Escrowing Disputed Sale Proceeds Under IRC 6325(b)(3): Close Now, Fight Later

Some property sales stall not because there is too little money but because too many people claim it. A contractor says his lien came first. A judgment creditor says the IRS notice was filed in the wrong name. An ex-spouse holds a recorded interest from a divorce decree. The IRS says it is ahead of all of them.

The buyer does not care who wins. The buyer wants clean title on closing day. IRC 6325(b)(3) gives everyone a way to get there: sell the property, put the disputed money in escrow, and let the money stand in for the property while the fight continues.

What the statute says

Section 6325(b)(3) allows the IRS to issue a certificate of discharge for property that is sold if, under an agreement with the IRS, the proceeds of the sale are held as a fund subject to the liens and claims of the United States, in the same manner and with the same priority those liens and claims had with respect to the discharged property.

That last phrase is the point. Nobody gains or loses priority by agreeing to the escrow. Whatever rights each party had in the house, it now has in the fund. The property is free; the dispute moves to a bank account.

How the payout order works

Publication 783 illustrates the concept. Two mortgages senior to the IRS total $32,000 and $5,000. The government's interest is $40,000. Three junior liens total $3,000, $12,000, and $2,990. The proceeds are paid in that order: the two senior mortgages, then the IRS, then the junior liens in their own order.

The escrow agreement locks that sequence in place. If a creditor later proves it was actually senior to the IRS, the order changes for the fund the same way it would have changed for the property.

When the escrow route makes sense

Use 6325(b)(3) when there is a real dispute about entitlement to the proceeds and the sale cannot wait for the dispute to end. Common real estate examples:

• Priority fights. A mechanic's lien, a judgment lien, or a second mortgage claims to be ahead of the federal tax lien. Under IRC 6323(a), the IRS lien is not valid against a holder of a security interest, a mechanic's lienor, or a judgment lien creditor until notice is filed. Exact recording dates and the definitions in IRC 6323(h) decide who is first.
• Ownership disputes. A co-owner says the taxpayer's share is smaller than the IRS thinks, or that the property was never the taxpayer's at all.
• Liability disputes. The taxpayer is contesting the underlying tax in a proceeding and wants the money preserved rather than paid over.
• Multiple liens across several tax periods, where the amount that should go to the IRS depends on a calculation the parties do not agree on.

If nobody disputes anything, skip the escrow. A 6325(b)(2)(A) discharge with payment at closing is faster.

Building the escrow agreement

Form 14135 Section 15 lists what the agreement must specify:

• The type of account
• The name of the depositary holding the account
• The conditions under which payment will be made
• The cost of the escrow
• The name and address of every party identified in the agreement
• Signatures of all parties, including the Advisory Group Manager

Publication 783 describes the order of approval. First, the draft escrow agreement goes in with the application. Second, the Advisory Group Manager approves the escrow agent, the reasonable expenses of the sale, the claim amounts and priorities, and the timing of distributions. Third, the agreement is finalized and signed by everyone, including Advisory, before the discharge issues.

Do not send money with the application. The escrow is funded at closing from the sale proceeds or by the applicant, and Publication 783 says the account must be funded before any claim or lien is paid from it. The certificate issues once the government's interest is placed in the approved escrow.

Choosing the escrow agent

The agent is usually the title company or closing attorney's trust account, or a bank escrow department. The IRS must approve the agent. Pick someone who will still be around, and who is comfortable holding funds for months or longer. Priority disputes are not quick. Spell out who pays escrow fees and how interest, if any, is allocated.

Resolving the dispute after closing

Once the property sells and the fund is in place, the parties have three ways out:

1. Agreement. The creditors and the IRS agree on priority and amounts, and sign a joint instruction to the escrow agent.
2. Administrative resolution. The taxpayer resolves the underlying tax, or the IRS concludes a claimant is senior after reviewing the documents.
3. Litigation. IRC 7426(a)(3) lets any person who claims to be legally entitled to all or part of the fund bring a civil action against the United States in federal district court. Under IRC 7426(b)(4), the court may award all or part of the fund to a party it finds holds an interest in or lien on it. Limitation periods for 7426 actions are in IRC 6532(c). Calendar them the day the agreement is signed.

Lenders and title companies should note IRC 7426(c): in these actions the underlying tax assessment is conclusively presumed valid. A creditor fighting over the fund argues priority, not whether the taxpayer really owed the tax.

A different tool for third-party owners

If you own the property but you are not the taxpayer, and you think the IRS is overvaluing its interest, IRC 6325(b)(4) may fit better. You deposit cash or post a bond equal to the IRS valuation, the property is discharged, and you have 120 days under IRC 7426(a)(4) to sue for a determination that the government's interest was worth less. That is a valuation fight. The 6325(b)(3) escrow is a priority and entitlement fight. They are not interchangeable.

Practical tips

• Start with the title report and recording dates. Most priority disputes are settled by a calendar and the definitions in IRC 6323(h).
• Get every claimant's position in writing before drafting the agreement. Surprises after signature are expensive.
• File early. Publication 783 asks for at least 45 days, and an escrow agreement adds negotiation time on top of the IRS review.
• Keep the closing statement and the escrow agreement consistent to the dollar.

For how the application package fits together, see the Form 14135 guide. Buyers worried about inheriting a seller's lien problems should read the purchaser protection guide.

The house can close today. The argument can wait in a bank account where it belongs.