Scoop Daniel was involved in property exchanges
Vail, CO, Colorado
Breckenridge attorney Scoop Daniel’s alleged disappearance to Brazil with client money has shined a light in the area legal and real estate community about “1031 exchanges.”
The Scoop scoop, if it is to be believed, is that Daniel made off like a thief in the night (or more accurately, the early morning) with money he had been holding in trust for several clients as a “qualified intermediary” in order to complete their various 1031 exchanges.
What, then, is a 1031 exchange and how was Daniel able to allegedly finance his retirement on the sunny Copacabana?
Here’s the answer, in three parts.
When real estate is held for some time in a rising market, the income tax value of the property is often less (sometimes considerably so) than the market value. When the owner wants to sell the property, this difference between the tax and market value of the property can create what may be a considerable tax problem for the seller. If the owner sells the property outright, he or she will be subject to capital gains taxes on the property.
One way to “avoid the gain” is to hold the property until the owner’s death. There may, however, depending upon the size of the estate and the nature of the heirs, be other estate tax implications.
“Exchange” is the key concept in a tax-deferred exchange. By use of this method, the gain is deferred rather than eliminated. The deferral lasts until the taxpayer sells the exchanged property in a transaction such as a subsequent outright sale. Of course, he or she could exchange property at some future date in yet another qualified exchange and thereby again defer taxes. Theoretically, there is no limit to the number of allowed exchanges. Clearly, this strategy can be employed not only to avoid a potential gain, but also as a centerpiece to building wealth.
If the assets acquired by this method are not sold or otherwise transferred in a taxable transaction prior to the taxpayer’s death, but instead, are “held” within his or her real estate portfolio, then the accumulated gain will be extinguished. Essentially, the tax value will equal the fair market value and therefore, the two being equal, there can be no “gain.”
Like-kind exchanges, also known as 1031 exchanges, provide that no gain or loss is recognized if a taxpayer transfers his or her real property for other real property which is “like-kind.” The section specifically applies to investment and business real property which is held for productive use in a trade or business or which is held for investment. Applying this definition, “like-kind” can mean, for example, the exchange of apartment units for a vacant lot which is held for appreciation.
One potential stumbling block, however, is the formality with which such exchanges must be conducted. Form is everything. The taxpayer must be prepared to demonstrate that the transaction is an exchange rather than a sale with subsequent reinvestment of the proceeds.
In order to avoid an “inadvertent” ” and therefore taxable ” sale, the exchanged-for property must be held for investment or productive use in a trade or business. In other words, the investment must remain locked up in a use substantially similar to that of the exchanged property.
Sometimes, this intent to lock up the exchanged-for property in a similar use is evidenced by the lapse of time (often two years) before it may ultimately be transferred.
The formalities of exchange also require the taxpayer to trade “up or even.” What this means is that, in order to avoid the gain, the value of the exchanged-for property must be equal to or greater than that of the relinquished property. If the taxpayer receives any cash in the deal, he or she will realize a taxable gain.
The third party
An often perceived problem, but not a problem in fact, is the requirement that the exchange be “simultaneous.” Typically, the taxpayer will find a replacement property he or she wishes to acquire but only rarely will the current owner of that property want to “trade” his or her property. To get around this problem, a “qualified intermediary” is employed, usually at a modest fee. Under this structure, a third person or entity (such as Scoop Daniel), acts as a “receptacle” into which both properties are deposited and the intermediary then transfers them back out to the new owners.
In this way, the taxpayer’s property may be transferred to someone other than the person owning the property. Further, money is never in the hands of the taxpayer and he or she is thereby “insulated” from the gain. Thus, the pot of money to which Mr.
Daniel allegedly had access.
In next week’s column, we will explore the world of reverse exchanges, various safe harbors and other related aspects of exchange.
Rohn K. Robbins is an attorney licensed before the Bars of Colorado and California who practices in the Vail Valley. He is a member of the Colorado State Bar Association Legal Ethics Committee and is a former adjunct professor of law. Robbins lectures for Continuing Legal Education for attorneys in the areas of real estate, business law and legal ethics. He can be heard on Wednesdays at 7 p.m. on KZYR radio (97.7 FM) as host of “Community Focus.” Robbins can be reached at 926-4461 or at email@example.com