Court Opinion

ID: 3065079
Source: CourtListenerOpinion
Date Created: 2015-10-14 22:28:45.802071+00
Date Added: 2024-06-11T11:41:24.298664
License: Public Domain

FOR PUBLICATION
 UNITED STATES COURT OF APPEALS
      FOR THE NINTH CIRCUIT

TERUYA BROTHERS, LTD, and             
SUBSIDIARIES,
                                           No. 05-73779
              Petitioner-Appellant,
                v.                         Tax Ct. No.
                                             17955-03
COMMISSIONER OF INTERNAL
                                            OPINION
REVENUE,
              Respondent-Appellee.
                                      
         Appeal from a Decision of the Tax Court
                  Argued and Submitted
          February 11, 2009—Honolulu, Hawaii

                 Filed September 8, 2009

      Before: Stephen Reinhardt, Melvin Brunetti, and
             Sidney R. Thomas, Circuit Judges.

                 Opinion by Judge Thomas

                           12623
12626 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE

                       COUNSEL

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, Depart-
ment of Justice, Washington, D.C., for the respondent-
appellee.
        TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12627
                              OPINION

THOMAS, Circuit Judge:

   This case requires us to determine whether two like-kind
exchanges involving related parties qualify for nonrecognition
treatment under 26 U.S.C. § 1031. Under the circumstances
presented by this case, we conclude that they do not, and we
affirm the judgment of the Tax Court. We have jurisdiction
over this appeal pursuant to 26 U.S.C. § 7482(a).1

                                     I

  Teruya Brothers, Ltd. (“Teruya”) is a Hawaii corporation
involved in, among other things, the purchase and develop-
ment 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”).

                                    A

   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.
  1
   Except where otherwise noted, all statutory references are to the Inter-
nal Revenue Code.
12628 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
   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 under-
stood and agreed that Teruya’s obligation to sell Teruya’s
interests to [Golden] is conditioned upon Teruya consummat-
ing 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 com-
mon 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 qual-
ifying 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
  2
   Teruya, Golden, and the Association had executed an Assignment,
Assumption, and Release which substituted the Association for Golden.
        TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12629
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).

                                    B

  The Royal Towers exchange substantially mirrored the
Ocean Vista transaction.

   In 1994 Teruya owned a fee simple interest in Royal Tow-
ers, an apartment complex in Honolulu, Hawaii. Late that
  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 incor-
porate those determinations. As the precise numbers involved are not rele-
vant to this appeal, we otherwise leave in place the parties’ stipulated
figures without further notation.
12630 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
year, Teruya agreed to sell Royal Towers to Savio Develop-
ment 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 success-
fully completing a § 1031 exchange.

   Anticipating that Royal Towers would soon be sold, in Sep-
tember 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 pur-
chase “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 BROTHERS v. COMM’R OF INTERNAL REVENUE 12631
   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 Kaahu-
manu 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.

   Times had a basis in Kupuohi I of $15,602,152, and real-
ized a capital loss of $6,453,372 on its sale. It did not recog-
nize this loss, however, because 26 U.S.C. § 267 prohibits the
recognition of losses from sales and exchanges of property
between “related parties.”4

  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).

                                    C

  On its corporate income tax return for the taxable year end-
ing 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-
  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 tax-
payer). 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.”
12632 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
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.

                               II

   26 U.S.C. § 1031(a)(1) is a well-worn exception to the gen-
eral 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 prop-
erty for another of like-kind, he is merely continuing an ongo-
ing 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 imposi-
tion of a tax on those who do not ‘cash in’ on their invest-
ments 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.

   Before 1989, taxpayers acting in concert could lawfully use
§ 1031 to defer the recognition of gain or accelerate the rec-
ognition of loss even as they cashed out of their investments,
as indicated by the following example:

    [A]ssume T owns Blackacre, which is worth $100
    and has a basis of $20, and her wholly owned corpo-
          TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12633
       ration, 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.

Id. ¶ 44.2.8.

   [1] Congress enacted § 1031(f) in 1989, largely eliminating
what it considered to be a tax loophole contained in the sec-
tion. See Omnibus Budget Reconciliation Act of 1989, Pub.
L. No. 101-239, § 7601, 103 Stat. 2106 (1989). Section
1031(f)(1) largely precludes the nonrecognition treatment of
gain or loss when a taxpayer exchanges like-kind property
with a related person, and when either party then disposes of
the exchanged property within two years.5
  5
   The subsection reads, in full:
      § 1031(f). Special rules for exchanges between related persons.
        (1) In general. If—
           (A) a taxpayer exchanges property with a related person,
           (B) there is nonrecognition of gain or loss to the taxpayer
      under this section with respect to the exchange of such property
      (determined without regard to this subsection), and
          (C) before the date 2 years after the date of the last transfer
      which was part of such exchange—
             i) the related person disposes of such property, or
              (ii) 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 nonrecog-
      nition 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 sub-
      paragraph (C) occurs.
12634 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
   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)].”

