Teruya Bros., Ltd. v. CIR

Citations: 580 F.3d 1038; 104 A.F.T.R.2d (RIA) 6274; 2009 U.S. App. LEXIS 20022; 2009 WL 2855833Docket: 05-73779

Court: Court of Appeals for the Ninth Circuit; September 8, 2009; Federal Appellate Court

SummaryOriginalCytator Case TreatmentBackward CitatorAnalysis

EnglishEspañolSimplified EnglishEspañol Fácil

The case involves Teruya Brothers, Ltd. (Teruya), a Hawaii corporation, appealing a Tax Court decision regarding the nonrecognition treatment of two like-kind exchanges under 26 U.S.C. § 1031. The Ninth Circuit, led by Circuit Judge Thomas, determined that the exchanges did not qualify for tax deferral and affirmed the Tax Court's judgment. 

Teruya owned the Ocean Vista condominium complex and engaged in discussions to sell it to Golden Century Investments Company (Golden) while intending to utilize a like-kind exchange for tax benefits. The negotiations culminated in a letter of intent from Golden that conditioned the sale on Teruya's ability to execute a 1031 exchange. Teruya also sought to acquire a property called Kupuohi II from Times Super Market, Ltd. (Times), in which it held a majority stake, intending to structure this transaction as part of a four-party exchange.

After formalizing the sale of Ocean Vista to the Association of Apartment Owners of Ocean Vista for $1,468,500, Teruya arranged for T.G. Exchange, Inc. (TGE) to facilitate the transactions. TGE was responsible for selling Ocean Vista and using the proceeds to purchase Kupuohi II, with Teruya contributing additional funds as needed. Ultimately, TGE sold Ocean Vista and subsequently purchased Kupuohi II, which was then transferred to Teruya. The court's examination centered on whether these related-party transactions could meet the requirements for nonrecognition under the tax code.

Teruya's initial basis in Ocean Vista was $93,270, with $1,345,169 in post-expense profits deferred under 26 U.S.C. 1031. Times had a basis of $1,475,361 in Kupuohi II and recognized a $1,352,639 gain from its sale, but paid no tax due to a significant net operating loss. After the exchange, Teruya acquired Kupuohi II, the Association obtained Ocean Vista, and Times received cash from the sale. 

In 1994, Teruya, owning Royal Towers, planned to sell it to Savio Development Company for $13.5 million (later reduced to $11,932,000), contingent on completing a 1031 exchange. In anticipation, Teruya sent Times a letter of intent to purchase Kupuohi I and Kaahumanu, both subject to a similar 1031 exchange. The boards approved the sales for $8,900,000 and $3,730,000, respectively.

In August 1995, Teruya contracted with TGE to facilitate the exchange under 1031. TGE sold Royal Towers to Saito for $11,932,000, using the proceeds plus $724,554 from Teruya to buy Kupuohi I and Kaahumanu. Teruya’s basis in Royal Towers was $670,506, deferring a $10,700,878 gain under 26 U.S.C. 1031. Times had a basis in Kaahumanu of $1,502,960, realizing a $2,227,040 gain but paid no tax due to a net operating loss; it also had a basis of $15,602,152 in Kupuohi I, incurring a $6,453,372 capital loss not recognized under 26 U.S.C. 267 due to related party restrictions.

Ultimately, Teruya deferred gains from both transactions on its tax return for the year ending March 31, 1996. The IRS disputed this treatment, issuing a notice of deficiency totaling $4,144,359, prompting Teruya to petition the Tax Court for redetermination.

The Tax Court upheld the IRS's non-recognition treatment in the case of Teruya Bros. Ltd. Subsidiaries v. Comm'r of Internal Revenue, permitting a timely appeal. Under 26 U.S.C. § 1031(a)(1), taxpayers typically must recognize gains or losses upon property disposition, but a section 1031 exchange allows deferral of gain recognition on like-kind property held for business or investment until the new property is sold. Taxpayers retain their original basis in the newly acquired property as part of this deferred treatment. This provision aims to prevent taxation on unrealized gains, preserving the taxpayer's investment continuity.

Prior to 1989, taxpayers could defer gain recognition or accelerate loss recognition through specific exchanges, as illustrated by a hypothetical involving T and her corporation, C Corp. Congress enacted § 1031(f) in 1989 to close perceived tax loopholes, limiting non-recognition treatment for exchanges with related parties if either disposes of the exchanged property within two years. Additionally, § 1031(f)(4) disallows non-recognition treatment for transactions designed to circumvent the statute’s purpose. Exceptions exist for exchanges that can prove non-tax avoidance as a principal purpose.

The review of the Tax Court’s legal conclusions is conducted de novo, while factual findings are assessed for clear error. The analysis emphasizes that tax classifications depend on the economic realities of transactions rather than their formal structure.

Exceptions to the requirement for recognizing all gains and losses on property dispositions are strictly limited, adhering closely to the wording and intended purpose of the exceptions outlined in the Code. Nonrecognition is permitted only if the exchange meets both the specific criteria for an excepted exchange and the underlying rationale for such exceptions. The government acknowledges that the transactions involving Ocean Vista and Royal Towers qualify as like-kind exchanges under Section 1031(a)(1). These four-party like-kind exchanges, while more complex than traditional two-party transactions, have been recognized for decades.

In these transactions, the taxpayer exchanges property with the involvement of a prospective seller, a prospective purchaser, and a qualified intermediary as the fourth party. The Tax Court has characterized this process as involving simultaneous transactions where the fourth party facilitates the exchange without becoming the taxpayer's agent for Section 1031(a) purposes. Thus, Teruya is the taxpayer, Times the prospective seller, the Association and Saito prospective purchasers, and TGE the qualified intermediary.

