It is the opinion of those who earn their livelihoods interpreting Internal Revenue Code tax regulations that oil and gas royalties should be treated as interests in real property for purposes of Code Section 1031, not as securities for purposes of the 1031 Code or as a partnership for purposes of Code Section 1031(a)(2)(D). Seek tax counsel to determine whether the Purchase and Sale Agreement, Management Agreement and Private Placement Memorandum between the taxpayer and sponsor marketing the mineral royalty comply with Code Section 1031.
Code Section 1031 Definition
A 1031 exchange allows the taxpayer to defer the federal and state capital gain and recaptured depreciation tax given a replacement property of equal or greater value is acquired within 180 calendar days of the initial sale. A qualified intermediary is required to accommodate the exchange, providing 1031 exchange documentation supporting the exchange in accordance with Code Section 1031 and holding the funds in a fiduciary role such that the taxpayer does not have access to the funds for the duration of the exchange.
Section 1031 of the Internal Revenue Code states:
“No gain or loss shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.”
Recognized gain, or the tax due upon sale of property, can amount to four, five and six figure tax obligations. The current federal capital gain rates on property held for at a year and a day is 15 percent scheduled to increase to 20 percent and possibly 23.8 percent. The additional Medicare Contribution Tax of 3.8, also effective January 1, 2013, targets net investment income of individuals, estates and trusts if taxpayer’s Modified Adjusted Gross Income (MAGI) exceeds $250,000 for marrieds and $200,000 for others. Add state federal capital gains tax and 25 percent recaptured depreciation taxes and the tax obligation can easily represent 40 percent of the sale.
If the taxpayer’s intent is to replace the asset sold by the same taxpayer with the exception of a disregarded entity or limited liability company, then the tax is deferred indefinitely or until time the replacement property is sold.
To qualify for a 1031 exchange:
- Property must be exchanged for like-kind property.
- Property cannot be exchanged for property excluded from 1031 consideration, including primary residence, indebtedness, securities, inventory and partnership interests.
- Both relinquished (old) and replacement property must be held for the proper intent of productive use in trade, business or for investment.
Oil and Gas Royalty
An oil and gas royalty allows the interest holder to receive a designated percentage of all oil and gas produced during the life of the interest. The interest is considered a non-operating interest and is not subject to production costs.
The like-kind property requirement refers to the nature or character of the property and not its grade or quality per Treasury Regulation § 1.1031(a)-1(b). Real property cannot be exchanged for personal property. Both state and federal law determine whether an oil and gas interest is considered real property.
The Service held that oil and gas interests in place are interests in real property for federal tax purposes per Revenue Ruling 68-226. Several service revenue rulings have held that state law is not considered when determining whether an oil or gas interest qualifies as real property for purposes of a 1031 exchange. The Service has determined that leasehold interests, royalty interests and overriding royalty interests are considered real property. See, e.g., Rev. Rul. 73-428, 1973-2 C.B. 303; Rev. Rul. 72-117, 1972-1 C.B. 226.
Exchanges for oil and gas royalties follow the same 1031 rules and closing pattern of other real property exchanges, with a qualified intermediary preparing exchange documents for both the first and second leg closings. The taxpayer sells real property to acquire oil or gas royalty as the replacement property.
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.
