What is a Qualified Escrow Account?

A qualified escrow account offers a secure and reliable way to hold and manage funds for a specific purpose while also providing protection for all parties involved. Investors often use this type of escrow account in a 1031 exchange to hold the funds from the proceeds of a sale until the purchase of a replacement property is complete. 

In a 1031 exchange, the investor usually names a Qualified Intermediary (QI) to facilitate the exchange, who will likely set up a qualified escrow account to hold the exchange proceeds from the relinquished property. At closing, the funds are transferred from the escrow account to the seller of the replacement property. 

The exchanger cannot access the funds while they are in the escrow account, protecting them for the party selling the replacement property. The only time the funds can be accessed is to acquire the property, or if they meet certain conditions. 

For example, if you, as an investor, sell a property for $600,000 that pays off a $450,000 mortgage held on the property, there are $150,000 in proceeds. To qualify as a 1031 exchange, you must direct the proceeds to the QI, who then deposits it into a qualified escrow account. 

What makes an escrow account “qualified”?

The term "qualified" refers to the fact that the account meets certain regulatory requirements, such as those set forth by the Internal Revenue Service (IRS) or state banking authorities. The requirements ensure the funds are used for their intended purpose and that they are not misapplied. The escrow account should be held in an FDIC-insured account. 

In a 1031 exchange, a qualified escrow account should: 

1. Be established with a QI, and not a disqualified person.
2. Hold the net sale proceeds from the sale of the relinquished property, which are to be applied to the purchase of a replacement asset. 
3. Limit the exchangers' right to use the funds other than outlined in the agreement.

Are there potential tax benefits to a qualified escrow account? 

In a 1031 exchange, there are cases when the proceeds aren’t subject to capital gains tax, as long as you purchase a qualifying replacement property with the funds within a certain amount of time. While the funds from the sale of the relinquished property are held in the qualified escrow account, they are usually not subject to taxation if the qualifications are met. A tax professional can advise you on the requirements of your own 1031 exchange and the potential tax benefits. 

Qualified escrow accounts are subject to the safe harbor rules, which say the exchanger can potentially avoid official receipt of the funds or property when completing a 1031 exchange. The safe harbor rule requires that the QI holds the exchange funds in a qualified escrow account or a trust account. The QI must also follow certain restrictions on the use of the exchange funds and provide certain notifications to the taxpayer.

By complying with the safe harbor rule, the taxpayer can avoid constructive receipt of the exchange funds, which could otherwise result in the recognition of gain for income tax purposes. Instead, the taxpayer's exchange is treated as a deferred exchange under Section 1031, allowing them to defer the recognition of the gain until a later time.