Background. Section 1031 is used to defer the gain on property (usually real property but not always) sold by a taxpayer.  The idea is that the taxpayer "exchanges" into replacement property.  Most exchanges are effected using a "qualified intermediary" ("QI") which holds the sale proceeds and uses the proceeds to buy replacement property.  However, exchanges with related parties pose problems under a part of Section 1031.  A 2009 ruling was a victory for the IRS and the US Supreme Court recently refused to change the result.

Facts. Teruya Brothers Ltd. (Teruya) owned 62.5% of the common shares of Times Super Market Ltd (Times), so the two entities were related. In 1995, in one series of planned transactions, Teruya transferred Real Property 1 to a QI, which then sold it to an unrelated third party. The QI used the sale proceeds, as well as additional funds from Teruya, to buy like-kind Replacement Property 2 for Teruya from Times, and then transferred Replacement Property 2 to Teruya. In another series of planned transactions, Teruya transferred Real Property 3 to the QI, which sold it to an unrelated party. The QI used the sale proceeds from Real Property 3, plus some cash from Teruya, to buy like kind Replacement Properties 4 and 5 from Times.

Teruya realized a $1.3 million gain on Property 1 and a $10.7 million gain on Property 3. Times realized and recognized a $1.3 million gain on Property 2 and a $2.2 million gain on Property 5, but these gains were offset by a large net operating loss. Times realized a $6.4 million loss on Property 4, but did not recognize it because of  a related-party restriction on loss recognition.

Teruya treated its transactions as tax-deferred like-kind exchanges under Code Sec. 1031, but IRS said the transactions ran afoul of the Code Sec. 1031(f)(4) related-party rule and hit Teruya with a $4 million deficiency.

Tax Court Hearing. In 2005, the Tax Court held that the transactions were economically equivalent to direct exchanges of properties between Teruya and Times (with boot from Teruya to Times), followed by the sales of the properties by Times to unrelated third parties.

Ninth Circuit. In 2009, the Ninth Circuit U.S. Court of Appeals concluded that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of Code Sec. 1031(f)(4). It rejected Teruya's contention that the economic consequences of the transactions to Times were irrelevant, and that Teruya's continued investment in real property was dispositive. Code Sec. 1031(f)(1)(C)(i) disallows nonrecognition treatment if a related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party's economic position in the aggregate is often the only way to tell if Code Sec. 1031(f) applies.

The Ninth Circuit said Teruya could have exchanged its properties directly with Times, followed by Times's selling Property 1 and Property 3 to the third-party purchasers, but this would not have had a tax-free result, since direct exchanges between related parties are ineligible for nonrecognition treatment when the exchanged property is sold within two years. Instead, Teruya employed the QI.  The QI's involvement served no purpose besides rendering simple, but tax disadvantageous, transactions more complex in order to avoid the related party restrictions.

The Ninth Circuit also affirmed the Tax Court's conclusion that Code Sec. 1031(f)(4) applied because improper avoidance of federal income tax was one of the principal purposes of the transactions.

Late in 2009, Teruya appealed the Ninth Circuit's decision to the Supreme Court. However, on Feb. 22, 2010, the Supreme Court declined to review the decision.