Why this matters: Tax aspects are basic to the sale or ownership of real estate. When applicable, income taxes have significant financial impact on sellers and buyers of real estate. This article explains how to offer tax advice when appropriate, increasing an agent’s marketability by widening the range of services and advice offered to clients.
Analyzing a transaction’s tax aspects
An owner of an income-producing parcel of improved real estate decides to hire a broker to market the property for sale, locate a buyer and close a sale. The owner interviews a few brokers to determine who they will employ.
During interviews, the owner intends to inquire into the:
- contents of the marketing package the broker prepares to market a property;
- scope of the advertising the broker initiates to locate prospective buyers; and
- professional relationship the broker has with buyer brokers.
One broker interviewed asks what the owner intends to do with the proceeds from the sale. The owner discusses their need to get out of income property to reinvest in management-free developable land for a later resale to a subdivider or builder.
Further, the broker asks the owner for the:
- price paid for the property;
- mortgage balance and its terms; and
- cost basis remaining in the property.
The broker explains these three key pieces of financial information are needed for an analysis and discussion about the tax consequences of a sale. The owner provides the figures for the broker’s analysis. [See RPI Form 354]
Related article:
Form-of-the-Week: INTAX and §1031 Profit and Basis Recap Sheet — Forms 351 and 354
Initial opinion of tax liability
The broker does some quick math (sales price minus basis equals profit) to approximate the amount of profit the owner realizes on a sale at the asking price. The broker determines the taxes on recaptured profits (25% rate) and long-term profits (15% rate) equal nearly one fifth of the net proceeds from a sale (plus one-twelfth for state taxes).
The owner is informed of the broker’s initial opinion about the owner’s tax liability on a sale. Further, the broker explains how the owner in a reinvestment plan avoids reporting the profit and paying income taxes on the sale when the seller acquires other real estate as a reinvestment. Thus, the sale of the income property and the purchase of land are linked as a continuing investment of the owner’s equity and debt in real estate.
The broker also informs the owner the purchase agreements entered into for the sale of the income property and the purchase of the land are to contain contingency provisions conditioning the closing of the sale on the owner’s purchase of other property.
Disclosure of known consequences
To avoid misleading the owner, the broker informs the owner they have not personally handled a §1031 transaction. Thus, the owner is on notice about the extent of the broker’s experience handling §1031 reinvestment plans for clients.
However, the broker lets the owner know the broker has taken courses on §1031 transactions and discussed §1031 funding procedures with brokers and escrow officers experienced in these reinvestment arrangements.
The broker assures the owner they are able to both locate a buyer for the owner’s income property and find suitable land for the owner’s reinvestment when the owner enters into a representation agreement with the broker.
The owner, now informed of the tax aspects of a sale, contacts a second broker. The broker is reticent to become involved in a review of the tax aspects of selling and buying property.
The second broker, in anticipation of being retained, prepares and reviews with the owner a representation agreement with an attached statement advising the owner the broker:
- has disclosed the extent of their knowledge of the tax consequences on the sale of real estate;
- is unable to give further tax advice on the rules and procedures involved in a §1031 transaction; and
- has advised the owner to seek the advice of their accountant or tax attorney on how to structure the sale and purchase of real estate to avoid reporting the profit realized on a sale.
Did both brokers comply with their agency duty to make proper disclosures to the owner about their knowledge and willingness to provide tax advice?
Yes! Both brokers met their agency duty undertaken when soliciting employment since each broker:
- determined the owner’s sale and reinvestment had tax consequences, called a material fact which requires disclosure;
- disclosed the extent of their knowledge regarding the possible tax consequences of the sale; and
- advised on the need for a competent professional to further advise the owner on the §1031 tax aspects.
A question then arises: Is a broker employed as the representative of an investor in the sale or purchase of real estate duty bound to give relevant tax advice to their seller?
The answer lies in the type of real estate involved and the client’s intended use of the sales proceeds.
Related video:
Read more about a §1031 reinvestment plan.
