The following excerpt is from the forthcoming edition of Tax Benefits of Ownership which gives an overview on a transaction’s tax aspects.

Analyzing a transaction’s tax aspects

Consider the owner of an income-producing parcel of improved real estate who intends to retain a brokerage office to market the property for sale. The owner interviews a few brokers and sales agents to determine who they will employ.

The owner’s primary concern is to hire a broker whose agents are most likely to produce a prospective buyer to purchase the property. Thus, the interviews with agents include an inquiry into:

  • the contents of the listing package the agent prepares to market income property;
  • the scope of the advertising the agent undertakes to locate prospective buyers and any costs to the seller;
  • the agent’s accessibility and responsiveness to inquiries into listings the agent publicizes; and
  • the professional relationship the agent has with brokers and agents who represent buyers.

One agent interviewed asks about the owner’s intended use of the proceeds from the sale. The owner indicates they want to reinvest the funds in developable land, to hold for profit on a later resale to a subdivider or builder.  Minimal management is the owner’s objective.

On request, the owner provides the agent with data on:

  • the price they paid for the income property;
  • the principal balance and terms of the mortgage on the property; and
  • the depreciated cost basis remaining in the property.

These three key pieces of data are needed for an agent to assist the owner in tax planning for a sale.

Initial opinion of tax liability 

The agent does some quick math to approximate the amount of profit the owner will take — realize — on a sale. The agent immediately determines the owner profits on a sale, they amount owed for profit taxes on unrecaptured gains (rates up to 25%) and long-term capital gains (rates from zero to15%-20% brackets) which equal a fifth of the net proceeds from a sale (plus 1/3rd more for state taxes).

The agent expands the discussion with the owner into how they can avoid reporting the profit and paying taxes on the sale by locating and buying land suitable for the owner to acquire – a §1031 reinvestment plan which starts with the property to be sold.

The agent also informs the owner that listing and purchase agreements entered into for the sale of the income property and the purchase of the like-kind replacement property will contain a contingency provision conditioning the closing of the sale on the owner’s purchase of other property.

Disclosure of known consequences

To properly relay the extent of the agent’s experience, the agent informs the owner they have not personally negotiated a sale that concluded with replacement property in a §1031 transaction. However, the agent has taken courses on §1031 transactions and discussed §1031 funding procedures with brokers and escrow officers who have relevant experience.

The agent explains that they are fully able to properly market the property and locate suitable land for the owner’s reinvestment, as well as follow up on the steps needed for §1031 tax avoidance if the owner lists the property with the agent’s broker.

The owner interviews a second agent concerning the sale of the property. However, on inquiry the agent is reluctant to become involved in a review of the income tax aspects of selling property and asks for no tax information.

The second agent hands the owner a written statement attached to a proposed listing agreement advising the owner that the agent:

  • 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 reinvestment plan; and
  • recommends the owner seek the advice of their accountant or tax attorney on how to properly avoid the tax on profit from the sale and purchase of real estate.

Did both agents comply with their agency duty to make proper disclosures to the owner about their knowledge and willingness to provide tax advice?

Yes! Both agents met the agency duty undertaken when soliciting employment for services in a commercial transaction since each agent:

  • considered the tax consequences of the owner’s sales transaction, thus implicitly treating profit taxes as a material fact;
  • disclosed the extent of their knowledge regarding the possible tax consequences of the sale; and
  • advised on any need for another professional to further review and advise on the §1031 tax aspects.

One necessary question remains for agents to sort out: does an agent employed by a seller of real estate owe their seller a duty to consider the need for tax advice as an included service to their seller?

The answer lies in a review of:

  • the type of real estate involved; and
  • the client’s intended use of the sales proceeds.

An affirmative duty to disclose as advise on material facts

Consider a seller’s agent who determines that information about the tax aspects of a sale is material to a sales transaction under consideration by their client. Tax information when known to the client in any type of sales transaction may alter their handling of the transaction. Due to an awareness of taxable events affecting a client, the agent owes their client a duty to disclose the extent of the agent’s knowledge on the transaction’s tax aspects.

