68 T.C. 310">*310 OPINION

Respondent determined the following deficiencies in petitioner's Federal income taxes as successor in interest to Metropolitan Savings & Loan Association of Los Angeles:

68 T.C. 310">*311 Other issues having been settled by the parties, the only issue for decision is whether commissions and other selling expenses incurred by petitioner in disposing of foreclosed property are deductible under section 162¹ or are chargeable to the reserve for losses from qualified loans pursuant to section 595.

All the facts are stipulated.

Metropolitan Savings & Loan Association 1977 U.S. Tax Ct. LEXIS 98">*99 of Los Angeles (hereinafter Metropolitan) was organized on or about June 16, 1936, under the laws of the State of California, as a domestic savings and loan association. Petitioner Allstate Savings & Loan Association (hereinafter Allstate or petitioner) is the successor in interest to Metropolitan which merged with petitioner on June 30, 1970. Pursuant to the merger, petitioner succeeded to all rights in the property of, and became subject to all debts and liabilities of, Metropolitan. During 1968 and 1969, Metropolitan reported its income on the basis of the calendar year, utilizing the cash receipts and disbursements method of accounting. Metropolitan used the reserve method in deducting its bad debt losses as provided by sections 593(b) and 166(c).

Metropolitan's principal activities during the years in issue consisted of acquiring cash savings from the public and lending money. Its loans primarily were loans secured by real property. Under California law, real property loans made by Metropolitan during the base period ² could not exceed a prescribed percentage of the value of the property securing them. Pursuant to standards prevailing in the California savings and loan industry 1977 U.S. Tax Ct. LEXIS 98">*100 during the base period, the appraised value of security property was not diminished by such anticipated acquisition and resale costs as brokerage commissions and other selling expenses.

Periodically throughout Metropolitan's operations, borrowers defaulted in the payment of real property loans or in the performance of other obligations imposed under the terms of deeds of trust securing payment of the loans. In order to collect on these defaulted loans, Metropolitan was required to initiate foreclosure proceedings. In each foreclosure case 68 T.C. 310">*312 during the base period, Metropolitan acquired such property through nonjudicial foreclosure, usually by exercise of a power of sale granted the lender under the terms of a trust deed. Once the property was acquired through foreclosure, Metropolitan attempted to dispose of it as soon as possible in order to maximize recovery of the loan for which the property was security.

As a result of its acquisition of property under foreclosure proceedings, Metropolitan paid or incurred various foreclosure expenses. Under California law, each parcel of property was the sole security 1977 U.S. Tax Ct. LEXIS 98">*101 for the loan, and the borrowers were not accountable for any foreclosure expenses paid or incurred by Metropolitan.

During 1968, Metropolitan sold 40 tracts of foreclosed real estate at an aggregate selling price of $ 4,262,600 and, on its 1968 Federal income tax return, deducted the $ 223,546 of brokerage commissions as ordinary and necessary business expenses under section 162(a). During 1969, Metropolitan sold 17 tracts of foreclosed real estate at a gross selling price aggregating $ 1,532,593 and deducted direct postforeclosure expenses in the total amount of $ 37,764. ³

On December 17, 1973, respondent determined deficiencies in Metropolitan's Federal income taxes for 1968 and 1969, denying the deduction claimed by Metropolitan under section 162(a) for commission and other expenses paid or 1977 U.S. Tax Ct. LEXIS 98">*102 incurred in selling foreclosed property. Respondent further determined that such commission and other expenses should be treated under section 595 as costs of disposing of such property, thereby increasing Metropolitan's reserve for bad debts for those years.

68 T.C. 310">*313 Under section 595(a), ^{41977 U.S. Tax Ct. LEXIS 98">*103} a building and loan association which, at a foreclosure sale, bids in security property as a general rule does not recognize gain or loss and does not become entitled to a bad debt deduction at that time. ^{51977 U.S. Tax Ct. LEXIS 98">*104} Rather, under section 595(b), the property so acquired is considered, for purposes of section 166, as "property having the same characteristics as the indebtedness for which such property was security." Any "amount realized" by the association with respect to such property is treated as a payment on account of the indebtedness, and any loss with respect thereto is treated as a bad debt to which section 166 shall apply.