An affirmative duty to advise
When income tax information may affect a client’s handling of a proposed transaction, their broker discloses the existence of the tax issue. Further, and limited to the extent of the broker’s knowledge, the broker reviews the transaction’s tax aspects with the client, in compliance with a broker’s agency duty or fiduciary duty owed the client.
Further, a seller broker assists their client in structuring the sales arrangement to achieve the tax objective.
As an exception, a broker representing the seller of a one-to-four unit residential dwelling available for sale has no duty to disclose their knowledge of possible tax consequences to their seller-client. Even when the tax consequences are known to the broker as most likely to affect the client’s decisions when known to the client, the seller broker has no duty to disclose, unless the topic becomes the subject of the client’s inquiry. [Calif. Civil Code §2079.16]
Advice disclosure
Consider a seller of a one-to-four unit residential property who enters into a representation agreement with a broker to sell the property. One of the attachments is the statutorily mandated Agency Law Disclosure form which states:
“A real estate agent is a person qualified to advise about real estate. When legal or tax advice is desired, consult a competent professional.”
Here, the reference to a competent professional may be the broker and agent involved. The “disclaimer” does not require the broker to advise about the transaction’s tax aspects or obligate the seller to employ another professional for tax advice. Thus, the client is left a bit rudderless by this statutory statement unless their broker speaks up. [CC §2079.16]
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Constructive receipt of like-kind sales proceeds
Continuing our example, the broker negotiates the seller’s purchase agreement to acquire a replacement one-to-four unit residential property prior to closing the sale of the seller’s property.
The seller asks the broker about the time period after closing the sales escrow for the seller to close escrow on the purchase of the replacement property to avoid paying profit tax on the sale. Neither escrow has yet closed, and the seller has never been involved in a §1031 reinvestment.
The broker informs the seller they are not sure of the number of days and orally advises the seller to consult a tax accountant. The seller does not do so, and the purchase agreement does not have a further approval contingency provision regarding the seller to obtain third-party advice on the tax consequences before closing their sale.
The sales escrow closes, and the seller receives the net sales proceeds which the seller deposits into their bank account. The reinvestment property is acquired within the proper time period between closings of the escrows.
Ultimately, the seller is taxed on the profit from the sale. The seller erroneously received the net proceeds of the sale rather than instructing escrow to disburse the net proceeds directly to the purchase escrow for their account as the buyer.
Here, the seller failed to avoid actual and constructive receipt of the sales proceeds, the essence of a continuing investment required of a §1031 reinvestment plan. To avoid receipt, the seller needed to either:
- directly transfer the sales proceeds from the sales escrow to the purchase escrow; or
- impound the sales proceeds with a third-party trustee until the proceeds are needed to fund the purchase escrow for the replacement property. [See RPI Form 172-4]
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Tax advice liability exception
Continuing with the above example, the seller then seeks to recover money from the broker for the profit taxes incurred due to adverse tax consequences on the failed reinvestment plan handled by the broker. The seller claims the broker breached their agency duty owed to the seller by failing to disclose that the structure of the seller’s transfer of net sales proceeds from the sales escrow to the purchase escrow for the replacement property results in adverse tax consequences due to the seller’s actual receipt of the reinvestment funds.
The broker claims they have no duty to advise the seller on the tax consequences of the one-to-four unit sale, since the Agency Law Disclosure stated:
- the broker does not advise on tax matters; and
- the seller is to look to other professionals for tax advice.
Did the seller broker have a duty to advise the seller on the tax consequences of the sale as known to the broker?
