Source: https://www.efirstbank1031.com/advancedTopics/residenceTopics_relatedPartyRules_teruyaBrothers.htm
Timestamp: 2019-04-22 07:09:04+00:00

Document:
Sidney R. Thomas, Circuit Judges.
Renee M.L. Yuen, Honolulu, Hawaii, for the petitioner-appellant.
Nathan J. Hochman, Assistant Attorney General, Jonathan S. Cohen, Bridget M. Rowan, Attorneys, Tax Division, Department of Justice, Washington, D.C., for the respondent-appellee.
Teruya Brothers, Ltd. ("Teruya") is a Hawaii corporation involved in, among other things, the purchase and development of residential and commercial real estate. This appeal concerns the tax treatment of real estate transactions involving two of Teruya’s properties, the Ocean Vista condominium complex ("Ocean Vista"), and the Royal Towers Apartment building ("Royal Towers").
Teruya owned a fee simple interest in a parcel of land underlying the Ocean Vista complex in Honolulu, Hawaii. Golden Century Investments Company ("Golden") held a long-term lease on the land, and the Association of Apartment Owners of Ocean Vista ("the Association") held a sublease on the property.
In March 1993, the Association wrote to Teruya, inquiring about the possibility of purchasing Ocean Vista. Teruya responded that it was not interested in selling, though it later told Golden, which was also interested in the property, that it might part with the land through a like-kind exchange.
Following a series of negotiations, Golden sent a letter of intent to purchase Ocean Vista from Teruya for $1,468,500. It also offered its cooperation "so that Teruya can effectuate a [ § ] 1031 tax deferred exchange of Teruya’s [i]nterests." The letter of intent was later amended to state, "It is understood and agreed that Teruya’s obligation to sell Teruya’s interests to [Golden] is conditioned upon Teruya consummating a [ § ] 1031 tax deferred exchange of Teruya’s [i]nterests."
In June 1994, Teruya proposed purchasing real property known as Kupuohi II from Times Super Market, Ltd. ("Times"), a company in which it owned 62.5% of the common shares. The proposal stated that "The purchase will be subject to a [ § ] 1031 four party exchange," and allowed Teruya to cancel the proposed purchase "should the Ocean Vista transaction fail to proceed according to present plans." Times agreed to sell Kupuohi II for $2,828,000.
On April 3, 1995, the Association made a formal offer to purchase Ocean Vista for $1,468,500, 2 which Teruya accepted. The parties’ contract provided that "Teruya may, in its sole discretion, structure this transaction as a tax-deferred exchange pursuant to section 1031 of the Internal Revenue Code." The contract also included as a condition precedent to the sale that "Teruya shall be in a position to close on its exchange replacement properties."
In August, T.G. Exchange, Inc. ("TGE") contracted to act as an "exchange party to complete the exchange" of Ocean Vista. TGE would convey Ocean Vista to the Association, and then acquire replacement property for Teruya with the Ocean Vista sale proceeds, all with the stated purpose of qualifying the exchange under 26 U.S.C. § 1031. Teruya agreed to identify suitable replacement property, and to provide any funds in excess of the Ocean Vista sale proceeds needed to purchase the replacement property. The parties agreed that if Teruya could not locate suitable replacement property, the contract between Teruya and TGE would be terminated.
On September 1, 1995, per the agreement, TGE sold Ocean Vista to the Association for $1,468,500. That same day, TGE used the proceeds from the Ocean Vista sale along with an additional $1,366,056 from Teruya to purchase Kupuohi II from Times for $2,828,000. 3 TGE then transferred Kupuohi II to Teruya.
Teruya’s basis in Ocean Vista was $93,270, but it deferred recognizing gain on its $1,345,169 in post-expense profits under the like-kind exchange provisions of 26 U.S.C. § 1031. Times had a basis in Kupuohi II of $1,475, 361, and realized and recognized a $1,352,639 gain on the property’s sale. Times paid no tax on this gain, however, because it had a large net operating loss for the tax year in question.