In the case of an organization which accounts for bad debt losses through reserves, as does petitioner, the net effect of section 595(a) and (b) is to defer recognition of gain or loss as a result of a foreclosure until such time as the creditor sells or otherwise disposes of the foreclosed property. The association's investment in the borrower's indebtedness is carried forward in the form of the security property. Upon the property's sale, the gain or loss is treated as a credit or charge to the bad debt reserve, as the case may be, depending upon the results of the sale. Under section 595(c), such gain or loss is to be computed by using the basis of the indebtedness as the 68 T.C. 310">*314 basis for the security property, determined as of the date of acquisition and "properly increased for costs of acquisition."

Section 595 says nothing specifically about how to handle the 1977 U.S. Tax Ct. LEXIS 98">*105 costs of disposing of the foreclosed property, such as brokerage commissions, title costs, revenue stamps, escrow fees, and other similar expenses. Petitioner contends that such expenses are separately deductible under section 162(a) as ordinary and necessary business expenses and do not affect the adjustment to the bad debt reserve. Respondent maintains that those expenses reduce the amount to be applied on the former owner's indebtedness and should be taken into account in computing the amount of the credit or charge to the bad debt reserve.

We agree with respondent.

Prior to 1952, domestic building and loan associations were exempt from Federal income tax. The Revenue Act of 1951 subjected them to a regular corporate income tax but allowed a special deduction for additions to bad debt reserves. This special deduction proved to be so large that such organizations remained virtually tax exempt until the Revenue Act of 1962 added sections 593 and 595 to the 1954 Code. H. Rept. 1447, 87th Cong., 2d Sess. 32 (1962), 1962-3 C.B. 703, 746.

The principal technique adopted in sections 593 and 595 for subjecting these organizations to heavier Federal income taxes was a drastic modification 1977 U.S. Tax Ct. LEXIS 98">*106 of the bad debt reserve provisions. Under section 593(c), these associations were directed to maintain three accounts to which additions were to be made with respect to bad debts: (1) A reserve for "losses on qualifying real property loans," (2) a reserve for "losses on nonqualifying loans," and (3) a supplemental reserve for losses on loans. See Leesburg Federal Savings & Loan Association v. Commissioner, 55 T.C. 378">55 T.C. 378, 55 T.C. 378">383 (1970). The additions to the first two of these reserves are designed to determine the amount deductible under section 166(c) as a reasonable addition to the reserve for bad debts. These two accounts function "as a substitute for deduction of debts as they are determined to be worthless." Levelland Savings & Loan Assoc. v. United States, 421 F.2d 243">421 F.2d 243, 421 F.2d 243">246 (5th Cir. 1970). ^{61977 U.S. Tax Ct. LEXIS 98">*107}

68 T.C. 310">*315 Additions to the reserve for losses on qualifying real property loans, which are involved in the instant case, are to be made pursuant to certain prescribed methods, including the "percentage of taxable income method." ^{71977 U.S. Tax Ct. LEXIS 98">*108} Under this method, used by Metropolitan during the years in controversy, an amount determined to be to the excess of 60 percent of the taxable income (computed without this deduction) over the amount allowed for nonqualifying loans was to be added to the bad debt reserve. But the addition could not exceed the amount necessary to increase the balance as of the close of the taxable year to 6 percent of the loans outstanding at such time and was subject to other limitations not pertinent in this case.

For the years 1977 U.S. Tax Ct. LEXIS 98">*109 in controversy, petitioner claimed and was allowed the maximum permissible addition to its reserve for losses from qualifying loans and, consequently, the maximum permissible bad debt deduction under section 166. In addition, petitioner deducted under section 162 the expenses incurred 68 T.C. 310">*316 in selling the foreclosed property, and respondent denied those deductions. ^{81977 U.S. Tax Ct. LEXIS 98">*110}

While there are ambiguities in section 595, we agree with respondent that the most reasonable interpretation of the section is that all the tax results of foreclosures, including the expense of disposing of the foreclosed property, are to be accounted for through adjustments to the association's reserve for losses from qualifying loans. The foreclosed property becomes a substitute for the debt. Any amount realized with respect to such property is treated as a payment on account of the debt, and any loss with respect to such property is treated as a bad debt.