No! On the sale of one-to-four unit residential property, sellers (and buyers) are expected, as a matter of public policy, to obtain tax advice from competent professionals which may or may not be the seller broker. [CC §2079.16]
A broker has no duty to voluntarily disclose any tax aspects on the sale of a one-to-four unit residential property, even when the information is known to the broker or the sales agent. However, in response to a direct inquiry from the seller (or buyer), the broker is to advise the client to the best of their knowledge. [Carleton v. Tortosa (1993) 14 CA4th 745]
Related Client Q&A:
The irony of mandated disclosures
The tax consequences of sales transactions involving reinvestment of the net sales proceeds in replacement property are as material to a seller as the structuring of carryback financing. However, carryback financing arrangements require a broker to make extensive mandated disclosures regarding documentation of the carryback and the rights of the carryback seller. However, carryback arrangements are far less frequently encountered and have far less documentation than §1031 reinvestment opportunities.
Further, the financial loss of profit taxes avoidable in a §1031 transaction often exceeds the risk of loss on an improperly structured carryback note and trust deed transaction. [Timmsen v. Forest E. Olson, Inc. (1970) 6 CA3d 860]
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Capitalizing on tax knowledge
A broker or broker’s agent often is not fully qualified to be an advisor on the sale and purchase aspects of a §1031 transaction. However, they are at least aware of its beneficial tax avoidance aspects available to a seller of any type of property other than a personal residence (with an exemption for that, too).
Further, real estate brokers and their agents with tax knowledge are duty-bound to advise their client about their knowledge concerning the tax consequences of the real estate transaction their client is about to enter — unless a one-to-four unit residential property is involved.
A savvy broker or agent capitalizes on their tax knowledge by advising clients on the tax results of their real estate transaction, regardless of the type of property involved. However, the broker or agent who advises a client on a transaction’s tax consequences has a duty to not mislead the client by intentional or negligent misapplication of the tax rules. [Ziswasser v. Cole & Cowan, Inc. (1985) 164 CA3d 417]
To avoid misleading the client when tax aspects of a sale or purchase are discussed, the broker or agent is advised to disclose to the client:
- the full extent of their tax knowledge regarding the transaction;
- how they acquired their tax knowledge; and
- whether the broker or agent intends to further investigate the matter or the client is to seek further advice from other professionals.
Related article:
Using the INTAX form to calculate the seller’s federal tax liability on a real estate sale
A shift in reliance and liability exposure by a writing
Brokers and agents who provide tax advice best serve their clients by involving the client’s other advisors in the final decision, such as the client’s attorney or accountant. Input from others who know the client eliminates future claims against the broker arising from adverse tax consequences allegedly caused by the client’s reliance on the broker’s opinion.
The most practical (and effective) method for shifting reliance to others or to the client when the broker provides their opinion on a transaction’s tax consequences is to insert a further-approval contingency provision in the purchase offer or counteroffer.
The contingency provision requires the client to initiate their own investigation by obtaining additional tax advice and further approval of the transaction’s tax consequences from an attorney or accountant before allowing escrow to close.
An oral or written warning, or general advice to a client to further investigate as in a disclaimer statement is insufficient. Advisory statements do not require the client to do anything. Worse, disclaimers never explain why the broker or agent providing the advisory statements believes the client needs to act to protect themselves, a patent failure of agency duties. A further-approval contingency provision makes the advice an opinion which the client is to confirm before closing. [Field v. Century 21 Klowden-Forness Realty (1998) 63 CA4th 18]
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Tax advisor’s further approval
In an exchange agreement (or purchase agreement), a further approval contingency regarding the transaction’s tax consequences requires a client to confirm the transaction qualifies for §1031 tax-exempt status as represented by the broker. When the client is unable to confirm the tax status, the client may terminate the transaction by delivery of a notice of cancellation. [See RPI Form 171 §5.2]
In other words, the client does not rely on the broker’s opinion when they decide to enter an exchange agreement with a further-approval contingency expressing the intent to close escrow only after further confirmation of the tax consequences.
Further, a purchase agreement or exchange agreement which contains a written contingency provision calling for a third party’s approval of some aspect of the transaction comes with an unwritten implied covenant. Under the implied covenant, a client may cancel a transaction only when they “act in good faith and with fairness” to obtain the third party’s approval, such as submitting data on the transaction for confirmation by an attorney or accountant.
