May 19, 2008 (Original publish date) • By Dennis Beaver
“Can you tell me about the legal responsibility an accountant and broker have for steering clients into a real estate investment that made no sense at all in terms of the risks involved? My parents — especially my mother — have been in real estate for many years and successful at it. But right now I am so worried. Can we please talk about this?” Thanks, Jim from Fresno.
I phoned Jim, and learned that his parents — having immigrated to California in search of financial success — were sitting on a keg of dynamite and a slow-burning fuse had been lit. As I would discover, while their real estate broker and accountant had some responsibility for the situation his parents were in, it was primarily their own greed and compulsive desire to make money and avoid paying income tax that could easily lead to their financial downfall.
Jim asked if I would meet his parents and visit the property they purchased. As I sensed an educational column, I agreed and drove to Fresno to find every a juicy lawsuit waiting to be filed.
What unfolded was a story of people who were not content to become millionaires, but who tried every legal and some questionable ways to get out of paying their fair share of taxes. “We pay too many tax,” Jim’s mother said.
“Mom was a real estate genius,” Jim boasted. He, by the way, is a psychiatrist. “She bought and sold commercial properties for years, but last year sold an office building and did a tax-free exchange, acquiring this 125-unit apartment house. It is rented exclusively to elderly residents,” he explained.
“A tax-free exchange is a way of selling property that has gone up in value, but instead of paying income tax on your profit and then putting the money in your bank account, all the sale proceeds go towards another property of greater or equal value, something like a trade.”
Explained nationally published author and Hacienda Heights Realtor Lawrence Elliott, who has also been a contributor to this column: “You are literally exchanging one piece of property for another of a similar or greater value, and therefore it is not income. This way, no tax is due now, but at some time in the future it will have to be accounted for. These are transactions intended to delay the payment of tax, not avoid it entirely,”
But he added a note of caution: “There are many reasons not to do an exchange, and what occurred here is a textbook example of buyers who only thought of avoiding tax, and had no idea of what they were getting into. Managing commercial property is easy in comparison to running a senior citizen retirement village. If you do not have the expertise, then you need to hire competent management, which will have a real cost, or skip the exchange entirely, as your effort to save on taxes could become a huge liability when — not if, but when — things go wrong,” he stressed.
Located in a rundown section of Fresno County, the average age of tenants was around 75, and the place had the feeling of a geriatric mental hospital.
But this “hospital” was complete with dangerous, uneven concrete walkways, leaking roofs, mold, a violent alcoholic resident maintenance man, and other aged and infirm residents who performed a host of jobs — some dangerous — all paid illegally, “because they want to get 1099 and we not pay tax,” Momma told me, unaware or unconcerned about the law.
In violation of the age requirements, younger residents had moved in, some of whom had gang members for children. The sprinkler system wasn’t working, vegetation was dying, the place was filthy, and 25 units were empty. In short, it was a sad and scary place for residents, many who had lived there for over 10 years.
It became clear that Jim’s parents were so cheap they squeaked, seeing only a tax benefit, and either had no idea what was wrong with the dump they were buying, or only thought of the tax advantage their “brilliance” had delivered. They chose to throw common sense out the window by refusing to have the property inspected.
“It is critical when buying an older property to spend the money for an inspection,” said Elliott. “If you do not, count on spending thousands of dollars later. With clients such as these, a Realtor needs to be strong and to insist on that inspection.
“Also, buyers should walk the property themselves taking careful notes of what they see. Finally, in these types of transactions, you need to work closely with an accountant to see if the rental income is really there. So often no one asks the single most important question: Why is it on the market if it is such a good income property?
“Do not be blinded by tax savings. If you save thousand dollars in income taxes but face monumental repair expenses or liability if sued, then don’t buy the property!,” pointed out the Realtor, who clearly cares about what is best for the client, not just his commission.
I ran the facts of this situation by three CPAs, and they all reached the same conclusion, summarized as follows:
“If your readers just paid the tax, and not worry about managing another property, they would clearly have been well ahead of the game, especially with this property. This is a textbook example of a tax-free exchange not to do. It can be financially dangerous to let yourself be only motivated by a desire to save on taxes.”
It is when things go wrong that the real estate broker or accountant is looked at closely in transactions such as this one.
I had more questions than answers after visiting the property. Was there adequate disclosure? Did my readers take the time to look at the property, or were they too intoxicated with the feeling that they had avoided paying taxes to care? Did they consult with an attorney or property manager and look at what it means to suddenly find yourself owning a retirement community?
I thanked Jim for contacting me and gave him one piece of legal advice, completely free. “Sell this property immediately. If you want to help your parents and preserve their money, it is time to become more involved in the family real estate business. Keep your mother under control!”
Dennis Beaver practices law in Bakersfield and enjoys hearing from his readers. Contact Dennis Beaver.