Escrow Agent Erroneously Releases 1031 Funds
to Taxpayer

IRS Accesses Tax

Recent tax case, Peter Morton v. US, No. 08-804C  (Ct. Claims, April 27, 2011), reinforces the necessity to follow the requirements of IRC §1031 and how easily an exchange can be tainted – even by a mistake by an escrow officer.

Peter Morton is one of the co-founders of the Hard Rock Café chain and he has several wholly owned S corporations, including Red, White and Blue Pictures, Inc. (RWB).  RWB owned an aircraft that was relinquished as part of a 1031 tax-deferred exchange but Mr. Morton personally is the plaintiff in the case because RWB was a pass through entity.  

In 1999, Mr. Morton (presumably through RWB) structured an exchange of a Gulfstream G-III for a Gulfstream G-IV aircraft.  RWB entered into an exchange agreement with a QI and an escrow agreement with an escrow agent.  RWB met all the requirements of the QI safe harbor, but the escrow agent accidentally placed the funds into RWB's non-exchange bank account.  RWB returned the funds the following day.

The government argued that RWB constructively received all the funds when the escrow agent accidentally and in contravention of the escrow agreement transferred funds from the escrow account to RWB.  The Court disagreed that an accidental transfer followed by an immediate return of funds would constitute actual or constructive receipt creating a taxable event for Mr. Morton.  Mr. Morton paid the taxes assessed by the IRS and sued for a refund in the Court of Claims.

The Court noted that significantly, Mr. Morton was bound by contract not to "receive, pledge, borrow or otherwise obtain the benefits of the Exchange Value" for at least 45 days.  "Legally, he could not do anything but return the funds to the proper account. If he had done anything other than return the funds, he would have been liable for conversion, or even theft."  Additionally, the court held that Mr. Morton should not be penalized for another's mistake when he took every step to validly effect an exchange.

The Court stated that he complied with all the requirements of the QI safe harbor over which he had control; he did not have control over the mistaken actions of a third party.  Therefore, he validly effected the exchange.

In the decision on a motion for summary judgment, the Court held that a taxpayer did not constructively receive exchange funds mistakenly placed in his bank account by the escrow agent and returned by the taxpayer the next day.

The Certified Exchange Specialists® at 1031 CORP. provide detailed instructions to your closing officer and work diligently to prevent mistakes.  Unfortunately, mistakes do occasionally happen (the most frequent is inadvertently including 1031 CORP. as a buyer of the replacement property) and we take immediate steps to correct the mistake.