Pitfalls of 1031 Exchanges: Placing Funds In Unqualified Escrow Accounts Results In Taxable Gains

To complete a “like-kind exchange” under Section 1031 of the Internal Revenue Code (“Code”) and thereby defer payment of tax on what would have been your gain, many technical rules must be followed. One of these is rules is that you must deposit the sales proceeds with a “qualified intermediary” pursuant to a qualified escrow agreement. If you do not, you will ruin your exchange.

A key requirement of like-kind exchanges is that the taxpayer cannot receive or control the sale proceeds. It does not matter whether you actually receive them into your bank account. If the sale proceeds are received and held by anyone other than a qualified intermediary, the exchange is ruined. As a general rule, anyone who has acted as your employee, attorney, accountant, investment banker or real estate agent or broker within two-years prior to the “sale” of the first relinquished property cannot act as your qualified intermediary. A qualified intermediary must be free of your control.

Even if you deposit your sales proceeds with a qualified intermediary, that is still not sufficient to protect your exchange. The proceeds must be deposited in a “qualified escrow account” in which your ability to use those funds is restricted. You must enter into an escrow agreement with the qualified intermediary. It must specifically restrict your ability to receive, pledge, borrow or otherwise use that money. If you do not enter into an escrow agreement limiting your ability to utilize the sale proceeds, then, pursuant to Sec. 1.1031(k)-1(a) of the Regulations under the Internal Revenue Code, you will be deemed to be in “constructive receipt” of the proceeds. It does not matter that you do not draw upon or pledge, borrow, or obtain the benefit of those funds. If there is no written agreement between you and the qualified intermediary that specifically restricts your ability to use those funds, then you will not have a valid exchange. As the taxpayers in a recent Tax Court opinion learned, a taxpayer’s election to limit his or her use of sale proceeds deposited without entering into an escrow agreement does not convert the escrow account into a qualified escrow account.

In Tax Court Summary Opinion 2011-14, taxpayers living in California owning undeveloped property in Arizona decided to sell their property as part of a 1031 exchange. They intended to purchase some property closer to their home in California. The Arizona property sold for $76,000. At the closing, the taxpayers received $10,000 in cash, and the remaining proceeds were placed in an escrow account with a title company. At the taxpayers’ direction, $61,743.25 was held in the title company’s escrow account and $4,256.75 was released to them. When the taxpayers located a replacement property in California, they instructed that the proceeds being held in escrow be sent to their seller’s title company in order to complete the exchange.

The Internal Revenue Service rejected their purported like-kind exchange and required the taxpayers to pay taxes on the gain from the sale of their Arizona property. It ruled that the taxpayers had not deposited the sale proceeds in a qualified escrow account. Even though the funds were deposited with title companies and the taxpayers did not use those funds other than for completion of an intended like-kind exchange, the IRS ruled that the accounts were not qualified escrow accounts. Its decision was based the argument that neither of the title escrow agreements contained provisions expressly limiting the taxpayers’ right to receive, pledge, borrow or otherwise obtain the benefits of the funds. The taxpayers could have demanded or otherwise used the money at will even if they did not actually do so. As a result, the IRS determined that they had constructively received the sale proceeds.

The taxpayers challenged the IRS ruling. At trial, the Tax Court agreed with the IRS, agreeing that, because the escrow agreements with the title companies did not expressly limit the taxpayers’ ability to receive, pledge, borrow or otherwise obtain the benefit of the funds and did not make any mention of a like-kind exchange, the agreements were not qualified escrow accounts. As a result, the Tax Court found that the taxpayers constructively received the sale proceeds and therefore the transactions did not qualify for a like-kind exchange.

The Tax Court’s treatment of these particular taxpayers may seem harsh since it seems clear that they intended to complete a like-kind exchange and never intended to access the deposited funds. The Tax Court, though, noted that Congress had enacted strict provisions with which taxpayers have to comply in order to receive the benefits of a tax-deferred exchange. Failure to comply with those requirements, even with the best intentions, will disqualify the exchange.