Rev. Rul. 81-169

ISSUE

Under the circumstances described below, is the exchange of a Series A bond of City X for a new Series AA bond of equal face amount a taxable transaction within the meaning of section 1001 of the Internal Revenue Code?

FACTS

A taxpayer, who reports income under the cash receipts and disbursements method of accounting, owned a Series A $1,000 bond of City X. The Series A bond bore interest at 9 percent, matured on February 1, 1996, and was subject to sinking fund payments calculated to provide for level debt service. City X was in default and could not pay interest on its bonds. As a result, City X proposed to issue a new Series AA bond for each Series A bond outstanding. The Series AA bond bears interest at 81/2 percent, matures February 1, 2006, and is not subject to sinking fund provisions. The taxpayer could either turn in the Series A bond for a Series AA bond or have the provisions of the Series AA bond stamped on the old bond. On the date that the taxpayer had the new provisions stamped on the old Series A bond, the fair market value of the Series A bond was $675 and the fair market value of the Series AA bond was $650.

LAW AND ANALYSIS

Section 1001 of the Code provides that gain or loss from the sale or other disposition of property will be determined by reference to the amount realized and the adjusted basis of such property, and will be recognized unless otherwise provided.

Section 1.1001-1(a) of the Income Tax Regulations provides that the gain or loss realized from the exchange of property for other property differing materially either in kind or in extent is treated as income or as loss sustained.

Rev. Rul. 73-160, 1973-1 C.B. 365, states that the income tax liability resulting from a particular transaction involving a change in the terms of outstanding securities is not controlled entirely by the mechanical means used for the accomplishment of the change. When the changes are so material as to amount virtually to the issuance of a new security, the same income tax consequences should follow as if the new security were actually issued. Each case of this nature must be governed by its own facts.

All of the changes in the terms of the bonds, taken together, result in a material difference in the terms. Therefore, the exchange constitutes a taxable exchange. The difference in the fair market value of the bonds is not a material factor in determining whether there is a taxable exchange. See Watson v. Commissioner, 8 T.C. 569 (1947), acq., 1947-2 C.B. 5; Emery v. Commissioner, 166 F.2d (2d Cir. 1948), aff'g. 8 T.C. 979 (1947); and Girard Trust Co. v. United States, 166 F.2d 773 (3rd Cir. 1948), aff'g. 69 E. Supp. 874 (E.D. Pa. 1947).

HOLDING

The exchange of the Series A bond for the Series AA bond is a taxable transaction within the meaning of section 1001 of the Code.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 56-435, 1956-2 C.B. 506, holds that the refunding of unmatured 51/2 percent water works Gold Bonds by the City of San Antonio by the issuance of 51/2 percent Revenue Bonds of the same face amount and maturing serially in the same year does not constitute a taxable exchange provided both types of bonds are of equal fair market value.

Rev. Rul. 56-435 is modified to remove the implication that nontaxability is conditioned on the equality of fair market value rather than the fact that there are no material differences in the terms of the bonds.