UNITED STATES TAX COURT



  TERUYA BROTHERS, LTD. & SUBSIDIARIES, Petitioner v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 17955-03.               Filed February 9, 2005.



      In 1995, in a series of planned transactions, P
transferred real properties to a qualified
intermediary, TGE, which then sold them to unrelated
third parties. TGE used the sale proceeds, as well as
additional funds from P, to purchase like-kind
replacement properties for P from a corporation related
to P.

     Held: The transactions in question were
structured to avoid the purposes of sec. 1031(f),
I.R.C., governing like-kind exchanges between related
persons. Under sec. 1031(f)(4), I.R.C., P is not
entitled to defer gains realized on the exchanges.
                                   - 2 -

       Jonathan H. Steiner, William E. Bonano, and Stanley Y.

Mukai, for petitioner.

       Jonathan J. Ono, for respondent.



                                  OPINION

       THORNTON, Judge:     Respondent determined a $4,144,359

deficiency in petitioner’s Federal income tax for its taxable

year ending March 31, 1996.      The issue for decision is whether

petitioner is entitled to defer gains realized on certain like-

kind exchanges under section 1031(a) or must recognize gains

under section 1031(f), which provides special rules governing

exchanges between related persons.1

                                Background

       This case is before us fully stipulated pursuant to Rule

122.       We incorporate herein the stipulated facts.   When

petitioner filed its petition, its principal place of business

was in Honolulu, Hawaii.

       Teruya Brothers, Ltd. (Teruya), is a Hawaii corporation.

Its business activities include purchasing and developing

residential and commercial real property.       During the taxable

year in issue, Teruya owned 62.5 percent of the common shares of

Times Super Market, Ltd. (Times).


       1
       Section references are to the Internal Revenue Code in
effect for the taxable year in issue and as amended. Rule
references are to the Tax Court Rules of Practice and Procedure.
                               - 3 -

I.   Exchanges of Properties

     In 1995, Teruya engaged in two separate real property

exchange transactions, referred to herein as the Ocean Vista

transaction and the Royal Towers transaction.

     A.   Ocean Vista Transaction

     Teruya owned a fee simple interest in Ocean Vista, a parcel

of land underlying the Ocean Vista Condominium complex in

Honolulu, Hawaii.   Teruya’s ownership interest in Ocean Vista was

subject to a long-term ground lease held by Golden Century

Investments Co. (Golden), which in turn was subject to a sublease

held by the Association of Apartment Owners of Ocean Vista (the

Association).

     In March 1993, the Association inquired about buying

Teruya’s fee simple interest in Ocean Vista.    Teruya responded

that its fee simple interest in Ocean Vista was not available.

Golden then proposed acquiring Ocean Vista as part of a like-kind

exchange.   In a letter of intent agreement, dated August 16,

1993, Golden agreed to purchase, and Teruya agreed to sell,

Teruya’s interest in Ocean Vista for $1,468,500.    An amendment to

the letter of intent, dated November 2, 1993, states:    “It is

understood and agreed that Teruya’s obligation to sell Teruya’s

Interests to * * * [Golden] is conditioned upon Teruya

consummating a [section] 1031 tax deferred exchange of Teruya’s

interests.”
                               - 4 -

     In June 1994, Teruya proposed buying Times’s interest in

“two pad sites” in Waipahu, Hawaii (these properties are

hereinafter referred to collectively as Kupuohi II).   Teruya’s

written proposal included these provisions:

     The purchase will be subject to a [section] 1031 four
     party exchange.

     Teruya may cancel the proposed purchase of * * *
     [Times’s] pad sites should the Ocean Vista transaction
     fail to proceed according to present plans.

Times accepted Teruya’s proposal.

     In a letter to Teruya and Golden, dated April 3, 1995, the

Association offered to purchase Teruya’s fee simple interest in

Ocean Vista for $1,468,500.2   Paragraph 9 of the offer to

purchase states:

     Tax-deferred Exchange. Teruya may, in its sole
     discretion, structure this transaction as a tax-
     deferred exchange pursuant to section 1031 of the
     Internal Revenue Code.

