1031 exchange gone bad

[Karen Lee]

My client keeps calling me and I keep telling her to go to someone that is more familiar with 1031 exchanges. This is the situation as I understand it:

My client has a piece of commerical property that he wants to use in a 1031 exchange. Exchange property is picked and the deal is ready to go through all criteria are met. My client finds out that the 1031 exchange company has gone bankrupt and their money is gone and so is the property. Why does this not make sense to me?

My client called Taxpayer Advocate Office and they said she had to pay taxes on the deal (what deal?). Looks like to me that they have lost $ and property and there isn't any taxes to pay just losses to report.

I feel so stupid...why would the $ be in the hands of the exchange company and the deed as well? Maybe the exchange property was of higher value and my client had to "put-up" money with the exchange company, the exchange company goes bankrupt takes money and the client loses "put-up" money and new property? Why wouldn't the whole deal reverse?

There is a possibility the $ will be recovered before the end of the year but well after the time period of selecting the exchange property. OH....this is what the client is talking about. Will they have to pay regular cap gain on the sale of their commercial property when the $ is recovered even though they were trying for the 1031 exchange that went sour?

OK, my first instinct is yes. My second is someone more familiar with 1031 exchanges needs to handle this for them.

Shouldn't I be on vacation or something?

Karen

[jainen]

>>Will they have to pay regular cap gain on the sale of their commercial property when the $ is recovered even though they were trying for the 1031 exchange that went sour?<<

They will have to report capital gains on the disposition and they will not be able to salvage the exchange. There is nothing like "reasonable cause" allowed; they simply have to follow the 1031 requirements exactly or it doesn't qualify. Whether it is taxable or not depends on the rest of the return.

I'm not sure if there is an investment loss. Probably there is, or perhaps a casualty loss, but I would want to study the transaction documents before I decided that.

Presumably they have a claim against the bankruptcy estate, but the exchange contract does not give them any collateral or security so they may not be able to recover anything. They should consult with an attorney to see if a claim of fraud or some other special application is appropriate.

[BulldogTom]

>>Will they have to pay regular cap gain on the sale of their commercial property when the $ is recovered even though they were trying for the 1031 exchange that went sour?<<

They will have to report capital gains on the disposition and they will not be able to salvage the exchange. There is nothing like "reasonable cause" allowed; they simply have to follow the 1031 requirements exactly or it doesn't qualify. Whether it is taxable or not depends on the rest of the return.

I'm not sure if there is an investment loss. Probably there is, or perhaps a casualty loss, but I would want to study the transaction documents before I decided that.

Presumably they have a claim against the bankruptcy estate, but the exchange contract does not give them any collateral or security so they may not be able to recover anything. They should consult with an attorney to see if a claim of fraud or some other special application is appropriate.

Jainen,

I respect your opinions, so I would like to ask what you think about this line of reasoning:

Since a "sale or other disposition" is required for imposition of tax under the code, could one not argue that the transaction never was completed. Thus, if there is no quid pro quo as the taxpayer did not receive something in exchange for the property given up, there is no "sale or other disposition". Then we have only a loss (casualty or investment) to deal with. The reason we use the QI in these transactions is so that we do not touch the sale proceeds so that we don't complete the transaction before the exchange is completed.

I may be stretching this a little, but I think this may be an argument that I would research in depth.

BTW, I was thinking along the same lines as your post before I thought of this.

Tom

Lodi, CA

[jainen]

>>there is no "sale or other disposition"<<

Possibly. That's why I said I would need to see the documents. It depends on how the exchange was structured and at what point they were in the exchange when it fell through. My guess is they did receive contractual exchange credits for the old property, and it was the loss of these credits that might be considered a sudden theft or casualty. In that case they would still have gain from the disposition.

It might even be a better tax position that way. The gain is taxed at 15%. The loss is an itemized deduction or an investment loss, but either way calculated on FMV instead of limited to original basis.

I would also scrutinize every piece of advertising this company had, looking for any hint of a bond, insurance, or guarantee. All the major facilitators are bonded, and if these guys also claimed to be but couldn't make good on it that might be a sign of fraud.

[Karen Lee]

Thanks so much. I have no intention on dealing with this. They have been clients for over 10 years and I've seen them through selling the same business 3 times now and that was difficult enough (for me).

Hope to hear some more opinions on this one.

There is an investigation going on. I haven't seen the paperwork but heard fraud mentioned.

Karen