Prior to the enactment of section 595(a), gain or loss on a foreclosure, where a creditor-association bought in mortgaged property, was measured by the difference between the amount of the obligations of the debtor applied to the purchase or bid price and the fair market value of the foreclosed property. ⁹68 T.C. 310">*317 Upon the subsequent sale of property, still another taxable event occurred, with the creditor-association recognizing capital gain or loss or ordinary gain or loss, depending on whether the foreclosed property was a capital asset, property 1977 U.S. Tax Ct. LEXIS 98">*111 held primarily for sale in the ordinary course of business, or real property used in the taxpayer's business. S. Rept. 1881, 87th Cong., 2d Sess. 47 (1962), 1962-3 C.B. 704, 753; sec. 1.166-6(c), Income Tax Regs.

Sections 593 and 595, as we read them, were intended to telescope the foreclosure, purchase, and resale of such property and treat 1977 U.S. Tax Ct. LEXIS 98">*112 them as a single transaction so that there would be only one taxable event rather than two. And the tax consequences of that single event were to be determined not by reporting the gain or loss on the sale of the foreclosed property, as such, but through a credit or charge to the reserve for losses on qualifying real property loans. If the amounts received from the sale of the property are less than the unpaid indebtedness, a charge will be made to the reserve account. If such amounts exceed the indebtedness, a credit is made to that account. The proper charge or credit to the reserve account can be computed only by taking selling expenses as well as foreclosure costs into account. Thus, S. Rept. 1881, 87th Cong., 2d Sess. 48 (1962), 1962-3 C.B. at 754, explains:

When the property is ultimately sold or disposed of, the difference between any amount realized and the original or previously reduced debt, is to be treated as ordinary loss or income and is to be charged, or credited, as the case may be, against the reserve for losses on qualifying real property loans.

Petitioner pins its case mainly upon the technical terms used in section 595.

First, petitioner has pointed out that section 595(b)1977 U.S. Tax Ct. LEXIS 98">*113 provides that the foreclosed property "shall be considered as property having the same characteristics as the indebtedness for which such property was security." Since the costs of servicing indebtedness due an association are deductible as business expenses under section 162(a), petitioner has argued that the costs of liquidating foreclosed property should be similarly so deductible. But this argument overlooks the fact that the section 595(b) language on which petitioner relies is introduced with the limitation "For purposes of sections 166 and 1221." No mention is made of section 162(a). If any implication 68 T.C. 310">*318 is to be drawn from this language, it is that the absence of any reference to section 162(a) reflects a congressional intent that all expenses, including those related to the sale of the foreclosed property, are to be treated under the section 166 bad debt provisions.

Next, petitioner maintains that the term "amount realized," used in the second sentence of section 595(b), has the same meaning as it is given in section 1001(b) -- "the sum of any money received plus the fair market value of the property (other than money) received." Thus, petitioner would read section 595(b) to 1977 U.S. Tax Ct. LEXIS 98">*114 provide that the gross proceeds of the sale of foreclosed property, undiminished by any selling expenses, should be treated as a payment on the indebtedness, leaving the selling expenses to be separately deducted under section 162(a).

But "amount realized" as used in the Code is not always limited by the literal provisions of section 1001(b). It is a term which takes its meaning from the context in which it is used. It may include the amount of a mortgage assumed by the purchaser or even the amount of a mortgage to which the property was subject at the time of the sale. Crane v. Commissioner, 331 U.S. 1">331 U.S. 1, 331 U.S. 1">13-14 (1947); Parker v. Delaney, 186 F.2d 455">186 F.2d 455, 186 F.2d 455">457-458 (1st Cir. 1950). In connection with the sale or exchange of residences under section 1034, the "amount realized" is computed by subtracting from the consideration received upon the sale precisely the same kinds of expenses as are here in dispute -- commissions and expenses of advertising the property for sale, of preparing the deed, etc. Sec. 1.1034-1(b)(4), Income Tax Regs.^{101977 U.S. Tax Ct. LEXIS 98">*115}

68 T.C. 310">*319 The Senate Committee Report accompanying the enactment of section 595 in 1977 U.S. Tax Ct. LEXIS 98">*116 explaining the operation of the section uses both the term "amount received" and the term "amount realized." S. Rept. 1881, 87th Cong., 2d Sess. 47-48 (1962), 1962-3 C.B. 753. The regulations define "amount realized" as used in section 595 to mean "an amount representing a recovery of capital, such as proceeds from the sale or other disposition of the property, payments on the original indebtedness made by or on behalf of the debtor" (including amounts received under Federal Housing Administration insurance contracts and Veterans' Administration guarantees), and collections on deficiency judgments obtained against the debtor. Sec. 1.595-1(e)(6), Income Tax Regs. Thus, as used in section 595, the term means the amount obtained by the lending association on the foreclosure and disposition of the security property which is available for application on the borrower's indebtedness. Such amount can be computed only by taking into account the selling expenses as well as the acquisition expenses.

