Humbling moments: Claims arising from 1031 exchanges
By W. Wesley Marston
"Complex problems have simple, easy to understand, wrong answers." - H.L. Mencken
I once had a 14-hour exam on IRC §1031. The professor awarded one A, and told the student recipient that he did not deserve it. Such was my introduction to this section of the code. Unfortunately, I still have to deal with like-kind exchange issues due to claims involving §1031.
Commentators on the subject of §1031 claims typically point to the fact that such exchanges require strict compliance with complex technical provisions.
While miscalculations of gain, missed deadlines, and failure to comply with other requirements may lead to claims, many §1031 claims arise for more basic reasons. The CPA either: (1) fails to discuss the potential availability of a §1031 exchange for a proposed transaction; or (2) gives a brief negative answer when the client asks whether a tax-deferred exchange is possible and fails to provide a detailed analysis.
Adele Accountant's actions followed a common pattern:
During a meeting on another subject, Adele's client asked whether he should consider a §1031 exchange for a proposed sale of his chain of convenience stores. Adele's off-the-cuff response was that the proposed transactions probably did not qualify, the structure would be complex and expensive, and there were other, simpler alternatives that would reduce taxes on the sales and be more consistent with the client's goals. The client proceeded to sell the stores. A few years later, another CPA asked the client why he did not do §1031 exchanges. The client filed a lawsuit for negligence against Adele.
Many of us have faced this scenario. The client asks whether they should consider a §1031 exchange or presents a transaction that might qualify. Either the transaction, or the client's personality or goals, make it such that an exchange is probably not a good fit. The adviser either does not address the §1031 issue or gives a brief answer stating that it might work, but that it probably is not the best way to proceed.
Perhaps the proposed replacement property would add complexity to the transaction. Maybe the client needs liquidity, and an exchange does not fit their stated goals. For whatever reason, the CPA does not encourage the client to look further into a §1031 exchange.
The trap is that, once the client concludes the transaction and pays taxes, he or she asserts - with the benefit of 20/20 hindsight - that a §1031 exchange would have been a perfect fit and that they were damaged due to the CPA's negligence.
I believe that, in many such cases, had the CPA performed an analysis, the client would not have ended up doing a §1031 exchange. The client might have even refused to pay for the analysis. However, all the client needs to bring a troublesome claim is to create a scenario under which the transaction might have qualified and an allegation that their CPA was negligent in not fully advising them as to the availability of an §1031 exchange.
The successful claimant receives the benefits of §1031 without the associated risks, costs, and restrictions.
The issue of damages is complex and arguably speculative in §1031 cases.
The claimant will seek, at a minimum, the amount of current taxes paid. Claimants will insist that they never planned to sell the property, so they would never realize the deferred gain. The defense will focus on the fact that predicting the value of future tax benefits is speculative. The claimant's initial damage claim will be high, and experts will battle over the computation. This leads to long, expensive litigation.
This type of §1031 claim is preventable.
Any time a client mentions a transaction that might be a candidate for a §1031 exchange - no matter how informally - any initial response should be followed by correspondence that confirms that the CPA did not render an opinion and offers to perform an in-depth §1031 analysis (or referral to a tax attorney or other professional if the CPA believes that it is beyond the scope of his or her expertise).
As Adele learned the hard way, a simple verbal answer is rarely a sufficient response to a §1031 question.
About the author:
W. Wesley Marston, J.D., LL.M., AIC, is assistant vice president - claims at CPA Mutual Insurance Co.