Tag Archives: 1031 Exchange

$23 Million Settlement Reached with UBS in 1031 Exchange Scam Lawsuit

The plaintiffs in a class action lawsuit who allege they lost over $80 million that they had placed with Southwest Exchange, Inc. (SWX) and several other 1031 exchange accommodators or qualified intermediaries (QIs) have reached a settlement with one of the defendants, UBS Financial Services, Inc. (UBS).

You can read our earlier post about the lawsuit here.

Under the terms of the settlement, the plaintiffs will receive $23 million from UBS.

The settlement was approved by the court on March 28, 2008, and a notice was sent to the class action plaintiffs on April 2, 2008.

You can read the settlement notice sent by the law firm of Hollister & Brace here.

UBS is one of several defendants who are alleged to have participated with Donald Kay McGahn and and others in a scheme to steal the money that had been entrusted to them to facilitate tax deferred 1031 exchanges.

In addition to UBS, the plaintiffs claim that other major financial firms, including Citigroup and Salomon Smith Barney, participated in the scheme.

A criminal investigation continues.

UPDATE:

For more on UBS, click here.

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Property of 1031 Exchange Scammer Ed Okun Goes on Sale

High-end retail complex properties in Kansas and Texas owned by the notorious Edward H. Okun have been put up for sale by a federal bankruptcy trustee.

The properties are the 1.1 million square foot West Oaks Mall in Houston, Texas, and the 587,512 square foot Salina Central Mall in Salina, Kansas.

Okun is alleged to be behind the 1031 exchange scam run by The 1031 Tax Group (1031TG) that defrauded thousands of people out of millions of dollars.

Okun was arrested in Miami, Florida, last month and charged with mail fraud, bulk cash smuggling, false statements, and forfeiture from a scheme to defraud and obtain millions of dollars in client funds held by The 1031 Tax Group. 

Those who were defrauded by Okun’s 1031 Tax Group had hoped to recoup some of their missing funds from Okun’s remaining assets — including the West Oaks Mall and the Salina Central Mall — which were purchased from monies allegedly taken from victims in the 1031 exchange scam.

But the Okun-controlled companies that owned the malls declared Chapter 11 bankruptcy in October. 

It is now unclear whether the proceeds from the sale of the properties would go Okun’s 1031 exchange scam victims.

Both properties apparently have a long line of creditors.

The trustee in the bankruptcy case has hired Keen Consultants, the new real estate division of KPMG Corporate Finance, to market both properties.

You can read our earlier post on Okun and his 1031 exchange scam here.

 

 

1031 Exchange Q and A: Using a 1031 Exchange to Avoid Recapture of Depreciation — Even If You Have No Capital Gains

Li-Ann owns a shoe factory on Grand Island, New York, that has decreased in fair market value since she inherited it 14 years ago. She was preparing to put the factory on the market when her lawyer suggested that she do a Section 1031 exchange rather than a sale in order to avoid paying capital gains taxes.

Li-Ann told her lawyer that she had no reason to use a Section 1031 exchange, since the property had decreased in fair market value.  She wasn’t going to make a profit on the sale, she said, and therefore wouldn’t be paying any capital gains taxes.  Since she wasn’t making any money on the property, she saw no benefit to a 1031 exchange.

Is Li-Ann correct?

The answer is No.  By focusing exclusively on capital gains, Li-Ann has missed half of the potential benefits of a 1031 exchange.

Li-Ann needs to take recapture of depreciation into account, not just actual profit, when deciding whether she will save money by using a Section 1031 exchange.

In this example, Li-Ann might well be wrong in thinking that because her property has decreased in fair market value, she would not owe any capital gains taxes on a sale.

Because depreciation reduces the adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on – when you sell the property.

Moreover, the government assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be recaptured when the property is sold.

The longer you’ve owned a particular property, the more depreciation has been taken, and the lower your adjusted basis.

Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

In fact, if you sell a property that you have owned for a long time, you are likely to have a sizable taxable capital gain (and be required to pay sizable capital gains taxes), even though you have no cash profit whatsoever.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you but carries over to the replacement property.

This recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031 exchanges.

Li-Ann should therefore consider using a Section 1031 exchange in order to avoid paying capital gains taxes on a potentially substantial “profit” that exists in the account books of the IRS, even though her property has not appreciated in value.

For more information on depreciation and 1031 exchanges, see our previous post Why Do a 1031 Exchange in a Down Real Estate Market?

For everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

Why Do a 1031 Exchange in a Down Real Estate Market?

Should you consider a 1031 exchange in a down real estate market?

In the booming real estate market of a few years ago, property owners saw their real estate assets increase dramatically in value.  As a result, if they sold their property they would have significant capital gains and therefore owe significant capital gains taxes that could be deferred or eliminated by a 1031 exchange.

Such dramatic increases in value are much less common in our current real estate market.  In fact, many properties have decreased in value, and would not lead to significant capital gains taxes if sold.

The question then is: if your property has not significantly appreciated in value, and you will not have a significant capital gain if the property is sold, is there still a reason to do a 1031 exchange?

The answer is yes.

Most people think of 1031 exchanges only in regard to avoiding capital gains taxes.  That’s only half the story.

In almost all real estate transactions, capital gains taxation has two components – taxes on actual gain and recapture of depreciation. The depreciation recapture provisions of Section 1250 (real property) and Section 1245 (personal property) apply to Section 1031 exchanges as well as sales. These provisions require depreciation to be recaptured at the higher ordinary income rate (instead of the long-term capital gain rate) when the property is sold or exchanged and a gain is recognized.

On the other hand, if you exchange property that is subject to recapture and no gain is recognized, the recapture potential of the relinquished property is not paid by you, but instead, carries over to the replacement property.

Moreover, this recapture potential can be deferred endlessly if you continue to transfer the property through Section 1031exchanges.

Thus, from a dollar perspective, avoiding the recapture of depreciation is just as important – and often more important – than avoiding taxes on actual capital gain since the monetary amount demanded by the government as recapture of depreciation is often larger than the taxes on actual capital gain.

In order to properly understand how recapture of depreciation works, you must first understand depreciation, and especially how the government looks at depreciation.

Simply stated, depreciation is loss of value. Over time all property except unimproved land depreciates, in the sense that over time all property except unimproved land undergoes wear and tear, becomes obsolete, and loses some of its physical integrity as foundations settle, damage is caused by long term exposure to air, water, and insects, and materials such as wood, metal, and concrete deteriorate.

The tax code properly recognizes this natural loss of value over time and allows property owners to deduct a prorated portion of this natural and inevitable loss of value each year from the owner’s basis in the property.

Deductions based on depreciation are taken according to schedules established by the IRS. For residential real estate and improvements, depreciation is taken over 27 years (known as the recovery period). For all other real property, including nonresidential investment property, depreciation is taken over a recovery period of 31 years.

While different kinds of assets are depreciated by different methods, all real properties, including buildings and permanent improvements, are currently depreciated using the straight-line depreciation method. Under the straight-line depreciation method, an identical proportional amount is deducted from your taxes as depreciation each year over the entire recovery period.

Crucially, because depreciation reduces your adjusted basis in a property, it has the effect of increasing the amount of profit – or, more precisely, the amount of capital gains that the IRS insists that you pay tax on when you sell the property.

The longer you’ve owned a particular property, the more depreciation has been taken and the lower your adjusted basis. Thus, the longer you own a particular property, the more depreciation will increase the amount of taxable capital gain, even without any cash profit due to appreciation.

For example, let’s say that you purchased a property 20 years ago for $400,000 and sell it today for exactly the same amount. You have absolutely no profit due to appreciation. But because of the depreciation allowable over the 20 years that you have owned the property, you will still have a taxable capital gain of approximately $300,000, even though you will have no cash profit whatsoever.

Even more significantly, even though you have no cash profit, you would still owe the government capital gains taxes of approximately $45,000!

Using a Section 1031 exchange allows you to legally avoid paying this tax, and instead, legally keep the money that you have deducted from your taxes as depreciation over the time that you’ve owned the property.

