What may come as a surprise to many real estate investors is the ability to use what is below the ground as a replacement in a Section 1031 tax deferred exchange.
May 15, 2024
By Al DiNicola, AIF®, CEPA™
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC Member of FINRA/SIPC
Real estate ownership typically is viewed as the land and what has been constricted on the land. In certain parts of the country there are air rights or above the buildings. There is also what is from the earth’s surface to a hypothetical place towards the center of the earth.
We have received several requests from potential investors who want information on §1031 exchange into a potential Delaware Statutory Trust (DST) mineral royalty program. We recently participated in a mineral rights due diligence symposium and wanted to provide some educational background on the topic of mineral rights.
Some of the country’s wealthiest families have been using mineral rights to develop a tax deferred exchange strategy since the mineral rights qualify as a like kind exchange.
By reinvesting the profits (via §1031 exchange) from the sale of real estate and identifying and acquiring mineral rights as the replacement asset is a different and acceptable way to defer capital gains. However, there is a need to have a basic understanding of the process.
Section 1031 Tax Deferred Exchange
Section 1031 of the Internal Revenue Code (aka 1031) enables investors when selling appreciated real estate to defer paying capital gains taxes when the real estate is sold. There are a set of rules established by the IRC regarding replacement value, utilizing all the cash, replacing any loans paid off. There are also those dates having over investors’ heads on identifying the replacement properties as well as closing on the replacement properties.
Mineral Rights Qualify as Replacement Property
Real property is considered surface, air and below the ground. Mineral rights are considered real property, and thus, they qualify for a §1031 exchange. Many people consider real property to only be commercials property, rental properties or vacant land. However, mineral rights are considered real property.
Exchanging into and out of Mineral Rights
Exchanging into Mineral Rights
- The first step may be the sale of the property: If you have any property that is held for investment property including commercial, residential real estate or even vacant land, offering the property for sale would be the first step. Selling the property would come next.
- A Qualified Intermediary (QI) will be required: You must have an arrangement to use the services of a QI. This is required by the IRS. The QI will hold the proceeds from the sale and handle the necessary transfer of funds to acquire the mineral rights which is considered the replacement property.
- The Replacement Property (Mineral Rights) must be identified. You have 45 days from the closing of the relinquished property to identify potential replacement properties. The QI will require this in writing and typically the QI has a form to be signed by you. The property must come with a legal description or address. A mineral right may also have a longer metes and bounds description. You can identify up to three properties regardless of their value, or more under certain conditions (200% rule or 95% rule).
- Mineral Rights are acquired. Within a total of 180 days from the closing of the relinquished property you must close on the purchase of the mineral rights. The mineral rights must be of equal or greater value to the property sold to defer all capital gains taxes.
Exchanging out of Mineral rights
- Mineral Rights may be offered for sale. One of the first determinations would be to properly identify the mineral rights. Having the mineral rights evaluated (or valued) and appraised is critical.
- Qualified Intermediary (QI) is needed. A QI arrangement is needed to complete the exchange process. Just as in the previous example there is a need to ensued compliance with all the §1031 exchange regulations.
- Sale of Mineral Rights: The proceeds from the sale of the mineral rights are held by the QI.
- Identify Replacement Property: All of the same rules regarding identifying replacement properties apply. Like kind properties may include other mineral rights, commercial property, rental property and vacant land.
- Acquire Replacement Property: The closing on the replacement property must occur within 180 days from the sale of the original mineral rights.
Considerations for Compliance
- Like-Kind Requirement: For exchanging “into” mineral rights any residential income or commercial property (including land) is considered like kind. For exchanging “out of” mineral rights suitable replacements can include other mineral rights, residential, or commercial real estate.
- IRS requires Strict Timeline Adherence: The adherence to the strict 45-day identification period and the 180-day acquisition period is what many investors may find difficult. This is especially true if the investor is not prepared. Missing these deadlines can disqualify the exchange.
- Qualified Intermediary Required: There is no exchange without the services of a QI. The QI cannot be someone who has acted as your agent in the past two years, such as your attorney or accountant.
- Everything needs Documentation. It is crucial to have the proper documentation of the transaction. The rules set out in the 1031 IRS guidelines are essential. The “paper trail” (electronic) needs to include contracts, closing statements, valuations and adherence to all procedural rules.
1031 Exchange Benefits of Mineral Rights
- Tax Deferral: The primary benefit is deferring capital gains taxes, which allows for reinvestment of the full sale proceeds into new property.
- Investment Flexibility: You can diversify your investment by exchanging mineral rights as one of your replacement options. When coming out of mineral rights you can exchange for different types of real estate.
Challenges do Exist
- Market Valuation: Determining the current and future valuation of mineral rights may be challenging. There may be market fluctuation in the future value.
- Environmental and Legal Concerns: There may be legal and environmental considerations. Fortunately, there are experts in the field, and we encourage interaction with these experts.
Conclusion
There are a variety of mineral rights that can be extremely valuable to investors. Working with knowledgeable professionals is the first step. The ownership of mineral rights is not for all investors. All real estate ownership includes risk. In part two we will cover and address the potential DST alternatives for mineral rights.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your §1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission).
Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin-Sherwood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
Thank you.
NAMCOA® – Naples Asset Management Company®, LLC
