Rev. Rul. 73-558

Advice has been requested whether, under the circumstances described below, a loss is allowable on the exchange of mortgage notes and whether the difference between the face amount of a mortgage note and the basis of the note that represented discount in valuing the note is ordinary income when collections are received.

In 1969, a savings and loan association using the cash receipts and disbursements method of accounting exchanged 6 percent residential mortgages with an aggregate face value and adjusted basis of 5,000x dollars for 61/2 percent mortgages on commercial property with an aggregate face value of 5,000x dollars. The fair market value of the mortgage loans on the date of the exchange was 4,250x dollars or 85 percent of the principal amount of the loans. The commercial mortgages had a composite maturity of approximately 161/2 years. None of the residential mortgagors were the same as the commercial mortgagors. There was no evidence that any of the commercial mortgage loans were uncollectible or that the debtors would default on their notes. In 1970 and 1971 the savings and loan association received periodic payments on the loans.

Section 1001(a) of the Internal Revenue Code of 1954 provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.

Section 1001(b) of the Code states, in part, that the amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.

Section 1001(c) of the Code states that, in the case of a sale or exchange of property, any gain or loss computed under section 1001 shall be recognized only to the extent determined under section 1002.

Section 1.1001-1(a) of the Income Tax Regulations provides, in part, that 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 extent, is treated as income or as loss sustained.

Section 1002 of the Code states that, except as otherwise provided in subtitle A of the Code, on the sale or exchange of property the entire amount of the gain or loss, determined under section 1001, shall be recognized. Section 1.1002-1(d) of the regulations provides that ordinarily, to constitute an exchange, the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only.

Section 1031 of the Code provides for the nonrecognition of gain or loss from the exchange of certain property for property of like kind but specifically excludes from its coverage among other things, bonds, notes, choses in action, and other securities or evidences of indebtedness.

Section 1221 of the Code provides, among other things, that the term "capital asset" does not include accounts and notes receivable (1) acquired in the ordinary course of trade or business for services rendered or (2) from the sale of the stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. In Burbank Liquidating Corporation, 39 T.C. 999 (1963), acq. 1965-1 C.B. 5, the Tax Court of the United States held that where a savings and loan association sold at a discount its mortgage loans made in the ordinary course of its business they are notes receivable acquired for services rendered and, thus, are ordinary rather than capital assets and the loss on the sale is deductible as an ordinary loss. Accordingly, since the savings and loan association in the instant case received notes that had a fair market value of 4,250x dollars in exchange for notes that had an adjusted basis in its hand of 5,000x dollars an ordinary loss of 750x dollars is allowable.

The answer to the second issue of whether the difference between the face amount of a mortgage note and the basis of the note that represented discount in valuing the note is ordinary income when collections are received is found in Darby Investment Corporation v. Commissioner, 37 T.C. 839 (1962), aff'd, 315 F. 2d 551 (6th Cir. 1963). In that case the United States Court of Appeals held that where a taxpayer acquired vendees' contracts from a home builder at a discount he must report as income each year the proportionate amount of the monthly payment which represents income from the discount of the investment.

Accordingly, in the instant case, a portion of each subsequent principal payment on the mortgage notes acquired is applicable to the 750x dollars market discount that was recognized on the exchange and such portion is, therefore, includible in ordinary income.