A taxpayer who wishes to avoid paying capital gains tax on realized gain from the sale of property may be able to do so by entering into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment any capital gains tax that would otherwise be due is deferred. Even if a transaction meets all of the other requirements for a Section 1031 Exchange the transaction may not qualify for deferral of gain if the parties involved in the transaction were “related parties” (as defined by the Internal Revenue Service) and the property involved in the transaction was disposed of within the two year period following the exchange.
Andy Gustafson
1031 Exchange and Mineral Interests
When a taxpayer enters into a traditional sale of real property the taxpayer may incur capital gains taxes as a result of any gain realized from the sale. Because realized gains have historically been taxed at a high rate taxpayers often look for legal strategies that reduce or eliminate capital gains taxes. One option is to enter into a Section 1031 Exchange instead of a conventional sale. If a transaction qualifies for Section 1031 treatment, capital gains taxes that would ordinarily be levied on the gain realized from the sale are deferred. There are, of course, a number of requirements that must be met for a transaction to qualify for 1031 Exchange treatment, including:
1031 Exchange and Leases
In a 1031 exchange, the Internal Revenue Service considers a lease of thirty or more years the same as real property. This is significant because lessees are able to sell their interest and replace with any type of real estate of equal or greater value. Fast food franchises, retail, cell tower and bill board lessees benefit from the 1031 exchange allowing them to defer the gain into another property. Lessor’s or landlord’s lease interest is not exchangeable and is treated as the receipt of advance rental income per Pembroke v. C.I.R. (1931) and Crooks v. C.I.R. (1989).
Leasehold Interests
A fee interest in land is like-kind to a lease interest in land given a term of thirty years or more. The lease qualifies if the term has renewable options extending over the thirty year threshold. The initial term could be ten years. If the lessee has five optional renewable five year terms, the thirty-five year periods would satisfy the 30-year requirement. The option to renew must be the lessee’s and not the lessor’s.
A taxpayer’s reversionary interest or the right to take back the property ownership interest upon the death of the lease holder allows the taxpayer to exchange out of the leasehold interest as the tenant and acquire a sublease in the same property qualifying as replacement property. Revenue Ruing 76-301 provides that the taxpayer may transfer its leasehold interest in the entire building and acquire a sublease of a portion of the building as replacement property.
Mineral Leases
A lessee’s interest in a mineral lease of thirty years or more is considered like kind to a real estate interest qualifying, for a 1031 tax deferral. In a mineral lease, the lessee has the right to extract the minerals for a set period of time or until exhaustion. Leasehold interests of less than thirty years is considered a carve out and not eligible for a 1031 exchange. A production payment represents a right to the mineral for a mutually agreed upon price and does not qualify for a 1031 exchange.
A mineral royalty allows the holder to receive a percentage of all minerals produced until exhaustion or in perpetuity. Per Revenue Ruling 73-428 and 72-117, a royalty interest is considered a real property interest for federal tax purposes and is eligible for a 1031 exchange. The Internal Revenue Service determined an overriding oil and gas royalty qualifies for 1031 treatment. An overriding royalty interest is when the mineral lessee grants a sublease while retaining a royalty interest. The lessor ceding the mineral lease maintains a royalty interest and does not qualify for a 1031 exchange.
In Crooks v. C.I.R. (1989), a transfer of mineral rights underlying farm property was exchanged for a 25 percent royalty interest in the oil and gas produced and a fee interest in other land was determined to be not like kind. The Tax Court found that the transaction was a lease because of the taxpayer retained economic interest.
Mineral interests transferred with real estate are not a separate asset to the taxpayer who conveys the property per Butler Consol. Coal Co. v. C.I.R. (1946). In Beeler v. C.I.R. (1997) unmined sand in land containing a sand mine was not separate property and not eligible for a 1031 exchange. In Peabody Natural Resources Co. v. C.I.R. (2006), the Tax Court determined that coal supply contracts are a bundle of rights subordinate to the ownership of the coal mines and not separable from the ownership of the land and the coal mine reserves.
Atlas 1031 Exchange has accommodated 1031 exchanges for cell tower, fast food franchise and mineral interests when the lessor is selling their thirty year leasehold interest. Mineral leases require an understanding of the rights to establish whether they are eligible for a 1031 tax deferred exchange.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
1031 Exchange Process Explained
The 1031 exchange process is fundamentally the same as when the tax deferral was legislated into law in the National Revenue Act of 1921. Historically, the intent was that as long as the taxpayer reinvested the net sales price into replacement property, the capital gains tax that would otherwise be triggered is deferred until the replacement property is sold. Farmers traded land for land, equipment for equipment and horses for horses. Over the years, investors applied the deferral strategy to the sale of real estate. The 1970s Tax Court case of Starker v. Commissioner established that the exchange did not have to be simultaneous or occur in one long closing.
1031 Exchange Foreign Property
In a 1031 exchange, foreign real and personal property, when exchanged for foreign real and personal property, qualify for a federal capital gain tax deferral. Real property can be any real property given the nature and character of rights of the exchange properties are essentially alike including likeness of physical properties, character of title conveyed, rights of the parties and duration of interests. Personal property must be exchanged for like-kind or like-class property, such as aircraft for aircraft, gold bullion for gold bullion or oil painting for oil painting. Predominance of use over the prior two years determines the property’s location.
1031 Exchange Examples
Thinking outside the box, a 1031 exchange applies to any property held in the productive use of a trade, business or investment. Property must be real property. 1031 exchange rules must be strictly followed to support the outcome, which is the deferral of federal and state capital gains and depreciation recapture taxes that can amount to over forty percent of the property sales price. The deferral is indefinite and ultimately due unless the property is stepped up to the taxpayer’s heirs upon death. When a replacement property sells, the gain can be deferred again and again in a 1031 exchange. Those otherwise paid out tax dollars represent interest free additional working capital available to taxpayers, both individual and corporate, trusts and limited liability companies subject to federal income taxes.
Real Property
Any real property located in the United States (US) can be exchanged for real property in the US while real property held internationally is eligible for real property held overseas. For example, if the taxpayer is subject to US federal taxation inherits property in India, when sold, the sale may trigger both Indian and US capital gains taxes. A 1031 exchange can defer the US capital gains tax when replacing the real property with another either in India or outside the US.
Examples of Real Property
- Improvements to land already owned by the taxpayer in a leasehold improvement exchange.
- Improvements to replacement property in an improvement exchange.
- Single family residential held as an investment for commercial property.
- Condominium held for investment exchanged for another condominium.
- Timberland for a farm or ranch.
- Subway franchise as lessee, selling their thirty plus year lease interest for real property.
Exchange Strategies
A 1031 exchange is either a forward or reverse exchange. In a forward exchange, the old or relinquished property is sold prior to acquiring the replacement property. In a reverse, the replacement property is acquired before selling the old property. Timing is the critical component when there is more than one property to be sold or purchased. If the taxpayer wants to exchange two relinquished properties into one or more replacement properties, given the two old properties can be sold within forty five calendar days of each other, a forward exchange strategy can be deployed. If the second property cannot be sold in the same forty five day period, then a combination forward/reverse exchange strategy is used to allow a percentage of the replacement property to be acquired by an Exchange Accommodation Titleholder, or EAT. The second relinquished property must be closed within 180 calendar days from the date the replacement property is closed. Upon closing, a deed conveys the interest to the taxpayer.
If the intent when selling real and personal property held in a business or for investment is to replace with like-kind or like-class property, then a 1031 exchange should be considered.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.