In sum, before the transaction Teruya owned Ocean Vista and Times owned Kupuohi II. After the exchange, Teruya owned Kupuohi II, the Association owned Ocean Vista, and Times had the cash from the sale of Ocean Vista (along with additional funds from Teruya).
The Royal Towers exchange substantially mirrored the Ocean Vista transaction.
In 1994 Teruya owned a fee simple interest in Royal Towers, an apartment complex in Honolulu, Hawaii. Late that year, Teruya agreed to sell Royal Towers to Savio Development Company ("Savio") for $13.5 million (later negotiated down to $11,932,000). As with the Ocean Vista transaction, this agreement was expressly conditioned on Teruya successfully completing a § 1031 exchange.
Anticipating that Royal Towers would soon be sold, in September 1994 Teruya sent Times a letter of intent to purchase two pieces of land known respectively as Kupuohi I and Kaahumanu. The letter was materially identical to the one Teruya sent to Times regarding Kupuohi II, and stated that "[t]he purchase will be subject to a [ § ] 1031 four party exchange," and that Teruya could cancel the proposed purchase "should the sale of the Royal Towers apartment fail to proceed according to present plans." Both companies’ boards of directors approved the two properties’ sale in early 1995, with Kupuohi I to be sold for $8,900,000, and Kaahumanu for $3,730,000.
In August 1995, Teruya contracted with TGE in order to qualify the exchange under § 1031. Similar to its agreement concerning the Ocean Vista exchange (which would be signed two days later), TGE would convey Royal Towers to Saito, acquiring replacement property for Teruya with the Royal Tower sale proceeds. Teruya agreed to identify suitable replacement property, and to provide any funds in excess of the Royal Towers sale proceeds needed to purchase the replacement property. The parties agreed that if Teruya could not locate suitable replacement property, the agreement between Teruya and TGE would be terminated.
TGE sold Royal Towers to Saito on August 24, 1995 for $11,932,000. Also on August 24, TGE used the proceeds from the Royal Towers sale along with $724,554 in additional funds from Teruya to purchase Kupuohi I and Kaahumanu from Times for $8,900,000 and $3,730,000, respectively. TGE then transferred the two properties to Teruya.
Teruya’s basis in Royal Towers was $670,506, but it deferred the recognition of its $10,700,878 in post-expenses profits under 26 U.S.C. § 1031. Times had a basis in Kaahumanu of $1,502,960, and realized and recognized a $2,227,040 gain on the property’s sale. Just as with Kupuohi II, though, Times paid no tax on this gain because it had a large net operating loss for the tax year in question.
In sum, before the exchanges Teruya owned Royal Towers and Times owned Kupuohi I and Kaahumanu. Afterwards, Teruya owned Kupuohi I and Kaahumanu, Savio owned Royal Towers, and Times held the cash from the sale of Royal Towers to Savio (along with additional funds from Teruya).
On its corporate income tax return for the taxable year ending March 31, 1996, Teruya, pursuant to 26 U.S.C. § 1031, deferred gain of $1,345,169 from the Ocean Vista transaction, and $10,700,878 from the Royal Towers transaction.
Rejecting Teruya’s treatment of the exchanges, the IRS issued Teruya a notice of deficiency of $4,144,359 for the tax year ending March 31, 1996. Teruya petitioned the Tax Court for a redetermination. The Tax Court considered the petition on the basis of stipulated facts, and it affirmed the IRS’s non recognition treatment in a published opinion. See Teruya Bros., Ltd. & Subsidiaries v. Comm’r of Internal Revenue, 124 T.C. 45 (2005). This timely appeal followed.
26 U.S.C. § 1031(a)(1) is a well-worn exception to the general rule that taxpayers must recognize gains or losses realized from the disposition of property in the year of realization. See 26 U.S.C. § 1001(c). Rather, in a so-called "section 1031" exchange, gain realized on the exchange of like-kind property held for productive business use or investment need not be recognized until the acquired property is finally disposed of. To preserve the appropriate tax consequences, the taxpayer retains his original basis in the newly acquired property. Id. at § 1031(d).
