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Do-it-yourself escrow blows up like-kind exchange

February 16, 2011

Taxpayers often think of the Sec. 1031 like-kind exchange rules as a way to "roll over" the gain from one investment property into another one. While the economics work that way, the tax law is a stickler for the formalities, as an Arizona couple learned yesterday in Tax Court.

The couple sold a Lake Havasu City property for $76,000. They took a $10,000 down payment and put the remaining $66,000 in an escrow account that they set up for themselves. The problem? The tax law requires that a third party have the escrow account. The judge explained the tax law requirements:

Section 1.1031(k)-1(g)(3), Income Tax Regs., defines a qualified escrow account as the following:

(ii) A qualified escrow account is an escrow account wherein --

(A) The escrow holder is not the taxpayer or a disqualified person * * *, and

(B) The escrow agreement expressly limits the taxpayer's right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account * * *.

The taxpayer's own limitation of use of the funds does not convert the escrow account into a qualified escrow account.

The judge said the do-it-yourself escrow failed:

Neither escrow agreement expressly limited petitioners' right to receive, pledge, borrow, or otherwise obtain the benefit of the funds nor made any mention of a like-kind exchange. Because of the lack of limitations, neither escrow account was a qualified escrow account. See Hillyer v. Commissioner, T.C. Memo. 1996-214; Lee v. Commissioner, supra. Although petitioners used the funds in the Capital Title escrow account to purchase the California property, the lack of express limitations in the escrow agreement results in petitioners' being treated as having constructively received the proceeds.

Result: no like-kind exchange; all of the gain was taxable in the year of sale.

If you do want to have your property sale and purchase treated as a Sec. 1031 exchange, you need to set it up properly at the start. Contact a reputable Sec. 1031 intermediary company. Do some due diligence to make sure they will be around when it's time to close the deal. Don't cheap out and do it yourself, because it will cost more in the end.

Cite: Crandall, T.C. Summ. Op. 2011-14

Tags: like-kind exchange.Section 1031.tax court.