Further, a concerned seller’s agent goes beyond a discussion of tax information and assists their client to structure the sales arrangement so they achieve the tax consequences most consistent with the client’s financial and investment objectives.

In conflict with these general rules about disclosures of material facts is a specific rule that in a one-to-four unit residential dwelling transaction a seller’s agent has no duty to disclose their knowledge of possible tax consequences. Even when the agent understands that the tax consequences when discussed might affect their client’s handling of a one-to-four unit sales transaction, the seller’s agent has no duty to disclose their tax knowledge, unless transaction-related taxes is the subject of the client’s inquiry. [Calif. Civil Code §2079.16]

Advice disclosure disclaimer without an explanation 

Consider the seller of a one-to-four unit residential property who employs a broker (and in turn the broker’s agent) to sell the property by entering into a listing agreement.

The listing agreement form used by the agent’s broker contains a boilerplate clause stating a real estate licensee is qualified to advise on real estate. This statement is a general statement consistent with the purpose of state licensing standards. However, further provisions state that when the seller desires legal or tax advice, the seller is to consult an appropriate professional. Nothing is said about the qualifications of the listing broker or their agent to advise on the transaction they are negotiating or whether they know the client need tax advice on the consequences they will experience.

The agent also hands the seller a statutorily mandated Agency Law Disclosure form that 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 competent professional consulted may just be the listing broker and agent involved — who on request are obligated to give their best advice.

Neither tax-aspects disclaimer calls for the broker or their agents to provide tax advice, much less obligate the seller as a threshold condition to employ another professional to advise on the tax aspects of their one-to-four unit residential transaction before closing escrow. These tax-aspects disclaimers reek with the implication that taxes in a transaction are material. If not, then no need exists for making the disclaimer of a duty. Left without advice, the client may be unclear on the tax consequences of a transaction, the terms of which their agent negotiated.

The agent markets the property and locates a buyer who enters into a purchase agreement with the seller. The purchase agreement, like the listing agreement, again states the seller is to consult their attorney or accountant for tax advice. The disclaimer, as is their nature, does not require the client to do anything, nor is a contingency provision required for a third-party professional approval before closing.

Prior to closing the sale, the agent also negotiates for the seller to purchase another one-to-four unit residential property, for which the agent prepares a purchase agreement offer that is accepted.

Before escrow closes on either transaction, the seller asks the agent about the number of days they have after the sale closes to purchase the replacement property and avoid paying profit tax on the sale. The seller has never been involved in a §1031 reinvestment plan.

The agent is unsure and orally advises the seller to consult a tax accountant. The seller does not do so. The agent now knows the seller knows and is concerned about tax consequences. Critically, the agent does not include a contingency provision for the further approval of the tax consequences in the purchase agreement or escrow instructions to protect the client.

Ultimately, the seller is taxed on the profit from the sale, but not because of the time constraints on the closing of escrow on the purchase of the replacement property. The profit is taxed because the seller failed to avoid receipt of the net sales proceeds. Escrow instructions dictated by the agent using the purchase agreement called for the net sales proceeds to be disbursed directly to the seller. To avoid receipt of the net sales proceeds as required by a §1031 reinvestment plan, the seller needed to direct escrow 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.

Tax advice liability exception

After being taxed on the profit from the sale, due to the mishandling of the net sales proceeds used to purchase the replacement property, the seller seeks to recover losses from the agent due to adverse tax consequences incurred on the sale of §1031 property. The seller claims the agent breached their agency duty by failing to disclose the structure of the seller’s transfer of net sales proceeds, as arranged by the agent, might (it will) result in adverse tax consequences due to the seller’s receipt of the reinvestment funds.

The agent claims they have no duty to advise the seller on the tax consequences of the sale since the listing agreement, the Agency Law Disclosure and the purchase agreement all clearly stated:

  • the agent does not advise on tax matters; and
  • the seller is to look to other professionals for tax advice.