   Section 1031(f) includes several exceptions, as well. As rel-
evant here, exchanges that otherwise run afoul of
§ 1031(f)(1)’s requirements may still qualify for nonrecogni-
tion treatment where “it is established to the satisfaction of the
Secretary that neither the exchange nor [the subsequent prop-
erty] disposition had as one of its principal purposes the
avoidance of Federal income tax.” § 1031(f)(2)(C).6

                                   III

                                   A

   We review the Tax Court’s conclusions of law and inter-
pretations 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).

   [2] In conducting our analysis, we are mindful of the fact
that tax classifications “turn on ‘the objective economic reali-
ties of a transaction rather than . . . the particular form the par-
ties employed.’ ” Boulware v. United States, 128 S. Ct. 1168,
1175 (2008) (quoting Frank Lyon Co. v. United States, 435
U.S. 561, 573 (1978)). Exceptions to the general rule requir-
ing the recognition of all gains and losses on property disposi-
  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).
        TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12635
tions are to be “strictly construed and do not extend either
beyond the words or the underlying assumptions and purposes
of the exception.” 26 CFR 1.1002-1(b). Thus, “[n]onrecog-
nition is accorded by the Code only if the exchange is one
which satisfies both (1) the specific description in the Code of
an excepted exchange, and (2) the underlying purpose for
which such exchange is excepted from the general rule.” Id.7

                                   B

   [3] As an initial matter, the government quite properly con-
cedes that the Ocean Vista and Royal Towers transactions
both qualify as like-kind exchanges under § 1031(a)(1).
Indeed, although significantly more complex than “tradition-
al” two-party transactions, four-party like-kind exchanges like
those utilized here have existed for nearly as long as the
§ 1031 exception itself. See, e.g., Mercantile Trust Co. v.
Comm’r of Internal Revenue, 32 B.T.A. 82 (1935). The Tax
Court has succinctly described such exchanges’ general form:

      Involved in this type of exchange is a taxpayer desir-
      ing 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 tax-
      payer. When the smoke has cleared, the taxpayer has
      exchanged his property in a so-called 1031 transac-
  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).
12636 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
      tion, the prospective purchaser has the taxpayer’s
      property, the prospective seller has cash, and the
      fourth party, with the exception of agreed compensa-
      tion, nothing.

   Coupe v. Comm’r of Internal Revenue, 52 T.C. 394, 405
(1969) (citing Mercantile Trust, 32 B.T.A. 82). Applying this
framework to our case, Teruya is the taxpayer, Times the pro-
spective seller, the Association and Saito each prospective
purchasers, and TGE the “fourth party,” or qualified intermedi-
ary.8

   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).

   [4] Thus, these exchanges may only be denied nonrecogni-
tion 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 sec-
  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).
       TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12637
ond to its legislative history.” In re Stringer, 847 F.2d 549,
551 (9th Cir. 1988). In this case, though, the statute’s text pro-
vides 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 nonre-
cognition treatment.

  Accordingly, we turn to § 1031(f)’s legislative history.

   [5] The House Report accompanying § 1031(f) establishes
that one of Congress’s primary concerns in passing this legis-
lation 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 circum-
stances where they have significantly changed their invest-
ment 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 tax-
payer can be viewed as merely continuing his investment.” Id.

   [6] Congress also wanted to prevent related parties from
taking advantage of § 1031(d)’s basis-shifting provisions to
avoid gains or accelerate losses on cashed-out investments.
The House committee wrote:

       Because a like-kind exchange results in the substi-
    tution 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 recog-
    nition of gain on the subsequent sale. Basis shifting
    also can be used to accelerate a loss on retained
12638 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
      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 nonrecog-
      nition treatment.

Id.

   Finally, the House committee offered an example of a
transaction it intended § 1031(f)(4) to cover:

      [I]f a taxpayer, pursuant to a prearranged plan, trans-
      fers 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 nonrecogni-
      tion treatment under section 1031.

Id. at 1341.

                                C

   [7] With this legislative background in mind, we conclude
that the Tax Court did not err in determining that the transac-
tions 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 Con-
gress’s primary aims in enacting § 1031(f)(4).

  [8] 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
       TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12639
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 eco-
nomic unit in this inquiry. Taxpayers cannot escape § 1031(f)
simply by hiding the benefits of improper like-kind exchanges
with a related party.

   [9] 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 prop-
erty. 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 prop-
erty under the guise of a non-taxable like-kind exchange,
these transactions were undoubtedly structured in contraven-
tion 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. 101-
247, pt. 6, at 1340.

