Like-Kind Exchanges, also known as 1031 Exchanges (for the relevant code section under the Internal Revenue Code) have long been used to defer taxation of gain from the sale of real estate used for business or held for investment. Section 1031 gives you this tax deferral if you reinvest the proceeds from the sale of your “relinquished” property into similar (like-kind) “replacement” property. Being of like-kind is the key to utilizing this tax deferral tool – you couldn’t, for example, exchange a piece of land for a yacht and defer taxes on the land gain.
Naturally, in addition to the like-kind there must be an “exchange” which may seem rather restrictive in meeting your objectives if you had to find another party willing to trade property with you that is agreeable to both. Fortunately, there is no such requirement for a direct trade, the law allows you to act through an agent known as a “qualified intermediary” much like a title company acts as the agent between buyers and sellers. Qualified intermediaries act as agent by holding your sales proceeds until a replacement property is identified and acquired – you as the exchanger must not have any access to the funds or the exchange will not qualify. There are also requirements as to when you must identify new property (within 45 days) and acquire the replacement property (180 days).
Given the new technologies and exploration growth in the domestic natural gas industry, more attention is being given to deferring taxation in transfers of mineral interests. The key to mineral rights qualifying as a like-kind exchange lies in the type of rights transferred. The right in the properties, and not just the properties themselves, must be similar. Typically, the landowners hold a mineral estate, meaning that they have exclusive and perpetual rights to the minerals under their land. The sale of all such mineral rights without any limitation as to the time or amount of minerals to be extracted by the buyer would qualify as like-kind property with real estate, whether improved or unimproved. As an example, someone could exchange mineral rights they sold for farmland, commercial property or even residential rental property.
In addition to outright mineral estates, mineral rights are often held as either a mineral lease or mineral royalty. In certain situations, these mineral rights can also qualify as like-kind to real estate. For example, an owner (lessee) of a mineral lease (also known as a working interest) should be able to exchange that property and defer taxes if his or her right in that lease is not limited as to time or quantities. Similarly, a royalty interest can be used as like-kind property in certain situation that are beyond the scope of this article.
Mineral rights will continue to be of importance to landowners in Arkansas and many states across the nation. Be sure that you invest the time to know all your options when faced with a decision to sell mineral rights. Avoiding the tax man may be an important part of making any deal work in your favor. Although like-kind exchanges are designed to be only a tax-deferral, for real estate that is to be held by families for multiple generations, the opportunity exists under the current estate tax laws to make this deferral permanent.
This article is intended to be a general discussion but, every transaction is unique and should be reviewed by your legal and tax advisors to assure that all is structured appropriately.