How Mineral Interest Owners Can Use Section 1031 to Defer Capital Gains

A 1031 exchange, which gets its name from Section 1031 in the Internal Revenue Code, is a swap of one real property for another that allows capital gain taxes to be deferred. Mineral interests, both working interests and royalty interests, whether held for business or investment purposes, can be sold and the tax on the gain on the sale deferred. There are certain rules, however, that must be followed in order to qualify for a 1031 exchange.

1. Proceeds from the sale must be held in escrow by a third party (referred to as an intermediary) and then used to buy the new property. You cannot receive the funds, not even temporarily.
   
   
2. The properties being exchanged must be considered like-kind in the eyes of the IRS for capital gains to be tax deferred. You can exchange working interests for royalty interests, royalty interests for royalty interests, royalty interests for working interests, and working interests for working interests. These are all considered like-kind in the eyes of the IRS. You CANNOT, however, “sell” a working interest and retain an overriding royalty interest. The IRS views this as retaining an interest and not selling an interest and does not qualify for a 1031 exchange.
   
   
3. Within 45 days of the sale of the interest a new interest must be designated, in writing, to the intermediary, specifying the interest you want to acquire. You can designate up to three interests as long as you eventually close on one of them. You can even designate more than three if they fall within certain valuation tests.
   
   
4. You must close on the new interest within 180 days of the sale of the old property. Please note: the 45 days rule above and this 180 days rule run concurrently from the day the sale of your interest closes.

There are other considerations that must be noted. You must consider if there will be funds left over after the intermediary acquires the replacement property. If there are funds remaining, the intermediary will pay it to you at the end of the 180 days and the portion of the funds you received will be taxed as partial sales proceeds, generally as a capital gain.

You also must consider mortgage loans or other debts on the interest relinquished as well as any debts on the replacement interest. If your liability decreases then that will be treated as if you received cash from the intermediary. For instance, if the liability on your relinquished interest was $50,000 and the liability on your replacement interest is $30,000, you would need to recognize the $20,000 reduction as partial sales proceeds.

If used correctly, there is no limit on how frequently you can do 1031 exchanges. Please keep in mind a 1031 exchange does not eliminate the gain on a sale of a mineral interest, it defers the gain on a sale of a mineral interest.

HoganTaylor Energy Services

If you would like more information about the Marginal Well Tax Credit and how it could potentially benefit your business, please contact the author of this article, Paige Buxton Graham. You may also contact Jeff Koweno, Energy Practice Lead, or any other member of the HoganTaylor Energy practice.

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.