From the standpoint of a foreclosing loan association attempting to collect a debt which has gone bad, the expenses of selling the foreclosed property are as much a part of the cost thereof as the 1977 U.S. Tax Ct. LEXIS 98">*117 expense of acquiring title to it. ^{111977 U.S. Tax Ct. LEXIS 98">*118} The proceeds of the sale used to offset one such set of expenses represent the "recovery of capital," sec. 1.595-1(e)(6), Income Tax Regs., as much as the other. In Woodward v. Commissioner, 397 U.S. 572">397 U.S. 572, 397 U.S. 572">576 (1970), dealing with whether litigation expenses with respect to a capital asset should be 68 T.C. 310">*320 capitalized or deducted, the Supreme Court observed that "such ancillary expenses [legal, brokerage, accounting, and/or similar costs] incurred in acquiring or disposing of an asset are as much part of the cost of that asset as is the price paid for it [emphasis added]." "[We] cannot see why the order in which these operations occurred * * * should make any difference in the characterization of the expenses." United States v. Hilton Hotels Corp., 397 U.S. 580">397 U.S. 580, 397 U.S. 580">584 (1970). ^{121977 U.S. Tax Ct. LEXIS 98">*119} Both sets of expenses must be paid before the lending institution can realize anything for application on the defaulted debt. The property may be a capital asset or may be held primarily for sale, but the expenses of selling the foreclosed property are inherently capital in nature.

To avoid the impact of this reasoning, petitioner emphasizes that its foreclosures were "regular," "systematic," "ordinary," and "necessary" and argues that, therefore, its selling expenses are deductible under section 162(a). Implicit in this argument is a concession that, where the foreclosed property is a capital asset in the hands of the lending institution, the selling expenses must be capitalized. But adoption of this position would require a determination of the character of the business activities of the lending institution and would thus reopen an issue which section 595 was intended to set at rest.

Prior to the enactment of section 595, there was confusion as to whether property foreclosed by savings and loan associations should be treated 1977 U.S. Tax Ct. LEXIS 98">*120 as capital assets, property held primarily for resale, or property used in the taxpayer's business within the meaning of section 1231. ¹³The committee68 T.C. 310">*321 report accompanying the enactment of section 595 (S. Rept. 1881, 87th Cong., 2d Sess. 47-48 (1962), 1962-3 C.B. 753-754, explains:

Under existing law the foreclosure event is considered a taxable transaction. This has been interpreted to mean that a bad-debt deduction may or may not arise at that time, depending upon the relation of the bid price of the property to the amount of the loan outstanding. Where the foreclosed property is bid in for the amount of the loan a bad debt deduction may not be taken under present law; however, a gain or loss may result at the time of foreclosure if the fair market value of property foreclosed is different from the price at which it was bid in. When the property is subsequently sold by the mutual savings institution, it may realize a further gain or loss on such disposition. Whether the gains and losses at the time of foreclosure and at the time of ultimate disposition are capital or ordinary gains and losses depends on the nature of the activities of the institution at each such time.

The bill 1977 U.S. Tax Ct. LEXIS 98">*121 seeks to avoid these erratic results by providing that in the future a foreclosure is not to be treated as a taxable event, and that amounts received by the mutual savings institution subsequent to the foreclosure are to be treated as payments on the indebtedness. This would be accomplished under the bill by treating the property received in a foreclosure (or other proceeding) as having the same characteristics as the debt for which it was security. Thus, for bad-debt (or loss) purposes the act of foreclosure will not create a taxable occasion; * * *

[Emphasis added.]

The difference between the amount received and the original or previously reduced debt is to be treated as ordinary loss or income and is to be charged, or credited, as the case may be, against the reserve for losses on qualifying real property loans. Since petitioner's position would require a finding on the "nature of the activities" of the lending institution at the time of the sale, it would frustrate this declared purpose to avoid the "erratic results" of making each case depend on its individual facts. It would ignore the express provision of section 595(b) that "For purposes of sections 166 and 1221" such foreclosed 1977 U.S. Tax Ct. LEXIS 98">*122 property "shall be considered as property having the same characteristics as the indebtedness" it secured.

