The Tax Court has recently determined that taxpayers’ failure to use a qualified escrow account in an attempted like-kind exchange rendered them ineligible for nonrecognition of gain under Code Sec. 1031. As a result, they wound up with taxable gain on the surrendered property. Ralph E. Crandall, Jr. and Dene E. Dulin, TC Summary Opinion 2011-14.
Background. A taxpayer generally recognizes gain or loss upon the sale or exchange of property. However, neither gain nor loss is recognized under Code Sec. 1031 on an exchange of property if:
- … the taxpayer exchanges property held for productive use in a trade or business or for investment for other property to be held for productive use in a trade or business or for investment;
- … the relinquished property and the replacement property are of “like kind”; and
- … the replacement property is identified and the exchange is completed within statutory time limits.
If a two-party like-kind exchange is impractical or undesirable, a taxpayer may still be able to get the benefits of Code Sec. 1031 by arranging a multi-party deferred exchange. In a deferred exchange, the replacement property must be (i) identified within 45 days after the taxpayer transfers the relinquished property, and (ii) received by the earlier date of 180 days after the taxpayer transfers the old property or the due date of the taxpayer’s return for the year (including extensions).
To qualify as a deferred exchange, the transaction must be an exchange of property, not a transfer of property for money. The reinvestment of the proceeds from a cash sale of one property into a second property of like-kind will not qualify as a Code Sec. 1031 exchange.
The taxpayer isn’t treated as actually or constructively receiving money or other property before he receives like-kind replacement property solely because the obligation of the transferee to transfer replacement property to the taxpayer is secured by cash or its equivalent, provided the security is held in a qualified escrow account or qualified trust. An escrow account is “qualified” if the escrow holder is not the taxpayer (or a disqualified person) and the escrow agreement expressly limits the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the cash or its equivalent held in the account.
Facts. Ralph E. Crandall, Jr. and Dene D. Dulin owned an undeveloped parcel of property in Arizona. The property was held for investment purposes and had a basis of $8,500. They wanted to own investment property closer to their California residence, so they decided to sell the Arizona property and purchase new property with the intention of executing a tax-free exchange.
On March 4, 2005, the taxpayers sold the Arizona property for $76,000. The buyers of the property paid petitioners $10,000, and the remaining $66,000 was placed in an escrow account with Capital Title Agency, Inc. (Capital Title). At the taxpayers’ direction, $61,743.25 was held in the escrow account, and $4,256.75 was released to the taxpayers.
The taxpayers made a series of payments to an escrow account with Chicago Title Co. (Chicago Title) from January–March of 2005. Neither the Capital Title nor the Chicago Title escrow agreements mentioned a like-kind exchange under Code Sec. 1031 or expressly limited the taxpayers’ right to receive, pledge, borrow, or otherwise obtain the benefits of the funds.
Parties’ arguments. IRS contended that, since the Capital Title escrow agreement didn’t restrict the taxpayers’ access to and use of the funds held in the escrow account, it wasn’t a “qualified escrow account.” Thus, the taxpayers were in constructive receipt of the proceeds from the sale of the Arizona property. The disposition of the Arizona property was a taxable sale, and recognized gain should have been reported on the taxpayers’ 2005 return.
The taxpayers claimed that the funds in the Capital Title escrow account were held solely for the purchase of the California property and that they received no proceeds from the sale of the Arizona property.
Conclusion. The Tax Court agreed with IRS that the disposition of the Arizona property was a sale, the proceeds of which were constructively received by the taxpayers upon deposit into the Capital Title escrow account. Although the taxpayers in fact used the funds in the Capital Title escrow account to purchase the California property, they failed to comply with the Code Sec. 1031 requirements for nonrecognition. The Capital Title escrow account wasn’t a “qualified escrow account” within the meaning of the Regulations due to the lack of express limitations on the taxpayers’ use of the funds. As a result, the taxpayers had taxable gain in 2005 from the sale of the Arizona property.
For more information about this case or 1031 exchanges in general, contact Partner F. Moore McLaughlin, IV, Esq., CPA at 401-421-5115 ext. 212 or by e-mail at mmclaughlin@mclaughlinquinn.com.