The concept behind this exception derives from the assumption that when an investor exchanges a piece of property for another of like-kind, he is merely continuing an ongoing investment, rather than ridding himself of one investment to obtain another. See Starker v. United States, 602 F.2d 1341, 1352 (9th Cir. 1979) ("The legislative history [of § 1031] reveals that the provision was designed to avoid the imposition of a tax on those who do not ’cash in’ on their investments in trade or business property."). "In effect, the nonrecognition provisions further defer tax consequences when, notwithstanding an exchange, the taxpayer maintains a continuing interest in similar property." 2 Boris Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts, (3d ed. 2000), ¶ 44.1.1.
[A]ssume T owns Blackacre, which is worth $100 and has a basis of $20, and her wholly owned corporation, C Corp., owns like kind property (Whiteacre), which is also worth $100 but has a basis of $140; T and C swap, and C immediately sells Blackacre to an unrelated person. If T had sold Blackacre, she would have recognized gain of $80, but C, whose $140 basis for Whiteacre becomes its basis for Blackacre, recognizes loss of $40. . . . [T]he presale exchange. . . [has] the effect of deferring recognition of T’s potential gain and accelerating recognition of C’s $40 loss.
Congress also included § 1031(f)(4), which provides that a taxpayer may not claim nonrecognition treatment under § 1031 for "any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of [ § 1031(f)]."
We review the Tax Court’s conclusions of law and interpretations of the tax code de novo. Westpac Pac. Food v. Comm’r of Internal Revenue, 451 F.3d 970, 974 (9th Cir. 2006). We review the Tax Court’s factual findings, including factual inferences drawn from a stipulated record, for clear error. Smith v. Comm’r of Internal Revenue, 300 F.3d 1023, 1028 (9th Cir. 2002).
Involved in this type of exchange is a taxpayer desiring to exchange property, a prospective purchaser of the taxpayer’s property, a prospective seller of the property the taxpayer wishes to receive in exchange, and a fourth party. In a simultaneously executed transaction (usually done through escrow) the fourth party receives the taxpayer’s property and sells that property to the prospective purchaser. With the funds he receives, he purchases the prospective seller’s property and then transfers that property to the taxpayer. When the smoke has cleared, the taxpayer has exchanged his property in a so-called 1031 transaction, the prospective purchaser has the taxpayer’s property, the prospective seller has cash, and the fourth party, with the exception of agreed compensation, nothing.
The government also does not argue that § 1031(f)(1)’s restrictions on direct exchanges between related parties encompass these indirect transactions. For like-kind exchanges conducted through a qualified intermediary, as these were, "the qualified intermediary is not considered the agent of the taxpayer for purposes of section 1031(a)." 26 C.F.R. § 1.1031(k)-1(g)(4)(i). Teruya, therefore, may be said to have exchanged properties with TGE, not "with a related person," as required to implicate § 1031(f)(1).
 Thus, these exchanges may only be denied nonrecognition treatment if they were "part of a transaction (or series of transactions) structured to avoid the purposes of [ § 1031(f)]." § 1031(f)(4).
The first step in determining whether these transactions were structured to avoid § 1031(f)’s purposes is, of course, identifying what those purposes are. To discern a statute’s purposes, "we look first to the language of the statute and second to its legislative history." In re Stringer, 847 F.2d 549, 551 (9th Cir. 1988). In this case, though, the statute’s text provides precious few clues as to Congress’s intent. Section 1031(f)’s existence alone tells us that Congress wanted to limit the ability of related parties to claim nonrecognition treatment for § 1031 exchanges. But, given that Teruya’s exchanges are not expressly covered under § 1031(f)(1), it would beg the question to conclude from the statute’s text alone that Congress wanted to deny these transactions nonrecognition treatment.
Accordingly, we turn to § 1031(f)’s legislative history.
