Cottage Savings Association v. Commissioner
499 U.S. 554 (1991)
Cottage was a Savings &
Loan company. They developed a scheme to get larger deductions on their
The value of Cottages'
assets (which was loans on real estate) was falling. Cottage and other
S&Ls started to exchange bundles of bad debts for other bundles of
bad debts. This allowed both S&Ls to claim they had traded property
with a high adjusted basis for
something with a lower fair market value, so they both experienced a loss, even though
they essentially started and ended with the same thing.
So for example, say each
bank had an outstanding million dollar loan that was in default. By
trading the bad loans, each bank could claim that they traded an asset
with an adjusted basis of $1M for
an asset with a fair market value of $0. Therefore they both had a loss of $1M.
See Philadelphia Park
Amusement Co. v. United States (126
F.Supp. 184 (1954)).
The IRS claimed that the
bundles of debts were virtually the same, so it wasn't like Cottage had
traded an asset at all, they still had the same asset. Therefore, they
could not claim a loss because they were still holding the asset.
The IRS had generally held
that a trade between two taxpayers for virtually the same object would
not be an event of realization.
The Tax Court found for
Cottage. The IRS appealed.
The Appellate Court reversed.
The US Supreme Court reversed
and allowed Cottage to claim the loss.
The US Supreme Court noted
that 26 U.S.C. §1001 says that
you cannot claim a loss on property until that loss is realized
by "the sale or other disposition of property."
The Court found that for the
IRS's exception to apply, the trade had to be 'virtually identical'. In
this case, the bad loans weren't identical enough.
The bad loans were made to
different people and were for different amounts and had different
properties as collateral. Even though they were still all bad loans,
they were materially different.
On the other hand, if you
traded a specific issue of a rare comic book to someone for the a
different copy of the exact same issue, then that trade would be
'virtually identical' and you could not realize any gain/loss on your taxes.