Teruya Brothers, Ltd v. Cir

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.