 The House Report accompanying § 1031(f) establishes that one of Congress’s primary concerns in passing this legislation was its belief "that the ’like-kind’ standard as applied to exchanges of property [wa]s too broad." H.R. Rep. No. 101-247, pt. 6, at 1340 (1989). "Under present law, taxpayers have been granted nonrecognition treatment . . . in circumstances where they have significantly changed their investment as a result of the exchange or conversion." Id. Instead, the committee felt "it is appropriate to accord nonrecognition treatment only to exchanges and conversions where a taxpayer can be viewed as merely continuing his investment." Id.
Because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties have engaged in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale. Basis shifting also can be used to accelerate a loss on retained property. The committee believes that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ’cashed out’ of the investment, and the original exchange should not be accorded nonrecognition treatment.
[I]f a taxpayer, pursuant to a prearranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031.
 With this legislative background in mind, we conclude that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of § 1031(f)(4). Under the guise of a like-kind exchange, the transactions allowed related parties to receive nonrecognition treatment while cashing out of investments using § 1031’s basis-shifting provisions. Precluding this type of tax result was one of Congress’s primary aims in enacting § 1031(f)(4).
 We first reject Teruya’s contention that the economic consequences of these transactions to Times are irrelevant to our inquiry, and that Teruya’s continued investment in real property is dispositive. Section 1031(f)(1)(C)(i) disallows nonrecognition treatment if the related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party’s economic position in aggregate is often the only way to tell if § 1031(f) applies. Moreover, Congress’s concern about related taxpayers acting in concert, as well as the House Report’s admonition that exchanges should not be accorded nonrecognition treatment where "the related parties have, in effect, ’cashed out’ of" the investment," H.R. Rep. No. 101-247, pt. 6, at 1340 (emphasis added), confirm that the taxpayer and the related party should be treated as an economic unit in this inquiry. Taxpayers cannot escape § 1031(f) simply by hiding the benefits of improper like-kind exchanges with a related party.
 Here, the changing economic positions of Teruya and Times readily show that the related parties used these exchanges to cash out of an investment in low-basis real property. Before the exchanges, Teruya owned Ocean Vista and Royal Towers, and Times owned Kupuohi I, Kupuohi II, and Kaahumanu. After the exchanges, Ocean Vista and Royal Towers had been sold, Teruya owned Kupuohi I, Kupuohi II, and Kaahumanu, and Times now had the cash from the Ocean Vista and Royal Towers sale (along with boot from Teruya). All in all, Teruya and Times decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount. By allowing Teruya and Times to cash out of a significant investment in real property under the guise of a non-taxable like-kind exchange, these transactions were undoubtedly structured in contravention of Congress’s desire that nonrecognition treatment only apply to transactions "where a taxpayer can be viewed as merely continuing his investment." See H.R. Rep. No. 101247, pt. 6, at 1340.
Our initial conclusion that these transactions were structured to avoid § 1031(f)’s purposes does not end our inquiry, for Teruya argues, and the Tax Court held below, that § 1031(f)(2) provides an additional limitation on § 1031(f)(4)’s scope.
 By their plain language, § 1031(f)(2)’s exceptions only apply to exchanges that violate § 1031(f)(1), which, as discussed above, these exchanges do not. Still, the Tax Court held below that "[b]ecause [ § 1031(f)(2)] is subsumed within the purposes of § 1031(f), any inquiry into whether a transaction is structured to avoid the purposes of section 1031(f) should also take this exception into consideration." Teruya Brothers, 124 T.C. at 53. We agree. Section 1031(f)(4) denies nonrecognition treatment only to those transactions that violate § 1031(f)(1)’s purposes. As transactions falling within § 1031(f)(2)’s exceptions by their very nature do not violate those purposes, § 1031(f)(2) must independently limit § 1031(f)(4)’s scope. In other words, a transaction does not violate § 1031(f)(4) if the taxpayer can establish "to the satisfaction of the Secretary" that the transaction did not have "as one of its principal purposes the avoidance of Federal income tax."