Moreover, petitioner in effect concedes that "amount realized" does not always mean gross sales proceeds. 1977 U.S. Tax Ct. LEXIS 98">*123 When 68 T.C. 310">*322 the foreclosing lending institution under State law is accountable to the borrower for receipts and the borrower is accountable for expenses, petitioner concedes that selling and other expenses are not deductible but, instead, increase the savings and loan association's basis in the foreclosed property and ultimately are credited to the reserve for losses on qualified loans. Yet in most instances, unless the gain on the foreclosure exceeds the amount of the debt, the net amount ultimately received and applied on the borrower's debt is the same, whether or not the borrower and lender are separately accountable for specific expenses. In that event, the entire gain on the sale is applied on the debt. There is nothing in the language of section 593 or 595 or their legislative history even suggesting that Congress intended to make the issue as to whether selling expenses should be credited or charged to the reserve account or deducted under section 162(a) turn on State law.

To buttress this "accountability" argument, however, petitioner focuses on section 1.595-1(e)(7) and (8), Income Tax Regs. Petitioner interprets these regulations to allow a deduction for all postforeclosure 1977 U.S. Tax Ct. LEXIS 98">*124 expenses, including selling commissions and expenses, where under State law the borrower in default is not accountable to the creditor for such expenditures. As we view those regulations, however, such an interpretation is erroneous.

The specific language relied on by petitioner is found in section 1.595-1(e)(7), Income Tax Regs., which in pertinent part provides as follows:

Section 595 does not change the treatment of rents, royalties, dividends, interest, or similar amounts received or accrued by the creditor with respect to acquired property, nor does it change the treatment of expenses incurred with respect to such property.

Petitioner points to examples (1) and (2) of section 1.595-1(e)(8), Income Tax Regs., ^{141977 U.S. Tax Ct. LEXIS 98">*126 1977 U.S. Tax Ct. LEXIS 98">*127 1977 U.S. Tax Ct. LEXIS 98">*128} which explain the treatment to be

68 T.C. 310">*324 accorded items of income received by, and expenses incurred by, a creditor during the interim period between the foreclosure and the sale of the property. Those examples, however, deal only with costs of maintaining property held by the creditor while it is rented, and nothing in the language of the examples outlines the treatment of selling expenses and commissions. When viewing the language of section 1.595-1(e)(7), Income Tax Regs., 1977 U.S. Tax Ct. LEXIS 98">*125 and the examples outlined in section 1.595-1(e)(8), Income Tax Regs., the only logical premise which can be drawn is that items of income and expenses generated by income-producing property must be allocated according to accountability for such items under State law. They do not purport to deal with expenses incurred in selling the foreclosed property.

The only provisions in section 595 and its accompanying regulations, dealing with costs similar to those in issue, are found in section 595(c) and section 1.595-1(d), Income Tax Regs.Section 595(c) states that the basis of foreclosed property in the hands of the creditor shall be the basis of the secured indebtedness, properly increased for the cost of acquisition. 1977 U.S. Tax Ct. LEXIS 98">*129 Such costs of acquisition are described in section 1.595-1(d), Income Tax Regs., as follows:

expenditures incurred by the creditor (for example, fees for an attorney, master, trustee, auctioneer, for publication, acquiring title, clearing liens, filing and recording, and court costs) * * *

These costs of acquisition are virtually identical to the selling commissions and expenses here at issue, and in our view, it would be an unwarranted inconsistency to apply such costs on the acquisition of property to the reserve for losses on qualifying real property loans but to deduct under section 162(a) the same type of expenditures on the subsequent resale of the same property.

In summary, we conclude the following:

(1) Commissions and other selling expenses ¹⁵ are not deductible under section 162 as ordinary and necessary expenses of petitioner's business.

68 T.C. 310">*325 (2) 1977 U.S. Tax Ct. LEXIS 98">*130 Commissions and other selling expenses must be accounted for through appropriate charges or credits to petitioner's reserve for losses on qualifying real property loans as provided in section 595(b) and its supporting regulations. ¹⁶

To reflect the foregoing,

Decision will be entered under Rule 155.