Paragraph 12 of the offer to purchase states:

     Conditions Precedent. The following shall be
     conditions precedent to the closing of the transaction
     contemplated hereunder: * * *

               (h) Teruya shall be in a position to close on
          its exchange replacement properties.

On April 27, 1995, Teruya’s board of directors accepted the

Association’s offer.



     2
       On June 14, 1994, Teruya, Golden, and the Association
executed an “Assignment, Assumption and Release”, wherein the
Association was substituted as a party in place of Golden.
                                - 5 -

     In August 1995, Teruya entered into an “exchange agreement”

with T.G. Exchange, Inc. (TGE), whereby TGE agreed to act as an

“exchange party to complete the exchange” of Ocean Vista for

replacement property to be designated by Teruya, with the stated

purpose of qualifying the exchange under section 1031.    TGE

agreed to acquire the replacement property with proceeds from the

sale of Ocean Vista and additional funds from Teruya as necessary

to effect the acquisition.   Paragraph 6 of the exchange agreement

states:

     Notwithstanding the foregoing, if * * * [Teruya] is
     unable to locate suitable Replacement Property by the
     date specified in the Acquisition Agreement [for Ocean
     Vista], then the Acquisition Agreement and this
     Exchange Agreement shall be terminated and the parties
     shall have no further obligations to each other * * *.

     Pursuant to the exchange agreement, Teruya transferred Ocean

Vista to TGE, and on September 1, 1995, TGE sold Ocean Vista to

the Association for $1,468,500.   At that time, Teruya had a

$93,270 basis in Ocean Vista.

     Also on September 1, 1995, TGE applied the proceeds from the

sale of Ocean Vista, as well as $1,366,056 in additional cash

from Teruya, to acquire Kupuohi II from Times for $2,828,000.

Times had a $1,475,361 adjusted basis in Kupuohi II and

recognized a $1,352,639 gain on the sale.3


     3
       The parties have stipulated that Times had a $1,475,633
basis in Kupuohi II at the time of its sale; however, this number
yields computational inconsistencies with respect to other
                                                   (continued...)
                               - 6 -

     At some point, TGE transferred Kupuohi II to Teruya.    As of

the date the petition was filed, Teruya still owned Kupuohi II.

     B.   Royal Towers Transaction

     In 1994, Teruya owned a fee simple interest in the Royal

Towers Apartment building (Royal Towers) in Honolulu, Hawaii.     On

or about December 12, 1994, Teruya and Savio Development Co.

(Savio) entered into a $13.5 million contract for the sale of

Royal Towers.   The contract stated that the sale was subject to

the “Seller [Teruya] being able to consummate [a section 1031]

exchange.”   Teruya and Savio later agreed to decrease the price

for Royal Towers from $13.5 million to $11,932,000.    In April

1995, Teruya’s board of directors approved the sale of Royal

Towers to Savio.

     In anticipation of Teruya’s sale of Royal Towers, Teruya and

Times previously had agreed that Teruya would purchase Times’s

interests in two parcels of real property in Waipahu and Aiea,

Hawaii (respectively, Kupuohi I and Kaahumanu).    One of the

purchase terms stated:

     The purchase will be subject to a [section] 1031 four
     party exchange.

                *    *    *    *       *   *   *



     3
      (...continued)
numerical stipulations. To avoid these inconsistencies, we have
found Times’s adjusted basis in Kupuohi II to be $1,475,361,
which is the number reflected on Times’s 1995 corporate income
tax return.
                               - 7 -

     Teruya may cancel the proposed purchase should the sale
     of the Royal Towers apartment fail to proceed according
     to present plans.

Early in 1995, the boards of directors of Times and Teruya

approved the sale and purchase of Kupuohi I for $8.9 million and

Kaahumanu for $3.73 million.