Did the seller’s agent have a duty to advise the seller on the tax consequences of the sale as known to the agent?

No, but not because of these unworkable disclaimers. On the sale of one-to-four unit residential property, sellers and buyers as consumers are expected as a matter of public policy to obtain tax advice from competent professionals other than the residential real estate brokerage office handling the transaction.

A broker and their agent have no duty to be forthcoming and voluntarily disclose any tax aspects surrounding the sale of a one-to-four unit residential property. This legislated rule applies even when the information on how to avoid the adverse tax consequences is known to the broker or the sales agent. In contrast, on a direct inquiry from the buyer or seller, the agent is duty bound to respond honestly and to the full extent of their knowledge. [Carleton v. Tortosa (1993) 14 CA4th 745]

The Agency Law Disclosure addendum attached to listing agreements and purchase agreements restates the law that eliminates the duty of a broker and their agents to disclose their knowledge about the tax aspects of a sale when a one-to-four unit residential property is involved.

The irony of mandated disclosures  

The tax consequences of sales transactions involving the use of sales proceeds to purchase replacement property are as material to a seller as the structuring of carryback financing. Carryback arrangements require an agent to make extensive mandated disclosures regarding documentation and rights of the carryback seller. However, carryback arrangements are less frequently encountered than §1031 reinvestment plans.

Further, the financial damage of profit taxes avoidable in a §1031 transaction often exceeds the risk of loss on an improperly structured carryback note and trust deed transaction. Unlike the agency duty of a broker and their agents in §1031 transactions, the agency duty an agent owes to their carryback seller includes full disclosure of information necessary for the seller to make an informed decision about the financial suitability of a carryback sale before the seller enters into the transaction. [Timmsen v. Forest E. Olson, Inc. (1970) 6 CA3d 860]

Avoid misleading clients by using disclaimers 

The boilerplate statement included in some listing agreements and purchase agreements, used by unionized real estate brokers and their agents, incorrectly implies they are not qualified (or worse, not authorized) to give tax advice.

When a broker or agent is not qualified to handle a §1031 transaction, they most likely are at least aware tax advantages are available through a §1031 reinvestment plan.  Further, real estate brokers and their agents with tax knowledge are duty-bound to advise their client about the material facts in a real estate transaction their client is about to enter — unless a one-to-four unit residential property is involved.

However, a savvy agent capitalizes on the tax knowledge they have by advising clients on the tax results of their real estate transactions, regardless of the type of property involved. As always, the agent who advises a client on a transaction’s tax consequences as part of their services 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- negligence – the agent needs to disclose to the client:

  • the full extent of their tax knowledge regarding the transaction;
  • how they acquired this knowledge; and
  • whether the client needs further advice from other professionals.

Shifting reliance for tax advice given to a client

Brokers and agents who provide tax advice are best served by involving the client’s other advisors in the final decision, such as their attorney or tax accountant. Input from others who know the client helps the agent eliminate future claims arising from adverse tax consequences ostensibly due to the client’s reliance on the agent’s silence or erroneous statement of opinion.

The most practical (and effective) method for shifting reliance to the client or others when the agent has discussions with the client about a transaction’s tax consequences is to insert a further-approval contingency provision in the purchase offer or counteroffer signed by the client.

