In 1031 exchange Tax Court case Kreisers vs First Dakota Title Limited, the Plaintiffs wished to relinquish a former office building and construct a new one. Plaintiffs had no special knowledge of real estate transactions or Section 1031 Exchanges, though they were aware that structuring their planned transactions as a Section 1031 Exchange would be beneficial from a tax standpoint.
As such, Plaintiffs agreed to use First Dakota as the QI for the proposed 1031 Exchange. First Dakota held itself out to be knowledgeable about 1031 Exchanges and capable of facilitating exchanges. Nowhere in Dakota’s advertising did they indicate they only handled forward Section 1031 Exchanges. Dakota’s representative who worked with Plaintiffs never asked what type of exchange the Plaintiffs proposed to enter into nor did anyone from Dakota follow up with the accountant who was working with Plaintiffs regarding the proposed construction exchange to find out any additional details. The Plaintiffs attended the closings for both the relinquished and replacement property but were not afforded the opportunity to view the closing documents until the day of closing. In short, Dakota was not aware that the transaction was intended to be a construction exchange and, therefore, the documents prepared and used for the transactions did not reflect that intention. “The result was that the amount of proceeds from the sale of the relinquished property used to purchase the replacement property qualified for tax deferral. The remaining proceeds ultimately paid to Kreisers (Plaintiffs) by First Dakota did not qualify and were subject to various taxes. The recognized gain for tax purposes was $317,087.”
Tax Court Outcome
The Court found that Dakota held itself out to be an expert on Section 1031 Exchange transactions and that they agreed to act as QI to facilitate Plaintiffs’ proposed exchange. The Court further held that Dakota, in the role of QI, had a duty of care to the Plaintiffs and that the duty of care was breached, therefore Dakota was negligent and was ordered to pay damages to the Plaintiffs. The Court’s holding that Dakota was negligent was based on a number of facts and circumstances, including:
• Dakota advertised that it handled Section 1031 exchanges but did not qualify that claim by indicating that it only handled forward 1031 exchanges
• At no point did Dakota indicate to Plaintiffs that it did not handle construction exchanges
• Dakota’s representative never asked relevant questions to Plaintiffs nor did he use a check list to ascertain what type of exchange was contemplated
• Dakota never sent an opening letter explaining the intended 1031 Exchange and/or asking about the Plaintiffs’ intentions which would have prevented the errors down the road
• Dakota did not provide closing documents ahead of time for Plaintiffs and/or Plaintiffs’ attorney to review which might have caught the error
• Dakota failed to follow-up regarding the excess proceeds held by Dakota following the closings resulting in yet another missed opportunity to correct the errors
Take Aways
For both taxpayers interested in entering into a Section 1031 Exchange and QIs who facilitate these exchanges, the holding in Kreisers is important. For QIs it should serve as a warning that they can be held liable for failing to uphold the duty of care owed to a taxpayer. A QI should be very clear with a potential client which types of Section 1031 exchanges the QI is capable of handling. Any limitations in the QIs capacity or availability should be clearly stated both in advertising and on a personal level to potential clients. Moreover, a QI must remember that a fiduciary duty of care is owed to clients, meaning that, among other things, all work performed on behalf of the client should be done with complete transparency so that the client has the opportunity to timely review documents throughout the process.
For a taxpayer, Kreisers reminds them that a QI who has negligently handled a Section 1031 Exchange, can be held liable for any resulting damages, including taxes that are levied against the taxpayer that should have been deferred but for the QIs negligence.
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