It is also important to note that the scheduled deductions for depreciation (and the resulting decrease in your property’s basis) are built into the tax code and are not at the discretion of the taxpayer. In other words, you cannot choose whether to depreciate your property and, hence, decrease your basis.

Even more significantly, you cannot claim an exemption from the recapture of depreciation because you did not, in fact, take the deductions due to depreciation that you were entitled to.

The government simply and absolutely assumes that you have taken all scheduled depreciation deductions, regardless of whether you have actually taken the depreciation deductions or not, and will insist that this allowable depreciation be “recaptured” when the property is sold.

So the answer to the question “Should I consider a 1031 exchange in a down real estate market?” depends not only on your actual capital gains, but also whether you want to avoid paying the government the amount of depreciation that the property has been entitled to during the time you have owned it.

In many cases, the answer will be yes.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

California Proposes to Eliminate 1031 Exchange Tax Benefits

In the midst of the worst real estate market in decades, bureaucrats in California have decided to make life in the Golden State even harder for real estate investors and professionals.

The California Legislative Analyst’s Office (CLAO) has recommended that property located outside California no longer receive the deferral of capital gains taxes offered by Section 1031.

California currently follows federal law regarding 1031 exchanges, permiting investors to exchange business or investment property for property of a like kind without paying state capital gains that might have accrued on the first property.

Under the new proposal, California would eliminate the tax exclusion for capital gains on like–kind exchanges involving out–of–state commercial property.

The reason CLAO gives for their proposal is that once the in-state asset is swapped for an out-of-state asset, the state losses all the gain since the owners will not report it.

The CLAO estimates that the state could gain revenue of approximately $25 million in 2008-2009 and $50 million in 2009-2010.

So, drowning under mountains of debt and overspending, California decides to go after its faltering real estate industry to help make up the shortfall.

CLAO’s argument in favor of eliminating deferral of state capital gains taxes for 1031 exchanges is specious at best. 

The Tenant-in-Common Association (TICA) has opposed the CLAO proposal.

We look forward to TICA mustering the facts and figures to blow it out of the water. 

If you would like more information or have questions or comments, you should contact Greg Ellis of TICA at gellis@ticassoc.org or 317.663.4176.

So far, no legislator has gone on the record in favor of the CLAO proposal.  We think it should stay that way.

Now is not the time to place greater burdens on the California real estate market.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

 

1031 Exchange Q and A: Unbuilt Property, Incidental Property, and IRS Deadlines

Bill owns a car wash in Chicago, Illinois. He wants to use Section 1031 to exchange his car wash for a tenancy-in-common interest in a shopping mall in Tuscan, Arizona, that will be built next year.

Can he exchange the real property involved in his car wash for real property that is not yet built?

What about the equipment and machinery used in the car wash?

Allso, Bill knows that under Section 1031, he has 180 days from the transfer of his car wash to identify replacement property and complete the exchange. He expects to transfer the car wash in late November, so he figures he has until late April to complete the exchange.

What would you advise Bill?

Bill can exchange his property for replacement property that is not yet built, so long as the replacement property is completed prior to the expiration of the 180 days.

The equipment and machinery used in the car wash (referred to as “incidental property” in Section 1031 exchanges) can be part of the exchange, so long as it meets the requirement that it is typically transferred with the real property of a car wash in standard commercial transactions and the total market value of the incidental property does not exceed 15% of the market value of the real property involved in the exchange.

Bill needs to be very careful if he transfers his relinquished property anytime after October 18.

Remember that the actual deadline for completing an exchange is the earlier of either 180 days from the date you transfer the relinquished property – or the date, including extensions, that your tax return is due for the year in which you transfer the relinquished property. Exchangers must report their exchanges on the tax return for the year in which the exchange begins.

Thus, if you relinquish property after October 18, you actually have less than 180 days to complete the exchange, unless you file for an extension.

If Bill transfers his car wash in late November, he should expect to file for an extension on his tax returns, unless he is absolutely certain that he can complete the exchange before April 15.

