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Friday, 28 August 2009

Crime of the Week: Multi-colored Swap Shop

UK readers may remember the style crime that was Noel Edmonds TV show, but they have probably never heard of Edward H. Okun, the former owner of The 1031 Tax Group LLP. The name of the company derives from a section of the US tax code, section 1031 as it happens, from which a minor industry peculiar to the US has evolved.

Under Section 1031, recognition of gains or losses arising on the alienation of property may be deferred on the exchange of certain types of property. Or in plain English, if a US tax payer buys a building for 100 which they decide to sell many years later for its market value of 200, they would pay tax on the profit of 100, but if they exchanged it for another property also worth 200, they would not recognise any gain, but they would carry over a "basis" of 100 in the new property.

In terms of tax policy, there is nothing particularly unusual about this as many countries operate what might broadly be termed reinvestment relief where the proceeds of the sale of movable or immovable property are reinvested in similar property. The US system is unique in that it requires the exchange of the old property for the new to qualify for the tax relief. There is no other mechanism under the US tax code for the vendor to achieve the same relief.

This creates a number of problems. First of all if you are selling one building and buying another, the buyer of the old proerty and the seller of the new property are almost certainly not the same person. Since those two other counterparties do not want to be involved in your tax affairs, it is necessary to introduce a third party accomodator who will enter into the buying and selling contracts with the other counter parties and exchange the properties with you to give you the desired tax effects.

Now the real estate market being what it is, the chances of being able to line up all your ducks in a row and contract a simultaneous sale and unconnected purchase are about as remote as Bernie Madoff chances of beatification. The solution was to amend the law to permit deferred exchanges, where you would enter into one half of the exchange with the intermediary who would sell the property and hang on to the proceeds, giving you 45 days to indentify and 180 days to complete on the purchase leg of the exchange. In order to make this work the accommodating party, called a Qualified Intermediary, had to be completely unconnected.

But in most cases, there were no requirements that the Qualified Intermediary should have any qualifications at all. Extraordinarily, the only place they have to be licensed is in Nevada, although that state does not require permits for unconcealed handguns. Elsewhere anybody who is fit to run a US company can set up as a 1031 intermediary.

Okun's business grew when the times were good, so that at any time his company would hold several hundreds of millions of dollars, but when the market peaked, volumes dropped and the group ran into a "liquidity problem", specifically because Okun had helped himself to $126 million of client monies, which is why he is going away until 2109.


Demetrius said...

If he had been pulling this kind of trick in the UK he would be in the House of Lords and a junior minister in the government by now.

Anonymous said...

I think you're missing a huge part of this. Okun was not in the 1031 business for very long. What he did was acquire 1031 companies with huge 1031 deposits, then pretty quickly take the deposits out to use for his own purposes. I believe he knew exactly what he was doing when he bought the companies. Example, he bought IXG for $9 million with $7 million down. This purchase gave him control of somewhere in the neighborhood of $150 million in deposits. Pretty easy scam. He could have even borrowed the $7 million, then used $7 million of the exchange deposits to pay back the lender. He virtually could buy the company with nothing out of pocket by use of a bridge loan.

Alex said...

"I believe he knew exactly what he was doing when he bought the companies."

I don't disagree. Thee whole scam would have to have taken place pretty quickly because the 1031 QI can only hold the money for 180 days at most, and usually a lot less so Okum would have had to act fast before he got closed down by a downturn in the market.

What surprises me is that so many people would give so much money to such a company without so much as a bank guarantee or any assurance that they would receive their new property in exchange.

The victims got hit twice because not only did they lose the sale proceeds, they also got hit with taxes on the gains on sale even though they didn't receive a penny from the sale.