WHAT IS A POT ESCROW?
© 1994 Bill Broadbent, S.E.C.-CCIM

A pot escrow is a single escrow which includes all principal parties to an exchange and may have more than one taxpayer who needs to defer taxes. It may be used effectively when an exchange involves several properties.

Here's how it works: Each party puts property (real or personal) into escrow (the pot) (usually a deed to property, or cash) and each party at closing receives either real or personal property from the pot (either a deed to property, cash, a carryback mortgage). A pot escrow is like a jigsaw puzzle in that it cannot be completed unless you have all the pieces.

Two major advantages of using a pot escrow
I) The lack of reciprocal property transfer, a common flaw in many exchange transactions is easily solved. Many times a taxpayer has a buyer for his property and wants to "open escrow" (Escrow #1). Escrow instructions are usually done in a Buy/Sell format and contain a sentence or two indicating that the Seller/Exchanger (Mr. E) intends to make a tax deferred exchange and the Buyer (Mr. B) agrees to cooperate as long as he incurs no additional expense.

The Seller/Exchanger then becomes a Buyer and actively searches for a property to acquire. He makes offers until one is accepted (by Mr.& Mrs. S) and again, he is encouraged to "open escrow" (Escrow #2). Escrow instructions for this second escrow frequently come out in a Buy/Sell format and contain language saying our Exchanger/Buyer intends to make a tax deferred exchange and the Seller (Mr.& Mrs. S) agree to cooperate as long as they do not incur additional expenses.

When escrow #1 is closed, the proceeds are transferred to Escrow #2, which is then closed. Many participants believe an exchange was completed. If such an exchange is audited by the IRS, it is extremely vulnerable because the IRS could interpret the transaction as a sale and reinvestment of sale proceeds, and not as a reciprocal exchange of properties. Related Buy/Sell transactions do not equal an exchange. A pot escrow solves the problem. A reciprocal transfer of properties is made and the Exchanger does not have the right to receive money (constructive receipt).

The second major advantage of a pot escrow
II) It is a superior vehicle to handle complex transaction structuring. For example, I received a call from an accountant, who said his client (Ms.H) wanted my help (as a consultant) in structuring a pot escrow for the following exchange:

• Ms. H owned a lot worth $75,000 with a loan of $21,000. She wanted to exchange her $54,000 equity for a rental house in northern California.
• Mr. S owned a rental house worth $93,000 with a loan of $65,000 which he wanted to sell.
• Mr.& Mrs. B had $75,000 cash and wanted to buy Ms. H's lot and own it free and clear so they could build a house on it.

The accountant said it would be a partially tax deferred exchange because Ms. H's equity in the lot was about twice the equity in the rental house she was acquiring from Mr. S. With $28,000 of her $54,000 equity being exchanged into the rental house he anticipated Ms. H would receive $26,000 cash, less costs. The net cash she received would be taxable.

I suggested that through a pot escrow we utilize $26,000 of Mr.& Mrs. B's cash to pay down the loan on Mr. S's property to about $39,000. This would give Ms. H a totally tax deferred exchange. I subsequently learned that Mr. S had been liened by the IRS for more than his equity in the rental house. We felt that the IRS might even ask to see the escrow instructions, so we had to be careful in documenting the flow of cash from Mr.& Mrs. B to avoid any questions of constructive receipt as far as Ms. H was concerned. This was carefully spelled out in our pot escrow. The transaction end result looked like this.

Ms. H and her accountant were delighted with our structuring of the transaction. Direct deeding of each property was also used so no one had to "go through strange title" for anyone else.

Ms. H. ended up with a totally tax deferred exchange since she traded even and up in both equity and debt.

Mr.& Mrs. B used the rest of their cash to pay off the $21,000 note on the lot. This end result would have been almost impossible without the benefit of a pot escrow format.

While the benefits of a pot escrow are substantial, few escrow people have been trained to do one properly. In over 40 years of exchanging I have met only a couple escrow officers who I'm sure could properly do a pot escrow. Since none of these people were local, our firm developed the ability to structure the transaction and draft the pot escrow document as part of our work as exchange consultants. We then submit these to our client's legal and tax counsel for review and fine tuning. In the event our clients do not have legal or tax advisors who are familiar with the intricacies of tax deferred exchanges they are welcome to use ours. When we've completed the legal and tax review, the document is given to the escrow officer who attaches several pages of general provisions and the escrow instructions are ready for signatures.

A pot escrow document cannot be drafted until all properties have been located and the equities and financing finalized through negotiation. Principals, agents and lenders who want to be sure there is a "deal" and who are unfamiliar with exchanges are often anxious for someone to "open escrow." This frequently results in flawed exchange escrow instructions being drawn in two stages (Buy/Sell), as described earlier in this article. Properly executed deposit receipt(s) are all the contracts necessary until all properties have been located and under contract. Then and only then can a proper pot escrow be developed. Overly anxious agents who prematurely demand escrow instructions "right away" may be causing unnecessary extra effort or even jeopardizing the quality of the escrow documentation.

It makes no difference where the principals or properties are located. Several years ago we directed a pot escrow in San Luis Obispo, California in which all the properties were in Tennessee and Florida. Only one of the principals lived in the state of California.

A semi-retired real estate broker approached me for consultation regarding the exchange of a property she wanted "done right." I provided her with some language to go into the deposit receipt when the listing agent found a buyer for her property which set forth our role as her exchange consultant. Similar language would be used when she made an offer to purchase her replacement property in southern California. Once the agents provided us with the appropriate information, we structured the pot escrow and guided it to a timely closing.

Since the Internal Revenue Service approved the "delayed exchange" many property owners and agents believe that exchanges are simple. Exchanges are still complex. To avoid the pitfalls, many issues must be examined and discussed. A pot escrow normally anticipates a concurrent (at the same time) closing for all properties. This is safer and usually less costly than a delayed (Starker type) exchange which has its own unique risks.

Exchanges may have tens to hundreds of thousands of tax dollars at stake. A taxpayer/exchanger should get competent assistance in structuring their transaction to minimize the chance of failure in the event of an audit.

After completing a pot escrow for clients we occasionally receive a nice "thank you" note. Here are a few recent comments:

"I want to extend my sincere thanks to you for your help in our 1031 exchange. Everyone involved in the transaction comments upon your work, elevating it to the status of 'work of art'."

R.J. Los Osos, CA

"Just a short note to thank you for the time and effort you put forth handling our "pot" escrow so professionally. Both you and our escrow officer were a real delight to work with and I look forward to working with you again in the future."

J.G. Palm Springs, CA

Copyright © 1997 Arnett & Broadbent, Inc. All rights reserved.