It's OK To Tell Them Why You Want Them to Hold Your Money

Originally published on Passive Activities and Other Oxymorons on March 4th, 2011.
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Ralph E. Crandall, Jr., et al. v. Commissioner, TC Summary Opinion 2011-14 

This case really mystifies me.  It is about a failed tax-free exchange.  So here's the deal.  One of the most general rules of income tax is that if you trade one thing for another thing and the thing you get is worth more than the basis of the thing you gave up, you have taxable income.  When the thing you get is money, most people understand that, but it is true regardless of what you get.  Like any good general rule, there are many exceptions.  Part III of Subchapter O contains a host of them including Section 1031.  Section 1031, like 401(k) and 501(c)(3), has worked its way into common conscious enough to rate a Wikipedia entry.  It's basic holiding is:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Although it has very broad applicability the biggest action in 1031 is in the area of real estate.  This is because all real estate in the United States is considered to be of like-kind with all other real estate in the United States.  So you can't swap your cow for a bull and have it qualify as a like kind exchange, but you can swap your farm land for an office builing.  I swear I don't make this stuff up.  I don't have enough imagination.

Since it is unlikely that somebody who wants your property is going to have property you want, taxpayers began devising schemes to do three way swaps.  Eventually this was regularized.  You can arrange to sell your property and have a "qualified intermediary" receive the proceeds.  You then have up to 45 days to designate a target property and 180 days (You may have to extend your return to have the full 180 days) to close on the target property.  Exchange facilitation is a minor industry.  I gave a cautionary tale about exchange facilitators a few months ago.  Basically you want to use one that keeps your money in a segregated account.  You won't go too far wrong using the likes of Wells Fargo, but you can shop around.

What happened to Ralph Crandall is a classic case of somebody getting half the story and going ahead and acting on it.  Maybe he heard about 1031 from his barber.  He didn't hear about it from my barber, certainly, because then he would have called me.  Actually, my barber cuts most of the CPA hair in central Massachusetts, so maybe he would have called somebody else, but he would not have flown blind.

Here's how it went:

Petitioners owned an undeveloped parcel of property in Lake Havasu City, Arizona (Arizona property). Petitioners held the Arizona property for investment. Petitioners desired to own investment property closer to their California residence. After receiving some limited advice concerning a tax-free exchange of properties, petitioners took steps to sell the Arizona property and purchase new property with the intention of executing a tax- free exchange. On March 4, 2005, petitioners 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 petitioners' direction $61,743.25 was held in the escrow account. Capital Title initially released $4,256.75 to petitioners. Petitioners' basis in the Arizona property was $8,500.


In furtherance of the purchase petitioners made payments to Chicago Title Co. (Chicago Title) and placed in an escrow account as follows:
Jan. 4, 2005 10,000.00
Mar. 14, 2005 (three separate payments)24,700.00, 4,256.75, 294.00
Mar. 18, 2005 61,550.00

The Capital Title and Chicago Title escrow agreements did not reference a like-kind exchange under section 1031, nor did they expressly limit petitioners' right to receive, pledge, borrow, or otherwise obtain the benefits of the funds

This is the part that mystifies me.  Capital Title is a name used by several companies so I can't be sure about it. Chicago Title , though,has a division that does 1031 exchanges.  Didn't Mr. Randall think to tell the company that he was trusting his money with that he was doing a 1031 exchange ?  Didn't they think to ask him why he was escrowing money?

I could go on at length about what is and is not allowed in handling 1031 exchanges but I generally don't.  The reason is that if you have a plain vanilla deal you should contact a company that does a lot of exchanges and do what they tell you.  It really doesn't matter what I think.  If you have a complicated transaction then give me a call.

The Tax Court felt sorry for Mr. Randall, but they couldn't help him:

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 [1996 RIA TC Memo ¶96,214]; 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.

We conclude that the disposition of the Arizona property was a sale and the funds deposited in the Capital Title escrow account represent the receipt of the proceeds. See sec. 1001(c). Consequently, this transaction does not qualify for section 1031 nonrecognition, and petitioners must recognize gain for 2005. See sec. 1001(c). The Court notes that the tax consequences are not what petitioners intended and the result may seem somewhat harsh. However, Congress enacted strict provisions under section 1031 with which taxpayers must comply. We also note that respondent has conceded the accuracy-related penalty.

How could he have avoided this problem ?  He could have told the people escrowing the money that he was doing a 1031 exchange.  If they didn't know what he was talking abou