Mineral interests such as oil and gas are eligible for a 1031 exchange deferring federal and state capital gain taxes given the transactions satisfy the Internal Revenue Code Section 1031 requirements. Smart owners selling fracking mineral interests of natural gas deposits should consider whether a 1031 exchange makes sense. The tax that would otherwise be paid is deferrable into any type of real property, including investment and commercial properties. The 1031 exchange represents an indefinite interest free loan or additional working capital for use towards acquiring replacement property.
Fracking
Hydraulic fracturing is a method of capturing natural gas from deep shale formations by pumping water, chemicals and pressure into horizontally drilled wells, fracturing the shale and releasing natural gas. Large shale formations are found from New York state, the Great Lakes Region down to Texas and the Great Plains. Over 30 states report fracking activity. Land owners are being sought to sell or lease their mineral interests.
Mineral Interests
When most people think of the term “real property” they envision land with or without improvements on the land. In reality, however, real property may also include what lies beneath the land in the form of minerals, oil, or gas. In fact, sometimes what lies below the surface of the land is far more valuable than the surface of the land. Understanding this, the law allows for separate and distinct rights to attach to minerals, oil or gas. What happens then if mineral interests are included in a Section 1031 Exchange? Does the presence of minerals (or something else of value under the surface of the land) prevent the exchange from qualifying on the basis that the properties are not “like-kind”?
A mineral lease qualifies for a 1031 exchange given the lease is for at least thirty years or perpetuity and enables the lessee the right to extract the mineral until exhausted. The exploration and extraction cost is borne by the lessee. Should the lessor grant a mineral lease and retains a royalty in an operating or working interest, the lease does not qualify for a 1031 exchange given the lessor retains an economic interest, per Crook v. C.I.R. (1989). If the lease is for a period shorter than thirty years, the lease is not eligible for a 1031 exchange. A production payment represents the right to receive a payment based upon a pre-determined percentage of the minerals. This is considered a “carve out” and not considered real property for federal tax purposes and not eligible for a 1031 exchange.
A non-operating interest where the holder of the mineral royalty incurs no cost of production enabling the holder to receive a percentage of all minerals produced for the life of the property interest is known as a royalty interest and considered a real property interest eligible for 1031 consideration.
1031 Exchange
Internal Revenue Code Section 1031 states “no gain or loss is recognized on the exchange of property held for productive use in a trade, business or for investment if such property is exchanged solely for property of like kind which is to be used for productive use in a trade, business or for investment.” Real property can be exchanged for any real property while tangible and intangible personal property must be exchanged for like kind personal property. 1031 exchanges must be completed within 180 calendar days. The taxpayer who sells is the taxpayer who buys. Replacement properties must be equal to or greater in fair market value than the relinquished property to defer one hundred percent of the capital gain.
Click on the button below to download the “Ten Point 1031 Checklist” to learn more about a 1031 exchange.
