This article clarifies the extent of the broker’s duty to disclose the tax aspects of a real estate transaction to his client.

Knowledge of material facts disclosed

An owner of income-producing real estate wants to sell the property. Pricing and marketing of the property are discussed with a few brokers.

One broker, viewing the owner as a potential client for further transactions, asks the owner what he intends to do with the net proceeds from a sale. The owner indicates he will eventually use the proceeds to purchase land to hold as a long-term investment.

The broker is aware the owner can avoid reporting and paying some or all of the taxes on his profit if he reinvests the sales proceeds in replacement property as a tax-free §1031 transaction.

Further, the broker candidly informs the owner he has not personally handled a §1031 transaction, but he has studied them and discussed them with brokers and escrow officers experienced in §1031 procedures. The broker knows he can assist the client by locating replacement property and by investigating the proper §1031 procedures if he is retained to market the property under a sales listing.

Conversely, a second broker contacted by the owner does not want to become involved in a review of the tax aspects of selling property.

The second broker, now aware of the owner’s tax concerns, informs the owner:

  • that he has reviewed the extent of his knowledge of the tax consequences on the sale of real estate with the owner;

  • that he is unwilling to investigate and give further assistance on the tax consequences of a sale; and

  • that the owner needs to seek advice from his accountant or tax attorney (or other competent real estate professional) on how to properly avoid profit reporting on the sale of real estate.

Did both of the brokers properly respond to the owner’s inquiry seeking tax advice?

Yes! Each broker:

  • determined the tax consequences of the sale might affect the seller’s handling of the sales transaction, thus establishing the tax aspects of the sale as a material fact;

  • disclosed the extent of his knowledge regarding the possible tax consequences of the sale; and

  • advised on the need for, and who would conduct, a further investigation and advise on the §1031 tax aspects of a sale.

The question then remains, “Must a broker give tax advice to an owner of real estate who employs him to sell the real estate?”

The answer lies in the type of property involved and the owner’s intended use of the sales proceeds.

Tell it like it is

All brokers acting as agents owe a general duty to all parties to disclose material facts known to them about the property which would put all parties on notice of the material fact. Further, all brokers owe their client a specific duty to advise on the consequences of material facts known by the broker to exist in the property and in the transaction.

As an agent in a real estate transaction, whether acting on behalf of the owner, buyer, tenant or lender, a broker and his agents owe a general duty to all participants in the transaction:

  • to refrain from misleading anyone by making intentional or negligent misrepresentations or omissions about the property and the transaction, called deceit; and

  • to disclose information known to the broker about the property and the transaction, which if disclosed, might affect the individual’s handling of the transaction, called material facts. [Ziswasser v. Cole & Cowan, Inc. (1985) 164 CA3d 417]

Further, a listing broker who determines the tax aspects of a sale are of concern to his client and has reason to believe the tax consequences might affect his client’s handling of a sale, has a specific duty to disclose to his client the extent of his knowledge on the tax implications, also called a fiduciary agency duty. A prudent listing broker will go beyond mere tax information and aid his client to achieve the best tax consequences possible.

However, on one-to-four unit residential dwellings, a listing broker is charged with no legal duty to his seller to disclose any awareness or knowledge he may possess about the possible tax consequences of a sale. The one-to-four unit rule applies even though the broker (or his agent) knows the disclosure of the tax consequences might affect the seller’s decision about handling the sale of his property. This legal loophole is sometimes irreverently called the dumb agent rule. [Calif. Civil Code §2079.16]

For example, a seller of a one-to-four unit residential rental property becomes a client of a broker on entering into a listing agreement employing the broker to sell the property.

The broker properly attaches to the listing agreement a statutorily mandated agency law addendum. The agency law addendum states: “A real estate agent is a person qualified to advise about real estate. If legal or tax advice is desired, consult a competent professional.”

The broker locates a buyer who enters into a purchase agreement with the seller to buy the rental property. The purchase agreement states the seller should consult his attorney, accountant or other competent professional for tax advice.

Concurrent with the sale of the property, the broker also negotiates the seller’s purchase of another one-to-four unit residential rental property, including preparation of the purchase agreement offer.

Before escrow closes on either the sale or purchase transactions, the seller, who has never been involved in a §1031 transaction, asks the broker how many days he has after the sales escrow closes to purchase the replacement property to avoid paying a profit tax on the sale.

 

The broker has no duty to advise the seller on the tax consequences of a one-to-four unit sale.

The broker informs the seller he does not know and advises the seller to consult with an accountant.

Ultimately, the seller is taxed on the profit from the sale since the seller failed to either directly transfer the sales proceeds to the purchase escrow or use an intermediary to impound the sale proceeds until they were needed to fund the purchase of the replacement property.

The seller seeks to recover his losses from the broker for his failed §1031 transaction. The seller claims the broker breached his duty to the seller by failing to disclose that the seller’s handling of the sale and purchase of the properties might result in adverse tax consequences.

The broker claims he has no duty to advise the seller on the tax consequences of the one-to-four unit sale and acquisition of replacement property since the mandated agency law addendum form clearly states:

  • the broker does not advise on tax matters; and

  • the seller should look to other professionals for advice.

