Teruya Bros., Ltd., v. Comm'r: 1031 Gain Deferral Denied in Multiparty Transaction
The federal tax court has considered whether taxpayer entered into legitimate 1031 transactions when taxpayer used a qualified intermediary in transactions involving third parties as well as two related corporations.
Teruya Brothers, Ltd. ("Teruya") entered into two four party 1031 exchanges. Times Super Market, Ltd. ("Times") was involved in both transactions. Teruya owned 62.5 percent of Times's common stock shares.
The first exchange involved Teruya's interest in Ocean Vista, a parcel of land on which a condominium development sat. In this transaction, Teruya entered into an agreement to sell its ownership rights to the condominium association ("Association"), with the agreement stating that the transaction was subject to Teruya "consummating a 1031 tax deferred exchange". Teruya's Board of Directors approved the negotiated sale price of $1,468,500 to the Association. Teruya also entered into an agreement with Times to purchase two parcels of property from Times, with that agreement stating that "purchase will be subject to a 1031 four party exchange".
Thereafter, Teruya entered into an agreement with T.G. Exchange, Inc. ("Intermediary") in order to facilitate the transaction. First, Teruya transferred its interest in Ocean Vista to the Intermediary, who then sold it to the Association at the agreed upon price. At the time of the sale, Teruya had a basis of $93,270 in Ocean Vista. The Intermediary took the proceeds from the sale and another $1,366,056 in cash from Teruya and transferred this amount to Times in exchange for the two parcels of land Teruya had negotiated to buy. The Intermediary then transferred the two parcels of land to Teruya. Times had a basis of $1,475,361 in the two parcels, and so recognized a gain of $1,352,639 from the transaction.
The second exchange involved Teruya's interest in the Royal Towers Apartment ("Royal Towers") building. Teruya entered into an agreement with Saivo Development Company ("Saivo") to sell the building to Saivo for $13.5 million, stating that the transaction was subject to Teruya "being able to consummate [a 1031] exchange". The purchase price was later reduced to $11,932,000 and Teruya's Board of Directors approved this sale price amount. Teruya and Times also entered into an agreement where Teruya would purchase two parcels of land from Times, with the agreement stating that "purchase will be subject to a 1031 four party exchange". Both company's board of directors approved the transaction.
The Intermediary and Teruya entered into an exchange agreement, and Teruya transferred Royal Towers to the Intermediary. The Intermediary then sold Royal Towers to Saivo for the agreed upon price, and used the proceeds plus $724,554 from Teruya to purchase the two parcels held by Times. At the time of sale, Teruya had a basis of $670,506 in Royal Towers, while Times had a combined basis of $17,105,112 in its two parcels. Times had a gain of $2,227,040 on one of the parcels, and so recognized this gain on its tax return.
On its tax returns, Teruya had deferred all of the gains it had received in the two transactions minus some expenses. The gains totaled $12,041,026 ("Gain"). The Internal Revenue Service ("IRS") sent Teruya a deficiency notice, stating that Teruya was required to recognize the Gain on its tax returns. Teruya challenged the IRS's determination.
The United States Tax Court agreed with the IRS's determination and ruled that Teruya had to recognize the Gain on its federal tax returns. Under Internal Revenue Code §1031, if an individual exchanges business or investment property for business or investment property of a like-kind, no gain or loss is recognized. A taxpayer is allowed to postpone the recognition of gain on the sale of qualifying property by the acquisition of replacement real property that is identified within 45 days of sale and purchased within 180 days. To facilitate a deferred exchange, the taxpayer can use a qualified intermediary, which is defined in the regulations as someone who is not the taxpayer, related to the taxpayer, or an agent of the taxpayer, and who enters into an agreement with the taxpayer to acquire taxpayer's property, transfers this property to a buyer, acquires like-kind property, and transfers replacement property to the taxpayer. To learn more about 1031 exchanges, click here.
The IRS did not dispute that the Intermediary had performed the normal functions of a qualified intermediary in a 1031 exchange. However, the IRS found that this 1031 exchange failed because the Teruya and Times were related entities under the tax code and so Teruya was required to recognize the gains from the transactions. Under the tax code, if related entities engage in an exchange of properties and then dispose of those properties in less than two years, the nonrecognition provisions of 1031 do not apply and gains from the exchange must be recognized unless the party can establish that avoidance of income tax was not one of the principal purposes of the transaction.
Teruya did not dispute that Times was a related party under the federal tax regulations, as Teruya was the majority shareholder of Times stock. Teruya argued that so long as it held the real estate it received back in the exchange, it did not matter what happened to the property it relinquished, which in this case was sold immediately.
The court rejected Teruya's argument. The court found that the transactions essentially amounted to a property exchange of properties between Teruya and Times, with Times then disposing of the properties it received from Teruya. The court determined that the multi-party structure used in these transactions was simply a method of obscuring the true result of these transactions. Since Teruya could not establish that avoidance of federal income tax was not one of the principal purposes for engaging in these transactions, the court ruled that the nonrecognition provisions of 1031 did not apply to these transactions because the properties transferred to Times were immediately sold and so Teruya had to recognize the gain from both of these transactions.
Teruya Bros., Ltd., v. Comm'r, Dkt. No. 17955-03, CCH Dec. 55,924 (T.C. Feb. 9, 2005). [This is a citation to a subscription, online legal research service. If an official reporter citation should become available for this case, the citation will be updated to reflect this information].
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