5.26 Using Escrow and Other Security Arrangements

When you sell property on the installment basis, the remaining sales proceeds (plus interest) may be placed in an escrow account pending the possible occurrence of an event such as the approval of title or your performance of certain contractual conditions. If the escrow account is irrevocable or there are no escrow restrictions preventing you from receiving immediate payment, the IRS does not allow installment reporting. It considers the buyer’s obligation paid in full when the balance of the proceeds are deposited into the unrestricted escrow account. If in a year after the year of the installment sale an escrow account is set up as a substitute for unpaid notes or deeds of trust, the IRS considers the escrow funds as payment in full, assuming there are no substantial restrictions on your right to the proceeds.

EXAMPLES
1. Anderson sold stock and mining property for almost $5 million. He agreed to place $500,000 in escrow to protect the buyer against his possible breaches of warranty and to provide security for certain liabilities. The escrow agreement called for Anderson to direct the investments of the escrow fund and receive income from the fund in excess of $500,000.
The IRS claimed that in the year of sale Anderson was taxable on the $500,000 held in escrow on the ground that Anderson’s control of the fund rendered the fund taxable immediately. Anderson argued he was only taxable as the funds were released to him, and the Tax Court agreed. The fund was not under his unqualified control. He might never get the fund if the liabilities materialized. Although Anderson had a free hand with investment of the money, he still lacked ultimate ownership.
2. Rhodes sold a tract to a buyer who was willing to pay at once the entire purchase price of $157,000. But Rhodes wanted to report the sale on the installment basis over a period of years. The buyer refused to execute a purchase money mortgage on the property to allow the installment sale election (required under prior law) because he wanted clear and unencumbered title to the tract. As a solution, Rhodes asked the buyer to turn over the purchase price to a bank, as escrow agent, which would pay the sum over a five-year period.
The escrow arrangement failed to support an installment sale. Rhodes was fully taxable on the entire price in the year of the sale. The buyer’s payment was unconditional and irrevocable. The escrow arrangement involved no genuine conditions that could defeat Rhodes’s right to payment, as the buyer could not revoke, alter, or end the arrangement.
3. In January, an investor sold real estate for $100,000. He received $10,000 as a down payment and six notes, each for $15,000, secured by a deed of trust on the property. The notes, together with interest, were due annually over the next six years. In July, the buyer deposited the remainder of the purchase price with an escrow agent and got the seller to cancel the deed of trust.
The agreement provides that the escrow agent will pay off the buyer’s notes as they fall due. The buyer remains liable for the installment payments. The escrow deposit is irrevocable, and the payment schedule may not be accelerated by any party under any circumstances. According to the IRS, the sale, which initially qualified as an installment sale, is disqualified by the escrow account.
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