Did the broker have a specific agency duty to disclose the tax consequences of the sale to seller?

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 other competent professionals, but not the real estate brokerage office hired to handle the transaction. [CC §2079.16]

Further, the broker has no affirmative duty to make a disclosure of the tax aspects of the sale of one-to-four unit residential property, even if the broker knows the rules for proper handling. The statutory agency law addendum handed to the seller in a one-to-four unit residential transaction specifies brokers, unless they voluntarily undertake a duty to advise the seller on the tax aspects, have no affirmative duty to do so. [Carleton v. Tortosa (1993) 14 CA4th 745]

Editor’s note California statutes state sellers and buyers of one-to-four unit residential properties should consult a competent professional for tax or legal advice since a real estate agent is only qualified to advise about real estate.

However, even if brokers deal only in owner-occupied, single-family residences and are not especially knowledgeable about the details of §1031 exchanges on investment properties, all brokers know a seller of investment property can avoid profit reporting by following §1031 exemption procedures.

If a broker is willing to let his client go over the waterfall without a raft, instead of training his agents to point out the benefits of a §1031 transaction, perhaps it is wise for the broker, himself or through his listing agent, to refer the client to a broker known to be competent and willing to share his tax knowledge with the client.

The mandatory agency law statement regarding a broker’s conduct in the sale of one-to-four unit residential property abrogates the broker’s general duty to disclose the tax aspects of a sale. However, the tax consequences of a sales transaction are as material to a seller as is the structuring of financing in a carryback sale.

The financial damage of avoidable taxation often exceeds the exposure to loss due to the risks created in an improperly structured carryback trust deed note. Also, profit taxes involve far fewer issues than a carryback sale presents. Alas, one more thing for a sales agent to learn to become competent!

Misleading disclaimer

The boilerplate statement in some listing agreements and purchase agreements used by organized brokers primarily implies real estate brokers are not qualified to give tax advice.

However, brokers are aware of, if not fully qualified to handle, §1031 transactions with its beneficial tax aspects for a seller.

Of course, real estate brokers with tax knowledge are duty bound to affirmatively advise their client about their knowledge concerning the tax consequences of the real estate transaction the client is about to enter into unless the property bought or sold by the client is a one-to-four unit residential property subject to the agency law addendum rules.

Tax aspects: a material fact

A listing broker can easily determine whether the tax aspects of a sales transaction might influence the decisions of his client regarding a sale before voluntarily giving the seller any tax advice on profit reporting avoidance.

A §1031 cooperation provision puts the seller on notice that he can avoid profit reporting on the sale of his property.

  All real estate in the hands of a seller is classified as his principal residence like-kind (§1031) property or dealer property.An inquiry as to what the seller of property other than his personal residence intends to do with the sale proceeds opens a window of opportunity for the broker to advise regarding the tax knowledge he does possess.

First, when representing buyers or sellers of business, rental or investment real estate, a broker should use a purchase agreement containing a §1031 cooperation provision. [See Form 150 §11.10]

A §1031 cooperation provision is not an advisory disclaimer which attempts to relieve a broker of his affirmative duty to give tax advice on property other than one-to-four residential units, but puts the seller on notice that he is able to avoid profit reporting on the sale of his property.

Thus, a broker who is not knowledgeable about handling §1031 transactions can avoid initiating a discussion of tax aspects, and still convey the message to the seller that the seller needs to consider and plan for the tax consequences before closing a sale, by including the §1031 cooperation provision in the purchase agreement.

Broker’s knowledge of tax aspects

If the seller has technical questions on tax handling which go beyond his broker’s knowledge or expertise, the listing broker has several options, including:

  • disclose the extent of his knowledge to the seller and advise the seller to seek any further advice from another source (and say so in a memo);

  • associate with a more knowledgeable broker who will handle the tax aspects;

  • consult with a tax attorney or accountant and pass the information and its source on to the seller; or

  • learn the procedures required of a §1031 reinvestment transaction and review them with the client.

Escrow officers can be of great assistance in a private discussion with a broker or sales agent who is confronted with a potential §1031 transaction. Many escrow officers and brokers advertise their expertise in handling §1031 tax deferred transactions to properly exploit their competitive advantage over other brokers.

Ideally, the knowledge possessed by any broker or sales agent who handles the sale of real estate used in the seller’s business, or held for investment (rental or portfolio property), should include an understanding of a few fundamental tax concepts:

  • the three income tax categories for real estate;

  • the §1031 profit reporting exemption;

  • installment sale deferred profit reporting;

  • interest deductions on real estate loans;

  • depreciation schedules and deductions;

  • standard and alternative income tax reporting and tax rates; and

  • the $25,000 deduction and real estate related business which allow rental property operating losses to reduce income taxes.

Each of these tax aspects is basic to real estate ownership. Collectively, they have a significant financial impact on both a seller and a buyer of any real estate, including their residence. A broker with a working knowledge of the tax aspects of real estate can and should consider offering a wider range of (full) services when competing for the representation of buyers and sellers.

Also, giving §1031 tax advice to a seller of investment property who actually follows the advice always leads to a second fee for handling the purchase of a replacement property and coordinating the transfer of sales proceeds.