 For the aforementioned reasons, we affirm the Tax Court’s determination that these exchanges were structured to avoid the purposes of § 1031(f), and thus violate § 1031(f)(4).
1 Except where otherwise noted, all statutory references are to the Internal Revenue Code.
2 Teruya, Golden, and the Association had executed an Assignment, Assumption, and Release which substituted the Association for Golden.
3 As the Tax Court noted below, some of the numbers in the parties’ stipulation of facts yield computational inconsistencies. Where the Tax Court made express findings as to the correct figures, we adopt and incorporate those determinations. As the precise numbers involved are not relevant to this appeal, we otherwise leave in place the parties’ stipulated figures without further notation.
4 The definition of "related person" is drawn from 26 U.S.C. §§ 267(b) and 707(b)(1), and includes, inter alia, family members, partnerships, and entities over which the taxpayer has control (or which control the taxpayer). See 26 U.S.C. § 1031(f)(3). Teruya has stipulated that at all times relevant to this litigation it and Times were "related parties."
§ 1031(f). Special rules for exchanges between related persons.
the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.
6 Nonrecognition treatment is also accorded to otherwise improper like-kind exchanges where the property is disposed of after the taxpayer’s or related party’s death, or in a compulsory or involuntary conversion. See § 1031(f)(2)(A)-(B).
7 The examination in this case began before the July 22, 1998 effective date of 26 U.S.C. § 7491, so that section’s burden-shifting rules do not apply here. See Internal Revenue Service Restructuring and Reform Act of 1998, Pub L. No. 105-206, Title III, § 3001(a), 112 Stat. 685, 726-27 (1998).
8 A qualified intermediary is a person, not the taxpayer or one closely related to him, who "[e]nters into a written agreement with the taxpayer . . . and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer." 26 C.F.R. § 1.1031(k)-1(g)(4)(iii).
9 We do not imply that taxpayers are precluded from using a qualified intermediary to facilitate a like-kind exchange with a related party. Qualified intermediaries may provide legitimate services to facilitate complex (but permissible) exchanges, such as by assisting with escrow. However, given the facts of this case, we conclude that the Tax Court did not clearly err in inferring that the qualified intermediary was interposed in this case in an attempt to circumvent the § 1031(f)(1) limitations. The government argues that every deferred exchange between related parties involving a qualified intermediary should be recast as a direct exchange between the related parties. Under that analysis, the government argues, if § 1031(f)(1) would preclude nonrecognition treatment for the recast transaction, then the deferred exchange should be deemed to have been structured to avoid the purposes of § 1031(f). The Tax Court properly rejected that mechanical theory as inconsistent with the structure of the statute.
§ 1031(f). Special rules for exchanges between related persons. . . .
11 In other contexts involving similar language, courts have disagreed on the standard to apply in reviewing whether a taxpayer has established a fact "to the satisfaction of the Secretary." Compare R.E. Dietz Corp. v. United States, 939 F.2d 1, 5 (2d Cir. 1991) (applying arbitrary and capricious standard), with Schoneberger v. Comm’r of Internal Revenue, 74 this T.C. 1016, 1024 (1980) (applying "strong proof" standard). We need not decide the appropriate standard to apply, nor do we interpret the precise contours in this context of the phrase "to the satisfaction of the Secretary."
12 Theoretically, the tax price to Times from reducing its net operating losses may have equaled or even exceeded the tax Teruya deferred, particularly in the Ocean Vista transaction. See generally Kelly Alton et al., Related-Party Like-Kind Exchanges, 115 TAX NOTES 467, at *26-27 (2007). We need not determine whether this possibility would evince a non-tax avoidance purpose, as Teruya has not argued the point on appeal.
13 The Conference Committee Report to § 1031(f) suggests several kinds of transactions between related parties that "generally" will not have unwarranted tax avoidance as a principal purpose, such as exchanges that do not involve basis shifting. See 101 H.R. Conf. Rep. No. 386, at 614. Teruya has not argued that its exchanges fall within these exceptions.

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