Thus, the implied covenant compels the client to submit documentation on the transaction to the third-party tax advisor, and to do so within the time period called for after the date of acceptance.
Here, the client’s broker usually steps into the chain of events and contacts the third party. The broker provides the paperwork the advisor requests to review the transaction for its §1031 tax-exempt status. On review, the broker arranges closing procedures needed to meet the client’s objectives and satisfy the objections of the third-party advisor.
Since fair dealing and reason are implied in every agreement and applied to the conduct of all participants, a termination of a §1031 transaction due to a disapproval triggering the contingency provision needs to be based on a justifiable reason.
On a potential disapproval and possible termination due to reasons expressed by the client or their advisor, the broker may be able to cure the defect which gave rise to the reason for disapproval or demonstrate the third party’s concern is unfounded, such as when their concern is in fact or in law an erroneous conclusion. [Brown v. Critchfield (1980) 100 CA3d 858]
Related article:
Form-of-the-Week: Preliminary Proposal and Exchange Agreement — Forms 170 and 171
Tax aspects: a material fact
All real estate in the hands of a seller is either:
- a principal residence;
- like-kind (§1031) property; or
- dealer property.
When representing sellers of real estate which, on a sale, qualify for the §1031 profit reporting exemption, a broker uses a purchase agreement containing a §1031 cooperation provision. [See RPI Form 150 and 151 §9.6]
A §1031 cooperation provision puts the seller on notice they may avoid profit reporting on the sale and that the buyer will cooperate when the seller decides to act to qualify their profit for a §1031 reporting exemption. It is not an advisory disclaimer by which a broker or agent attempts to relieve themselves of their responsibility to give tax advice. The provision represents the broker’s advice about taxes and puts the issue in the hands of the client to further pursue.
Again, a broker who is not knowledgeable about the handling required for a §1031 reinvestment may initially avoid a discussion of tax aspects by including the §1031 cooperation provision in all purchase agreements. The §1031 cooperation provision conveys to the seller the seller’s need to consider, plan for and inquire about the tax consequences of the sale. [See RPI Form 150 and 151 §9.6]
Related video:
Read more about the purchase agreement contents.
Knowledge of basic tax aspects
Technical questions by a seller which go beyond their broker’s knowledge or expertise require a truthful response from the broker, including:
- disclosing the extent of their knowledge to the seller and advising the seller to seek further advice they may want from another qualified source;
- associating with a more knowledgeable broker, a tax attorney or accountant who provides the seller with the advice; or
- learning how to handle §1031 reinvestments and giving the advice themselves.
Escrow officers are indispensable assistants to a broker who is aware they have a §1031 transaction. Many escrow officers and transaction brokers advertise their expertise in handling §1031 tax-deferred reinvestments to broadcast their competitive advantage over other escrow officers and brokers.
Ideally, brokers and agents handling the sale of real estate used in the seller’s business or held for investment (both are like-kind property) will, as a matter of their need for basic competency, possess an understanding of several fundamental tax concepts, such as:
- the principal residence owner-occupant’s individual $250,000 profit exclusion on a sale;
- the separate income and profit categories for different types of real estate;
- the §1031 profit reporting exemption;
- interest and related deductions on mortgages;
- depreciation schedules and cost recovery deductions;
- the $25,000 deduction and real estate-related business adjustments for rental property losses;
- the tracking for reporting rental income and losses separately for each property;
- profit and loss spillover on the sale of a rental property;
- standard and alternative reporting and their tax bracket rates; and
- installment sales with deferred profit reporting.
These tax aspects are basic to the sale or ownership of real estate. When applicable, income taxes have significant financial impact on sellers and buyers of real estate. Any broker or agent with a working knowledge of the tax aspects of real estate is advised to consider offering a wider range of services — including tax advice — when competing to represent buyers and sellers.
Additionally, when a seller gets tax advice concerning a §1031 reinvestment plan and follows the advice, it always leads to a second fee — for negotiating the purchase of the replacement property and coordinating the transfer of funds.
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