Form Matters – Part Deux

In Uncategorized on 02/15/2011 at 18:21

I recently discussed  WB Acquisitions, Inc. and Subsidiaries as an example of following the forms, and the penalties for not doing so. Now we have another example of form not followed, with grave consequences for the taxpayer. Again, while I don’t usually comment on 7463’s, this case is a good example of why taxpayers need competent advisers to help them follow the rules.

In Crandall and Dulin, T.C. Sum. Op. 2011-14, 2/15/11, taxpayers wanted to sell one piece of unimproved realty held for investment (on which they had a substantial gain) for another closer to home. They tried the usual forward-deferred 1031—sell the old, escrow the proceeds of sale with a Qualified Intermediary, locate and identify the new, and close, all within the 45-180 day timeframe of Section 1031. All this the taxpayers did–except the paperwork was defective.

The taxpayers took a few thousand dollars worth of proceeds out of escrow, but that in itself didn’t torpedo the 1031. Tax Court went off on the proposition that “(T)he … 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.” Crandall, at p. 4.

Tax Court went on to say “(T)he taxpayer’s own limitation of use of the funds does not convert the escrow account into a qualified escrow account. Klein v. Commissioner, T.C. Memo. 1993-491.” Crandall, at p. 7.

Although the properties were like-kind, although the timeframes of Section 1031 were adhered to, although the taxpayers clearly intended to do a 1031 exchange, the defective paperwork resulted in a deficiency.

IRS kindly conceded the accuracy-related penalty in a rare moment of mercy.

The takeaway—don’t use a boilerplate escrow agreement. Carefully put in the magic language of Regulation Section 1.1031(k)-1(g)(3)(ii)(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.”

Leave out that language and it can get expensive.

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