     In August 1995, Teruya entered into an “exchange agreement”

with TGE, whereby TGE agreed to act as an “exchange party to

complete the exchange” of Royal Towers for replacement property

to be designated by Teruya, with the stated purpose of qualifying

the exchange under section 1031.   TGE agreed to acquire the

replacement property with proceeds from the sale of Royal Towers

and additional funds from Teruya as necessary to effect the

acquisition.   Paragraph 6 of the exchange agreement states:

     Notwithstanding the foregoing, if * * * [Teruya] is
     unable to locate suitable Replacement Property by the
     date specified in the Acquisition Agreement [for Royal
     Towers], then the Acquisition Agreement and this
     Exchange Agreement shall be terminated and the parties
     shall have no further obligations to each other * * *.

     Teruya transferred Royal Towers to TGE, and on August 24,

1995, TGE sold Royal Towers to Savio for $11,932,000.   At that

time, Teruya had a $670,506 basis in Royal Towers.

     Also, on August 24, 1995, TGE applied the proceeds from the

sale of Royal Towers, as well as $724,554 in additional funds

from Teruya, to acquire Kupuohi I and Kaahumanu from Times for
                                  - 8 -

$8.9 million and $3.73 million, respectively.4   At the time of

the sales, Times had a $15,602,152 adjusted basis in Kupuohi I

and a $1,502,960 adjusted basis in Kaahumanu.    Times realized a

$6,453,372 capital loss on the sale of Kupuohi I but did not

recognize this loss on its tax return because of the restriction

on transactions between related taxpayers under section 267.5

Times realized and recognized a $2,227,040 gain on the sale of

Kaahumanu.

      At some point, TGE transferred Kupuohi I and Kaahumanu to

Teruya.   As of the date the petition was filed, Teruya still

owned these properties.

II.   Federal Income Tax Return

      Petitioner filed Form 1120, U.S. Corporation Income Tax

Return, for its taxable year beginning April 1, 1995, and ending

March 31, 1996.   Under section 1031(a)(1), petitioner deferred

$1,345,169 in realized gain from the Ocean Vista transaction

(after deducting claimed selling expenses of $30,061) and



      4
       The proceeds from the sale of Royal Towers ($11,932,000)
and the additional funds from Teruya ($724,554) total
$12,656,554. The agreed sale price for Kupuohi I ($8.9 million)
and Kaahumanu ($3.73 million), however, totaled $12,630,000. The
parties do not explain this seeming discrepancy.
      5
       The parties stipulated the $6,453,372 realized capital
loss on the sale of Kupuohi I; however, on the basis of the $8.9
million sale price and the $15,602,152 adjusted basis that the
parties stipulated, it appears that the loss realized was
actually $6,702,152. The parties do not address this seeming
discrepancy.
                              - 9 -

$10,700,878 in realized gain from the Royal Towers transaction

(after deducting claimed selling expenses of $560,616).

III. Notice of Deficiency

     In the notice of deficiency, respondent determined that

petitioner must recognize $12,041,026 in gains, which consists of

the gains that Teruya deferred on its Federal income tax return

for its taxable year ending March 31, 1996.6

                            Discussion

     This case presents an issue of first impression regarding

the application of section 1031(f), which restricts

nonrecognition of gain or loss with respect to like-kind

exchanges between related persons.7

I.   General Requirements for Like-Kind Exchanges

     Section 1031(a)(1) generally provides that no gain or loss

shall be recognized on the exchange of like-kind properties held

for productive use in a trade or business or for investment.

Under certain conditions, a taxpayer’s nonsimultaneous transfer

and receipt of like-kind properties may qualify for section 1031



     6
       The deferred gains from the Ocean Vista and Royal Towers
transactions that the parties stipulated total $12,046,047. The
parties do not explain the seeming discrepancy between this
figure and the $12,041,026 adjustment in the notice of
deficiency.
     7
       The examination in this case commenced in November 1997.
Consequently, the burden of proof rule of sec. 7491(a)(1) does
not apply. Internal Revenue Service Restructuring and Reform Act
of 1998, Pub. L. 105-206, sec. 3001(c), 112 Stat. 727.
                              - 10 -

treatment, provided generally that the taxpayer identifies the

new property within 45 days and receives it within 180 days of

transferring the old property.   See sec. 1031(a)(3).   To

facilitate such a deferred exchange, the taxpayer may use a

qualified intermediary; i.e., a person who is not the taxpayer,

an agent of the taxpayer, a related person to the taxpayer, or a

related person to an agent of the taxpayer, see sec. 1.1031(k)-

1(k), Income Tax Regs., who enters into a written exchange

agreement with the taxpayer and, as required by this agreement,

acquires property from the taxpayer, transfers this property,

acquires like-kind replacement property, and transfers this

replacement property to the taxpayer.   Sec. 1.1031(k)-

1(g)(4)(iii), Income Tax Regs.

