therefore that no loss could be deducted under Section 165 of the Code (id. at 592-593). In this case, the court observed that the "facts of this case and the issues raised closely parallel" those of San Antonio (App., infra, 1a). Relying on its opinion in San Antonio, the court here held that respondent's claimed deduction was allowable because the exchanged mortgages were "materially different" (id. at 2a-3a). REASONS FOR GRANTING THE PETITION The question presented here -- 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 -- is the same as the first question presented in our petition in United States v. Centennial Savings Bank, (Resolution Trust Company, Receiver), filed today. 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 and the issue is of considerable importance to the administration of the federal tax laws. /3/ Accordingly, we believe that it is appropriate for the Court to grant certiorari in this case as well, to be considered together with the Centennial case (see footnote 10 of our petition in Centennial). Alternatively, the Court may wish to hold this case pending the outcome of Centennial. CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted. JOHN G. ROBERTS, JR. Acting Solicitor General /4/ SHIRLEY D. PETERSON Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General ALAN I. HOROWITZ Assistant to the Solicitor General RICHARD FARBER BRUCE R. ELLISEN Attorneys JUNE 1990 /1/ Memorandum R-49 specifically provided in part (App., infra, 7a-8a): 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." See App., infra, 10a. /3/ We are supplying respondent's counsel with a copy of our petition in Centennial. /4/ The Solicitor General is disqualified in this case. APPENDIX