For more information on this topic, and for everything you need to know about 1031 exchanges, see our book 1031 Exchanges Made Simple, available at Amazon.com.

To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to strategicfox@gmail.com

Lawsuit Claims $80 Million Stolen in 1031 Exchange Scheme

More 1031 exchange accommodators are in very hot water.

And millions of dollars that people thought were going to be used for 1031 exchanges are missing.

Last week, Edward Okun and others were indicted in a 1031 exchange intermediary scheme that is alleged to have defauded clients of approximately $132 million.

A class action lawsuit has been filed in the California Superior Court of Santa Barbara County alleging that 130 people from 12 states lost over $80 million that they had placed with Southwest Exchange, Inc. (SWX) and several other 1031 exchange accommodators or qualified intermediaries (QIs).

The QIs are alleged to have been taken over by Donald Kay McGhan and other individuals with the purpose of stealing the money that had been entrusted to them to facilitate tax deferred 1031 exchanges.

The lawsuit claims that a “group of thieves discovered that these Exchange Accommodators were unregulated businesses holding large sums of cash that needed ready access to only a small percentage of the money to operate as going concerns. Pursuant to a conspiracy, these thieves purchased several Exchange Accommodators, gained access to their funds held in trust with the assistance of certain brokerage houses, stole the majority of those funds for personal gain, and caused over $80,000,000 in damages which was exposed when the real estate market finally cooled.”

According to the lawsuit, money held in trust by SWX was funneled to shell companies that Santa Barbara businessman Donald Kay McGhan set up to launder the funds, which were then withdrawn for his and his accomplices’ benefit.

The plaintiffs claim that the exchange accomodators were operated as a ponzi scheme by Donald Kay McGhan and his alleged accomplices.

Because the real estate market was hot in 2004 and 2005, money coming in for new 1031 exchanges could be used to cover funds deposited for previous exchanges that McGhan and his cohorts had already raided.

When the real estate market suddenly cooled at the end of 2005, the number of 1031 transactions declined and not enough money was coming in to cover the embezzled funds, according to the suit.

By April 2006, the scheme began to unravel as SWX faced liquidity problems, the lawsuit states, and by October 2006, approximately $80 million was missing from the trust funds.

The QI defendants in the lawsuit include Southwest Exchange, Inc. (SWX), doing business as Southwest Exchange Corporation and Southwest 1031 Exchange, and Qualified Exchange Services, Inc. (QES).

Individual defendants include Donald Kay McGhan, Jim J. McGhan, Dean A. Koch, Nikki M. Pomeroy, Albert Conton, Peter John Demarigny, Kyleen M. Dawson, and Megan L. Amsler.

Donald Kay McGhan, 73, was the founder, chairman, and president of the McGhan Medical Corporation, maker of silicone breast implants and for many years one of the Santa Barbara’s top employers. McGhan left the company, now called Inamed Aesthetics, in 1998, and the company later settled a fraud suit filed by the Securities and Exchange Commission alleging that McGhan had filed false financial statements that misled investors.  McGhan himself paid a $50,000 fine to the SEC.

Additional corporate defendants include Capital Reef Management Corp., Cennedig LLC, Medicor LTD, International Integrated Industries LLC, Ventana Coast LLC, and Sirius Capital LLC.

The plaintiffs also claim that major financial firms Citigroup, Salomon Smith Barney, and UBS Financial Services participated in the scheme.

There is also an ongoing criminal investigation.

You can see the complaint here.

Our advice:

If you’re planning to do a 1031 exchange, make sure that you perform due diligence in your choice of a QI or exchange accomodator, make sure that the QI is bonded, and make sure that you work with an experienced tax advisor and attorney who can help you navigate the 1031 exchange process. 

And, as we’ve said before, it is imperative that the Federation of Exchange Accomodators (FEA) work more closely with state and federal authorities to establish regulations for QIs that will restore and maintain public confidence.

UPDATE:

A $23 million settlement has been reached with UBS Financial Services, one of the defendants in the plaintiffs’ class action lawsuit.  You can read our post about the settlement here.