      Teruya used a qualified intermediary, TGE, to facilitate its

transfers of Ocean Vista and Royal Towers and its acquisitions of

Kupuohi II, Kupuohi I, and Kaahumanu.   Respondent does not

dispute that these transactions meet the general requirements for

like-kind exchanges under section 1031(a)(1).   Respondent

contends, however, that section 1031(f) requires petitioner to

recognize gains on the transactions.

II.   Rules Applicable to Related-Person Exchanges

      Section 1031(f)(1) provides generally that if a taxpayer and

a related person exchange like-kind property and within 2 years

either one disposes of the exchanged property, the nonrecognition
                              - 11 -

provisions of section 1031(a) do not apply.    Instead, any gain or

loss must be taken into account as of the date of the

disposition.   As one of the few enumerated exceptions to this

rule, section 1031(f)(2)(C) provides that a disposition of

exchanged property will not be taken into account if “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.”8

     It is undisputed that Times and Teruya were related persons

within the meaning of the statute.9    Respondent makes no

argument, however, that section 1031(f)(1) applies directly to

the Ocean Vista and Royal Towers transactions.10   Instead,

respondent argues that petitioner has run afoul of section

1031(f)(4), which provides:   “This section [1031] shall not apply

to any exchange which is part of a transaction (or series of



     8
       Other exceptions, not implicated here, apply to
dispositions after the death of the taxpayer or related party,
see sec. 1031(f)(2)(A), and to involuntary conversions, see sec.
1031(f)(2)(B).
     9
       A related person is any person bearing a relationship to
the taxpayer described in sec. 267(b) or 707(b)(1). Sec.
1031(f)(3).
     10
       Respondent appears to acknowledge implicitly that sec.
1031(f)(1) applies only in the case of a direct exchange between
related persons and that this case does not involve such a direct
exchange. Consistent with such a view, the regulations provide
that a “qualified intermediary is not considered the agent of the
taxpayer for purposes of section 1031(a).” Sec. 1.1031(k)-
1(g)(4)(i), Income Tax Regs.
                                - 12 -

transactions) structured to avoid the purposes of this subsection

[(f)].”   Inasmuch as the statute does not directly identify or

describe the purposes of subsection (f), we turn our attention to

the legislative history.

III. Legislative History:    Purposes of Section 1031(f)

     Property acquired in a like-kind exchange generally takes

the basis of the property relinquished.        See sec. 1031(d).   In

other words, there is a “shifting” of tax basis between the

relinquished property and the replacement property.        See H. Conf.

Rept. 101-386, at 613 (1989).

     Before 1989, Congress was concerned that because of this

basis-shifting effect, “related parties * * * 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.”

H. Rept. 101-247, at 1340 (1989).      In effect, because of basis

shifting, related persons were able to “cash out” of their

investments in property having an inherent gain at relatively

little or no tax cost.     See 

some cases, basis

shifting allowed related persons to accelerate a loss on property

that they ultimately retained.       See 

these

perceived abuses, Congress concluded 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
                              - 13 -

the investment, and the original exchange should not be accorded

nonrecognition treatment.”   

is reflected in

section 1031(f), as enacted in the Omnibus Budget Reconciliation

Act of 1989, Pub. L. 101-239, sec. 7601(a), 103 Stat. 2370.

     Congress was also concerned that related persons not be able

to circumvent the purposes of this rule by using an unrelated

third party:

          Nonrecognition will not be accorded to any
     exchange which is part of a transaction or series of
     transactions structured to avoid the purposes of the
     related party rules. For example, if 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. [H. Rept. 101-247, supra at 1341.]

