NEW YORK, July 31 (Reuters) - A real estate attorney may have acted negligently but cannot be sued for malpractice because his clients cannot prove his actions caused their losses, a divided New York state appeals court said Tuesday.

The Appellate Division, First Department, found in a 4-1 ruling that there was "strong evidence" that Howard Stern acted negligently when he helped Wo Yee Hing Realty sell a building as part of an arrangement to defer capital gains taxes, even though he had no experience handling such transactions.

But the majority ruled that Wo Yee Hing Realty had no evidence that it would have been able to complete the transaction and defer its taxes, even if Stern had performed adequately.

"To prevail on its claim of legal malpractice, plaintiff must prove not only that defendant was negligent, but also that defendant's negligence was a proximate cause of its losses," wrote Justice David Saxe for the majority.

In 2006, Wo Yee Hing, a company owned by three brothers, hired Stern to represent it in the sale of a residential and commercial building in Manhattan. The brothers planned to sell the building as part of a 1031 exchange, named for the section of the Internal Revenue Code that permits such transactions.

Under the law, a company can defer the capital gains tax resulting from the sale of commercial or investment property if it identifies a similar "replacement" property within 45 days and takes possession of that property within 180 days. The exchange must be done through a "qualified intermediary," a third party.

A 1031 EXCHANGE

The brothers claim that Stern assured them he knew how to perform a 1031 exchange. Stern asserts that he repeatedly told them he was unfamiliar with these transactions and that the brothers told him they would handle the details.

Either way, the majority said, there is evidence Stern acted negligently by undertaking the preparation of the sales contract, since by his own admission he was unqualified to handle a 1031 exchange.

As a result, checks for $10.2 million were made out to Wo Yee Hing, rather than to an intermediary, making a 1031 exchange legally impossible, according to the court.

Nevertheless, Wo Yee Hing failed to show it would have been able to complete the exchange for a replacement property even if Stern had done everything properly, Saxe wrote.

"Plaintiff failed to present any evidence that it had identified any property that it was capable of buying within the statutory time frame. Nor did it present any evidence that it could have closed on its purchase within 180 days."

The majority also included justices John Sweeny, Dianne Renwick and Rosalyn Richter.

In dissent, Justice Leland DeGrasse wrote that the majority's holding was "unrealistic," since the company knew almost immediately that a 1031 was no longer permissible and therefore did not bother to identify a suitable property to buy.

"It would have been impossible for plaintiff to purchase or even identify anything that qualified as replacement property," he wrote. "It would also have been pointless for plaintiff to go through the motions of doing so once it received the proceeds of the sale."

Ralph Drabkin, whose firm represents the company, said he was "at a loss" to explain the majority's reasoning but had not yet determined whether to appeal.

"Once you learn at a closing that you have failed to meet the requirements of the 1031 exchange, what rational person would go forward?" he said. "It's an undue burden that the court places on the client who relies on the expertise of an attorney."

Tracy Peterson, Stern's lawyer, said they were "pleased" with the ruling.

"Both courts found that as a matter of law, there was no legal malpractice," she said.

The case is Wo Yee Hing et al v. Howard Stern, Appellate Division, First Department, No. 7020.

For Wo Yee Hing: Caitlin Robin of Drabkin & Margulies.

For Stern: Tracy Peterson of Braverman & Associates.

(Reporting by Joseph Ax)

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