The government does not assert that Section 1031(f)(1) applies to these indirect transactions, meaning the exchanges can only be denied nonrecognition treatment if they were part of a scheme to circumvent the purposes of Section 1031(f). To evaluate the structuring of these transactions against Section 1031(f)'s objectives, one must consider both the statutory language and its legislative history. Although the statute provides limited insight, its existence implies a congressional intent to restrict related parties from claiming nonrecognition treatment. Legislative history indicates that Congress aimed to narrow the 'like-kind' standard for property exchanges, addressing concerns that it was too broadly applied.

Taxpayers currently receive nonrecognition treatment for exchanges or conversions that significantly change their investments. However, Congress intends for nonrecognition treatment to apply only when a taxpayer is merely continuing their investment. The House committee expressed concerns that related parties exploit basis-shifting provisions under section 1031(d) to avoid recognizing gains or accelerate losses, specifically by engaging in like-kind exchanges of high basis property for low basis property. If a related party exchange is followed by a quick disposition of the property, it indicates that the parties have effectively "cashed out" of their investment, negating the nonrecognition treatment.

An example provided by the committee illustrates that if a taxpayer transfers property to an unrelated party, who then exchanges it with a related party within two years, the related party cannot claim nonrecognition treatment. The Tax Court concluded that the transactions at hand were structured to sidestep the goals of 1031(f)(4) by allowing related parties to receive nonrecognition treatment while cashing out of investments using the basis-shifting provisions.

The court rejected Teruya's argument that the economic outcomes for Times were irrelevant, asserting that section 1031(f)(1)(C)(i) denies nonrecognition treatment if the related party disposes of exchanged property within two years, regardless of the taxpayer's actions. The inquiry must consider the economic positions of both the taxpayer and the related party as a unit to determine the applicability of 1031(f). The evidence indicated that Teruya and Times structured their exchanges to cash out of low-basis real property investments, ultimately reducing their real property investments by approximately $13.4 million while increasing their cash position by the same amount. This manipulation contravened Congress's intent to limit nonrecognition treatment to scenarios where the taxpayer is simply continuing their investment.

The excerpt examines the structuring of property transactions by Teruya to avoid tax implications under Section 1031(f) of the Internal Revenue Code. Teruya could have executed simpler, direct exchanges with Times, but opted for a more complex arrangement involving a qualified intermediary, TGE, to sidestep the tax restrictions that apply to related party exchanges. Direct exchanges would have required recognizing gains if properties were sold within two years, thus making them ineligible for nonrecognition treatment. The involvement of TGE aimed to create the appearance of a valid exchange to qualify for tax benefits that may not have been available otherwise.

The text highlights that while Teruya argued for an exception under 1031(f)(2) that permits nonrecognition treatment if tax avoidance is not a principal purpose, the Tax Court found that the transactions were indeed structured primarily to achieve unwarranted tax avoidance. The analysis of the Royal Towers exchange illustrates this point; had Teruya sold directly, it would have recognized a gain of nearly $11 million. Instead, through the intermediary structure, only Times recognized a significantly lower gain of $2.2 million, and due to net operating losses, Times paid no tax on this gain. Similarly, in the Ocean Vista transaction, the tax advantages achieved by the Teruya/Times arrangement were far greater than those from a straightforward sale. Consequently, the Tax Court's denial of nonrecognition treatment to Teruya was affirmed, underscoring the conclusion that the transactions were designed to improperly avoid federal income tax.

Teruya argued that it did not engage in improper tax avoidance as it lacked a fixed right to cash during the transactions, asserting that they constituted 1031(a) like-kind exchanges. However, this view overlooks the critical issue of whether the transactions were designed to evade the intent of 1031(f). Teruya’s focus on its investment in like-kind property neglects the tax implications for its related party, Times. Consequently, the Tax Court's ruling that these transactions were structured to circumvent 1031(f) provisions, thus violating 1031(f)(4), is affirmed. The document includes a note on the definition of "related person," stipulates that Teruya and Times were related parties, and clarifies that the examination date predates the effective date of certain burden-shifting rules. It also defines the role of qualified intermediaries in like-kind exchanges, concluding that in this case, the intermediary was likely used to bypass 1031(f)(1) restrictions.

The government contends that all deferred exchanges involving related parties and a qualified intermediary should be treated as direct exchanges between those parties. According to the government, if such a recast transaction is prohibited from receiving nonrecognition treatment under section 1031(f)(1), it suggests the transaction was structured to circumvent the intent of 1031(f). However, the Tax Court rejected this approach as inconsistent with the statute's framework. Section 1031(f) specifies that certain dispositions are not considered for the purpose of paragraph (1)(C), including those after the death of the taxpayer or related person, in compulsory or involuntary conversions before such events, or when it is satisfactorily established that tax avoidance was not a principal purpose of the exchange. There is a noted disagreement among courts about the standard for determining what satisfies the Secretary, with some applying an arbitrary and capricious standard and others requiring strong proof. The document does not resolve which standard applies nor does it define the phrase's implications in this context. Additionally, it theorizes that the tax implications for Times from reducing its net operating losses could have been equal to or greater than the tax deferred by Teruya in the Ocean Vista transaction, although this point is not contested on appeal. The Conference Committee Report for 1031(f) identifies types of transactions that typically do not have tax avoidance as a principal goal, particularly those without basis shifting. Teruya did not assert that its transactions fell within these exceptions.