     Equating a qualified intermediary with the “unrelated party”

referred to in the above-quoted example, respondent reads the

example to mean that a deferred exchange between related parties,

involving a qualified intermediary, should be recast as a direct

exchange between the related parties.   If section 1031(f)(1)

would preclude nonrecognition treatment for the recast

transaction, respondent concludes, then the deferred exchange

should be deemed to have been structured to avoid the purposes of

section 1031(f).   Respondent suggests that such an analysis ends

the inquiry under section 1031(f)(4).
                                - 14 -

     Although respondent’s argument has superficial appeal, it is

only loosely grounded in the above-quoted, highly elliptical

example in the legislative history.      Cf. Mandarino, “Reconciling

Rulings on Related Party Like-Kind Exchanges”, 30 Real Estate

Taxn. 174, 175 (Third Quarter 2003) (“Because of the way this

example is drafted, it appears not to make the point for which it

is offered.”).   Moreover, respondent’s analysis fails to consider

the non-tax-avoidance exception of section 1031(f)(2)(C).11

Because this exception is subsumed within the purposes of section

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.

     Petitioner seems to suggest that Congress intended section

1031(f) to apply only insofar as the taxpayer fails to “continue

its investment” in property that it receives in a related-person

deferred exchange.   Petitioner seems to suggest that what happens

to the relinquished property is of no consequence.     We reject any

such suggestion as flatly contrary to section 1031(f), which

applies with equal force to postexchange dispositions by either

the taxpayer or the related person.




     11
       As previously discussed, in the context of a direct
exchange between related parties, sec. 1031(f)(2)(C) allows the
taxpayer to establish that neither the exchange nor the
disposition had as one of its principal purposes the avoidance of
Federal income tax.
                               - 15 -

IV.   Analysis of the Ocean View and Royal Towers Transactions

      Teruya exchanged Ocean View and Royal Towers for like-kind

replacement properties formerly owned by Times.   A qualified

intermediary immediately sold Ocean Vista and Royal Towers to

unrelated third parties.   Times received the proceeds, plus

additional cash from Teruya.

      These transactions are economically equivalent to direct

exchanges of properties between Teruya and Times (with boot from

Teruya to Times), followed by Times’s sales of the properties to

unrelated third parties.   The interposition of a qualified

intermediary in these transactions cannot obscure the end result.

Petitioner offers no explanation for structuring the Ocean Vista

and Royal Towers transactions as it did, and the record discloses

no reason (other than seeking to avoid the section 1031(f) rules)

for Teruya’s using a qualified intermediary to accomplish the

transactions.   Under the circumstances, we are led to the

conclusion that Teruya used the multiparty structures to avoid

the consequences of economically equivalent direct exchanges with

Times.   As discussed below, petitioner has failed to establish

that avoidance of Federal income taxes was not one of the

principal purposes of the Ocean Vista and Royal Towers

transactions.
                              - 16 -

V.   Non-Tax-Avoidance Exception

      Petitioner argues that Teruya’s continued investment in

like-kind properties meets the requirements of the non-tax-

avoidance exception under section 1031(f)(2)(C), as subsumed

within section 1031(f)(4).   Section 1031(f)(2)(C) provides that

there shall not be taken into account any disposition “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.”12

      With respect to both the Ocean Vista and Royal Towers

transactions, petitioner contends that “there was no intent to

disguise an actual sale of the relinquished property in order to

reduce or avoid gain recognition on such sale, because a sale of

the relinquished property was not intended in the first place.”

In other words, petitioner contends that from the outset of both

transactions, Teruya intended to qualify for deferred like-kind

exchange treatment and did not intend to make direct sales of the

properties.   Petitioner points to the fact that Teruya, Times,

Golden, the Association, and Savio agreed in various documents




      12
       In other contexts involving similar language, we have
applied a “strong proof” standard. See, e.g., Schoneberger v.
Commissioner, 

, 1024 (1980). Because it makes no
difference to the outcome of this case, we do not apply any
heightened standard of proof.
                              - 17 -

that the Ocean Vista and Royal Towers transactions were

conditional on effecting a section 1031 exchange.