The contingency provision imposes a duty on the client to initiate the investigation and obtain additional tax advice and a decision about the 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 further investigate — is insufficient. Further, advisory statements do not require the client to act like a contingency provision does. Worse, advisories do not explain why the broker or agent providing the advisory statements does or does not believe the client needs to act on one or more of the statements to protect themselves. A further-approval contingency provision avoids all this noise, making the agent’s advice an opinion to be confirmed by the client before closing. Here, risk mitigation is the goal. [Field v. Century 21 Klowden-Forness Realty (1998) 63 CA4th 18]

Tax advisor’s further approval  

In a purchase agreement (or exchange agreement) involving implementation of a §1031 reinvestment plan, a further-approval contingency provision regarding the transaction’s tax consequences calls for the client to confirm, prior to closing, that the transaction qualifies for §1031 tax-exempt status, as represented by the agent. When the client is unable to confirm the tax status as represented, they may terminate the transaction by delivery of a notice of cancellation. [See RPI Form 171 §5.2j]

Essentially, the client is not relying on the agent’s opinion when they decide to enter into a purchase or exchange agreement with the intent to close escrow only after further confirmation of the tax consequences opined by the agent.

Further, a purchase agreement or exchange agreement containing a written contingency provision also contains an unwritten implied covenant provision. Under the implied covenant, before a client may cancel a transaction based on third-party approval, they are required to “act in good faith and with fairness” in their effort to obtain third-party approval, such as submitting data on the transaction for confirmation by an attorney or accountant they retain.

Here, the client’s agent usually steps into the chain of events by getting authority from the client to contact the third party and providing the paperwork needed to review the transaction for its §1031 tax-exempt status. On review, the agent makes procedural changes needed to meet the client’s objectives and satisfy the concerns of the third party advisor.

Since fair dealing and reason are implied in every agreement and applied to the conduct of all parties, a termination of the exchange agreement due to the disapproval of an activity or occurrence subject to a contingency provision must be based on a justifiable reason.

On a potential disapproval and possible termination due to reasons expressed by the client or their third party advisor, the agent might be able to cure the defect that gave rise to the reason for disapproval, or demonstrate that the third party’s concern is unfounded, i.e., when the third-party advisor’s concern is an erroneous conclusion. [Brown v. Critchfield (1980) 100 CA3d 858]

An agent who is not knowledgeable about the handling required for a §1031 reinvestment initially avoids a discussion of tax aspects by including the §1031 cooperation provision in the purchase agreement. The provision brings to the seller’s attention the availability of activities that go to the tax consequences of the sale and provide for tax handling to be addressed and implemented before closing.

An agent’s knowledge of basic tax aspects in transactions 

A client’s technical questions which go beyond their agent’s knowledge or expertise require a forthcoming and meaningful response from the agent, including:

  • disclosing the extent of their knowledge to the seller and advising the seller to seek further advice from another qualified source;
  • involving a more knowledgeable broker, tax attorney or accountant who provides the seller with advice; or
  • learning how to handle §1031 reinvestments and giving the advice themselves.

Escrow officers are of great assistance to an agent who has a potential §1031 transaction on their hands. Many escrow officers, transaction agents and persons holding themselves out as qualified intermediaries advertise their expertise in handling §1031 reinvestments.

Ideally, agents handling the sale of like-kind §1031 real estate do, as a matter of basic competency, possess an understanding of several fundamental tax concepts, such as:

  • the $250,000 principal residence profit exclusion on a sale;
  • the separate income and profit categories for different types of real estate ownership;
  • the §1031 profit reporting exemption;
  • the mortgage interest deduction (MID);
  • depreciation schedules and cost recovery deductions;
  • the $25,000 deduction and real-estate-related business adjustments for rental property losses;
  • the tracking of rental income/losses separately for each property;
  • profit and loss spillover on the sale of a rental property;
  • standard and alternative tax bracket rates; and
  • carryback sales with deferred profit reporting.

These tax aspects are basic to the sale or ownership of real estate commonly listed and sold by agents. One or more always apply. When they apply they have significant financial impact on sellers and buyers of real estate. Any agent with working knowledge of the tax aspects of real estate may offer a wider range of services — including tax advice — when competing to represent buyers and sellers in their real estate transactions.

Additionally, a seller receiving tax advice concerning a §1031 reinvestment plan who follows the advice always leads to a second fee. It is earned for negotiating the purchase of the replacement property and coordinating the transfer of funds. Add in the goodwill created with the client and you generate referrals of like-type clients.