   Indeed, as Teruya could have achieved the same property
dispositions through far simpler means, it appears that these
transactions took their peculiar structure for no purpose
except to avoid § 1031(f). Teruya could have exchanged its
12640 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
properties directly with Times, followed by Times selling
Ocean Vista and Royal Towers to the third-party purchasers.
There was no need to use (and pay) a qualified intermediary.
The rub, of course, is that Teruya couldn’t have done this tax
free, as direct exchanges between related parties are ineligible
for nonrecognition treatment when the exchanged property is
sold within two years. Instead, Teruya employed TGE, whose
presence ensured that Teruya was technically exchanging
properties with the qualified intermediary, not with its related
party. TGE’s involvement in these transactions thus served no
purpose besides rendering simple — but tax disadvantageous
— transactions more complex in order to avoid § 1031(f)’s
restrictions.9

   Our initial conclusion that these transactions were struc-
tured 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.

   [10] As discussed previously, § 1031(f)(2) establishes sev-
eral circumstances where a related party exchange may still
qualify for nonrecognition treatment despite technically vio-
lating § 1031(f)(1). The broadest of these exceptions,
§ 1031(f)(2)(C), allows otherwise improper exchanges to earn
   9
     We do not imply that taxpayers are precluded from using a qualified
intermediary to facilitate a like-kind exchange with a related party. Quali-
fied 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 mechani-
cal theory as inconsistent with the structure of the statute.
           TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12641
nonrecognition treatment where “it is established to the satis-
faction of the Secretary that neither the exchange nor [the sub-
sequent] disposition had as one of its principal purposes the
avoidance of Federal income tax.”10

   [11] By their plain language, § 1031(f)(2)’s exceptions only
apply to exchanges that violate § 1031(f)(1), which, as dis-
cussed 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 transac-
tion 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 vio-
late § 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 satis-
faction of the Secretary” that the transaction did not have “as
one of its principal purposes the avoidance of Federal income
tax.”
  10
    The subsection reads:
       § 1031(f). Special rules for exchanges between related persons.
       ...
          (2) Certain dispositions not taken into account. For purposes of
       paragraph (1)(C), there shall not be taken into account any
       disposition—
            (A) after the earlier of the death of the taxpayer or the death
       of the related person,
            (B) in a compulsory or involuntary conversion . . . if the
       exchange occurred before the threat or imminence of such con-
       version, or
            (C) with respect to which it is established to the satisfaction
       of the Secretary that neither the exchange nor such disposition
       had as one of its principal purposes the avoidance of Federal
       income tax.
12642 TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE
  [12] Despite our determination that § 1031(f)(2) indepen-
dently limits § 1031(f)(4), we conclude that the record sup-
ports the Tax Court’s determination that the improper
avoidance of federal income tax was one of the principal pur-
poses behind these exchanges. We therefore affirm the Tax
Court’s denial of nonrecognition treatment to Teruya.11

   The Tax Court’s conclusion that these transactions were
structured for unwarranted tax avoidance purposes is sup-
ported by an examination of the tax consequences of the
Royal Towers exchange. Had Teruya sold Royal Towers
directly to Saito, it would have had to recognize nearly $11
million in gain. Because the transaction was presented as a
like-kind exchange, however, only Times, which sold Kupu-
ohi I and Kaahumanu to TGE, had to recognize any profit.
However, Kaahumanu had a much higher basis than Royal
Towers (relative to its fair market value), and Kupuohi I’s
basis far exceeded its fair market value. Thus, Times recog-
nized only $2.2 million in gain on the transaction, far less
than Teruya would have faced from the direct sale of Royal
Towers. Moreover, Times paid no tax on even this smaller
gain, as it was able to carry over net operating losses from
previous years. Similarly, in the Ocean Vista transaction,
though Times recognized gain virtually identical to that which
Teruya deferred, Times paid no tax due to its net operating
losses. Thus, the Teruya/Times economic unit achieved far
more advantageous tax consequences by employing this
  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 capri-
cious standard), with Schoneberger v. Comm’r of Internal Revenue, 74
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.”
        TERUYA BROTHERS v. COMM’R OF INTERNAL REVENUE 12643
unique structure than it would have had Teruya simply sold
its properties to the third-party buyers itself.12

   Teruya contends that it did not have an improper tax avoid-
ance purpose because it never had any fixed right to cash at
the time of these transactions; indeed, the exchanges could
only have been completed as § 1031(a) like-kind exchanges.
But this argument misses the point. Teruya’s undisputed
intent to complete successfully a like-kind exchange — per-
haps germane to whether the transactions were exchanges or
sales under § 1031(a) — is irrelevant to whether these trans-
actions were structured to avoid § 1031(f)’s purposes. More-
over, by focusing only on its own continued investment in
like-kind property, Teruya ignores the crucial tax conse-
quences of these exchanges to its related party, Times.13

                                   IV

  [13] 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).

   AFFIRMED.

  12
      Theoretically, the tax price to Times from reducing its net operating
losses may have equaled or even exceeded the tax Teruya deferred, partic-
ularly 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.