July 2001

War Story: Like-Kind Property Exchange (IRC Section 1031)

Successful restaurateur and chef Paul Grubman (not his real name) has owned and operated Grubman’s Diner in Manhattan for several years. His accountant, John Baker, CPA (not his real name), has been preparing Grubman’s tax returns and advising him about miscellaneous related matters for several years. The diner is so profitable that the chef is able to purchase the apartment building that houses the restaurant on the ground floor.

After several years, Grubman needs a newer, larger location. He informs Baker, who advises the chef to exchange the old property for the new one in order to avoid any taxable gain (an Internal Revenue Code section 1031, or Starker, exchange). Baker also outlines for Grubman a few of the rules that need to be followed in order to legally effect a 1031 exchange:

• The exchange must be of “like-kind” properties; in this case, apartment buildings with a restaurant.
• The taxpayer uses a “qualified intermediary” to transfer the relinquished property to a buyer, and to receive the replacement property for the taxpayer.
• The replacement property must be identified within 45 days and must be purchased within 180 days of the sale of the relinquished property.

Baker also gives Grubman the name and number of an intermediary to effect the exchange for him. The chef has a strong dislike for middlemen due to difficulties he had in purchasing his building, and he decides to search for a new property by himself. He also advertises his restaurant and apartment building for sale in various newspapers.

Grubman accepts an offer of $3.3 million for his building. Meanwhile, Baker advises him to call the intermediary to make the property exchange for him, but the chef seems overwhelmed by the details of selling his own property and searching for a new property while running his restaurant.

Over the next five weeks he is able to identify a new “like-kind” restaurant/apartment property that will serve his planned expansion. He is still within the required 45 days of selling his old property, and still has about four and a half months to purchase the replacement property.

Three weeks later, a fire breaks out in the new restaurant’s kitchen and destroys most of the interior. Grubman is so distressed by the damage that he changes his mind about purchasing the property and begins to seek out another replacement property. None of the properties he visits suits his purposes, however, and he finally starts to worry enough about the 1031 exchange to call the intermediary, who is out ill and unable to return the call.

Meanwhile, escrow closes on the property being sold by Grubman, and a misunderstanding between the chef and the escrow company causes the proceeds from the escrow to go directly into one of Grubman’s accounts. Grubman calls Baker for advice on what to do with the proceeds, but the CPA has to tell the chef that his receipt of the proceeds, prior to investing them in like-kind property, renders them fully taxable. The use of a 1031 exchange is no longer an option.

Results

Grubman now has a taxable gain of about $2.9 million, and the tax payable on that comes to about $750,000. His attorney sends Baker a letter setting forth a demand for that amount. The letter also cites negligence on the part of the CPA for failure to inform Grubman that his receipt of sale proceeds from the escrow company would preclude the use of a 1031 exchange.

Baker had advised Grubman on several occasions to secure the services of an intermediary, who would have received the sale proceeds and effected the exchange, but none of that advice is in writing.

The case goes to trial, and the jury finds that Baker had not adequately warned Grubman about not receiving the property sale proceeds. The jury also finds that the burden to properly execute the exchange fell primarily on the CPA, who had a long professional relationship with the chef. The accountant was held liable for two-thirds of the loss, or $500,000.

Loss Prevention Tips

• Follow up a preliminary or cursory conversation with a client regarding a planned transaction with a quick letter to the client (and retain a copy in your file). The letter should address the topic of the conversation, the fact that the planned transaction is complex and subject to many requirements, that the discussion only addressed the requirements in a summary manner, and that if the client decides to proceed with the transaction, she or he should schedule a meeting for a detailed analysis of the transaction before entering into any aspect of the transaction;
• Do not sign any documents drafted by the “qualified intermediary” stating that your firm is responsible for advising the client on the tax ramifications of a 1031 exchange unless you have been formally engaged to actually provide that advice and actually do provide that advice;
• If you are formally engaged to advise a client on the tax ramifications of a 1031 exchange, your firm should prepare an engagement letter detailing your firm’s responsibilities with respect to the engagement. The engagement letter should also address the aspects of the transaction that your firm cannot address and that must be addressed by the qualified intermediary (to preserve the tax-free nature of the transaction); and
• Once the engagement letter has been prepared, your firm should prepare a second letter for your client as soon as possible. The letter should detail your understanding of the transaction, your understanding of how each step of the 1031 transaction will proceed, and the tax ramifications of each step of the 1031 transaction. The letter should also state that the client should consult you immediately if it appears the actual transaction will deviate from your description of the transaction, because that deviation could affect the tax-free nature of the 1031 transaction.