IRS 1031 Property Exchange- Consider Deferring Your Tax Bill By Selling Your Minerals

IRS 1031 Property Exchange- Consider Deferring Your Tax Bill By Selling Your Minerals

At LandGate, we have clients constantly asking if they should lease their minerals or sell them. That’s a tough question, as not all mineral rights owners are in the same financial situation. And with the price of oil at $39 per barrel, oil companies are not actively leasing. Mineral buyers, however, are definitely spending a lot of money these days.

A huge benefit to selling your minerals vs leasing them is that you are going to get paid a lot more to sell and there are some attractive tax benefits to selling mineral rights.

  • If you sell your minerals for more than your basis (value of the minerals when you acquired them), and you have owned the minerals for more than a year, then all or a portion of what you are paid will be subject to long-term capital gains taxes. A capital gains tax is a federal tax on profits from the sale of an asset.
  • If you lease your minerals, the lease bonus and royalty you receive is taxed as ordinary income.
  • The long-term capital gains tax rate is lower than the ordinary income tax rate.

But one of the best tax benefits of selling your minerals is that you can take advantage of Section 1031 of the Internal Revenue Code. This is often called the 1031 Property Exchange or Like-Kind Exchange rule. Meaning that as an alternative to paying long-term capital gains taxes, a 1031 exchange allows you to defer all taxes by reinvesting the profit from the sale of one property (“Relinquished Property”) into the purchase of another property (“Replacement Property”).

To qualify for a 1031 exchange, the property being sold and purchased must fit the definition of “real property”. Real property can be defined as land, and anything growing on, affixed to, or built on it. This also includes man-made buildings as well as crops. Real property is best characterized as property that doesn’t move, or that is attached to the land. Real property may include not just the land, but anything that is permanently located within or under the land, to include oil and gas minerals rights.

Here is an example of how it works in a situation where you want to sell your minerals.

  • You have owned your minerals for more than a year. Less than 1 year would result in a short-term capital gain tax rate which is higher than long-term capital gains tax rate.
  • Not certain what your minerals are currently worth? Call LandGate for an accurate valuation.
  • LandGate valued your minerals at $1,500,000. LandGate listed your minerals with an asking price of $1,500,000.
  • LandGate brought you a buyer with an offer of $1,500,000 and you accepted it.
  • In preparation for closing, you talk to a tax advisor about the tax consequences of receiving such a large sum of money. The tax advisor asks you to have LandGate determine the value of the minerals at the time you acquired them. (purchased or inherited minerals) That value will be the basis and used in your tax calculation.
  • LandGate determines that your basis is $500,000.
  • You tell your Tax advisor that you would like to use the proceeds to buy a lake house after selling the minerals.
  • Your tax advisor determines that the house you want to buy would qualify under the 1031 like-kind exchange rules and recommends you consider a 1031 exchange. He presents you with the following scenario:
Sales price you will receive at closing $1,500,000
Basis in the minerals  $ 500,000
Profit $1,000,000

 

Your capital-gains tax rate is 15%
Long-term capital gains taxes you will owe $ 15,000

 

  • If you reinvest the $1,000,000 profit into a qualifying like-kind property, you can defer paying $15,000 in capital gains taxes. Sound like a great idea? Absolutely!

Your tax advisor can assist you in the 1031 process. If you have not yet found the lake house or Replacement Property you want to buy, your tax advisor will likely recommend you consider a “Delayed 1031 Exchange”, which will involve these very important requirements:

  1. Prior to closing, you need to select a Qualified Intermediary (“QI”). You will enter into an exchange agreement with the QI. The QI will be responsible for transferring your minerals to your buyer and holding the proceeds from the sale of your minerals in a trust or escrow account to ensure that you don’t actually receive the sale proceeds. Once you have identified a lake house that qualifies as a Replacement Property, the QI will manage the closing and then transfer the Replacement Property to you pursuant to the exchange agreement.
  2. Within 45 days following the closing on the sale of your minerals, you must identify the Replacement Property you want to buy. The legal description or street address will be critical.
  3. You must close on the acquisition of the Replacement Property within 180 days following the closing on the sale of your minerals.

There are different types of 1031 exchanges. The above example is the Delayed Exchange, which is required when the Replacement Property will be acquired after closing of the Relinquished Property. A couple other more common exchanges are the Simultaneous Exchange, which is utilized when you want to close on the sale of the Relinquished Property at the same time you close on the purchase of the Replacement Property. And a Reverse Exchange is used when you want to purchase the Replacement Property before the Relinquished Property is sold.

LandGate has a one of a kind valuation tool to assist you in knowing what your property was worth when you acquired it, and what it’s worth now. If you are considering the sale of your minerals, start with LandGate. And if you are looking for additional properties for a 1031 exchange, let us help.

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THIS BLOG IS INTENDED TO BE INFORMATIONAL ONLY. WE ARE NOT INTENDING TO GIVE TAX ADVICE. PLEASE CONSULT A TAX PROFESSIONAL.

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