     Petitioner’s contentions might be relevant in determining

whether a transaction is in substance an exchange or a sale of

like-kind property.   See Alderson v. Commissioner, 

(9th Cir. 1963), revg. 

(1962).   In the instant case,

however, they have little relevance.   In the first instance,

respondent does not contend that the transactions in question

were disguised sales or otherwise fail to meet the general

requirements of section 1031(a)(1).    More fundamentally, section

1031(f) presupposes that an exchange to which it applies

otherwise meets the requirements of section 1031(a)(1).    See sec.

1031(f)(1)(B).   Even if Teruya never intended to make a direct

sale of the relinquished properties, this does not mean that

section 1031(f) is not implicated or that the deferred sale was

not structured so as to avoid Federal income taxes.   The economic

substance of the transactions remains that the investments in

Ocean Vista and Royal Towers were cashed out immediately and

Times, a related person, ended up with the cash proceeds.

     With respect to the Ocean Vista transaction, petitioner

contends that there was no tax avoidance purpose because Times

recognized a gain on its sale of Kupuohi II ($1,352,639) that was

larger than the gain Teruya would have recognized ($1,345,169)
                                  - 18 -

had it sold Ocean Vista directly to the Association for cash.13

Although Times recognized a gain in the Ocean Vista transaction

that slightly exceeded Teruya’s gain deferral, it appears that

Times paid a much smaller tax price for that gain recognition

than Teruya would have paid if it had recognized gain in a direct

sale of Ocean Vista.     On its corporate income tax return for

taxable year ending March 31, 1996, Teruya reported taxable

income of $2,060,806.     Consequently, if Teruya had made a direct

sale of Ocean Vista, the gain recognized on that sale presumably

would have been taxable at a 34-percent corporate income tax

rate.     See sec. 11(b)(1)(C).   By comparison, on its Form 1120 for

its taxable year ending April 25, 1996, Times reported a net

operating loss (NOL) of $1,043,829.        Thus, although Times

recognized a considerable gain on the Ocean Vista transaction,

because of offsetting expenses, it did not incur tax on that

gain.     Instead, the only tax consequences of Times’s gain

recognition were reductions of its NOL for its taxable year

ending April 25, 1996, and of its NOL carryovers for subsequent

taxable years.




     13
       The $1,345,169 figure includes approximately $30,061 in
claimed selling expenses that Teruya deducted in computing its
sec. 1031(a) deferral. Petitioner assumes that Teruya would have
incurred these same selling expenses in a direct sale of Ocean
Vista.
                                 - 19 -

      In sum, petitioner has failed to persuade us that avoidance

of Federal income tax was not one of the principal purposes of

the Ocean Vista and Royal Towers transactions.

VI.   Conclusion

      Petitioner offers no explanation for Teruya’s use of the

qualified intermediary in the Ocean Vista and Royal Towers

transactions.      We infer that the qualified intermediary was

interposed in an attempt to circumvent the section 1031(f)(1)

limitations that would have applied to exchanges directly between

related persons.      Petitioner has failed to show that avoidance of

Federal income tax was not one of the principal purposes of the

Ocean Vista and Royal Towers transactions.      We conclude that

these transactions were structured to avoid the purposes of

section 1031(f).      Consequently, petitioner is not entitled, under
                              - 20 -

section 1031(a)(1), to defer the gains that it realized on the

exchanges of Ocean Vista and Royal Towers.14


                                   An appropriate order will be

                              issued denying petitioner’s motion

                              to supplement the record, and

                              decision will be entered for

                              respondent.




     14
       On Sept. 8, 2004, petitioner filed a motion to supplement
the record with three letters from respondent to petitioner.
Each of these letters concerns a technical advice memorandum that
involves a multiparty transaction among a taxpayer, a qualified
intermediary, and a related person. In a rambling 96-page reply
brief, petitioner contends that these letters provide an
abundance of evidence that respondent has been improperly
administering sec. 1031(f)(4). Because we find that the letters
petitioner submitted have no relevance to the issues in this
case, we will deny petitioner’s motion to supplement the record.