Each year taxpayers spend billions of their hard-earned dollars on federal taxes. One way to defer taxes is to engage in a like-kind exchange under Section 1031 of the Internal Revenue Code. These exchanges allow taxpayers to defer taxation and have more of those dollars to spend today.

A like-kind exchange (commonly referred to as a Section 1031 exchange) is particularly beneficial for oil, gas or other mineral properties. As long as investors properly plan ahead to satisfy the requirements of a like-kind-exchange transaction, managing an exchange is not difficult. Here's how investors can determine whether to enter into a like-kind exchange, the necessary steps, and potential tax traps to avoid.

Generally, when you sell, exchange or otherwise dispose of property, you pay tax on any gain resulting from the transfer. The like-kind exchange is an exception to this general rule. It allows you to exchange property held for productive use in a trade or business or held for investment purposes for other business or investment property without paying federal income tax on that property.

The unreported gain is not recognized for federal income tax purposes and is not subject to tax until the property received in the exchange is ultimately disposed of in a taxable transaction. Through a properly structured like-kind exchange, the payment of tax can be deferred for many years, and potentially forever.

How to qualify

To qualify for tax deferral, the transaction must strictly comply with the statutory like-kind-exchange requirements. The Section 1031 exchange rules first require that both the property transferred and the property received are held for productive use in a trade or business or held for investment purposes. The exchange cannot involve property you hold or intend to acquire for personal use.

Second, the exchange must involve a reciprocal transfer of property rather than an exchange of property solely for money. This does not require two parties to simultaneously trade properties. Most often, a like-kind exchange is structured as a non-simultaneous or deferred exchange. As a deferred exchange, the seller transfers his or her property (commonly referred to as "relinquished property") to a buyer and acquires new property (commonly referred to as "replacement property") from a different party at a later date.

To qualify as a Section 1031 exchange, the seller, however, may not actually or constructively receive the proceeds from the sale of the relinquished property. Thus, a qualified intermediary generally holds the proceeds in escrow pending completion of the like-kind exchange. The seller must also identify the replacement property that he or she wishes to acquire within 45 days after transferring the original property, and close on the sale of such property within 180 days after transfer. If these deadlines are not met, the seller is subject to tax on any gain recognized.

Another qualification: the property exchanged must also be of like kind or of a similar character or nature to the property acquired. The statute is quite generous in this regard and generally allows real property to be exchanged for any other real property. Therefore, sellers of interests in oil, gas or other mineral property can easily satisfy this requirement, even if they do not exchange a mineral interest for another mineral interest and even if the properties are located in different states.

Mineral interests can be exchanged for remarkably diverse properties as long as both the mineral interests and the replacement property constitute real property under state law. Moreover, an interest in oil, gas and other minerals, in, on and under, and that may be produced from certain land, constitutes an interest in real property for federal income tax purposes, regardless of the treatment of such interest under state law.

As a result, a working interest qualifies as like-kind to other real property, such as an undivided interest in undeveloped real property, a hotel or an improved ranch, as long as the working interest remains in effect until the exhaustion of the mineral deposit. The same is also true of overriding royalty interests, which may be exchanged for other real property, such as a fee interest in real property or an operating interest.

Even if the seller receives money or other property that is not like kind to the property transferred by the seller, the entire transaction is not disqualified from like-kind-exchange treatment. Instead, the seller recognizes gain to the extent that the money or other disqualified property received does not exceed his or her realized gain on the sale.

Tax Benefits

Structuring the disposition of an interest in mineral property as a like-kind exchange is substantially beneficial from a tax perspective. Through the exchange, the seller of mineral interests defers paying federal income tax on the transaction.

This tax deferral is essentially an interest-free loan from the federal government to the seller to finance the acquisition of new property, with payments not due and payable until the seller disposes of the newly acquired property in a transaction that requires gain recognition. Although a like-kind exchange does not avoid taxes, the time value of money makes a tax deferral a valuable tool for investors.

Disadvantages

Despite substantial tax benefits, these transactions are not without disadvantages. For instance, the rules preclude the seller from receiving or using the sales proceeds before the taxpayer actually receives the like-kind replacement property. Many times this means the seller is unable to access the sales proceeds for at least 180 days from the date the relinquished property is sold or until the date the replacement property is acquired by the qualified intermediary on behalf of the seller. Any cash removed by the seller is taxable to the seller in the year of the sale.

Even though using a qualified intermediary to structure a like-kind-exchange transaction is common practice and provides the seller with additional time to locate and acquire adequate replacement property, it also exposes the investor to counterparty risk. Neither the state nor federal government regulates these qualified intermediaries, which are entrusted with the funds of many investors. Should the qualified intermediary enter bankruptcy, the seller may be unable to obtain his or her funds and complete the exchange. Selecting a reputable company as a qualified intermediary and undertaking proper due diligence to ensure the qualified intermediary has sufficient financial backing and security procedures in place to protect your funds substantially mitigates these risks.

Potential Pitfalls

Structuring a like-kind exchange presents many traps for the uninformed investor. Investors should be mindful of these potential pitfalls, because failing to meticulously follow the Section 1031 exchange rules disqualifies the entire transaction from the substantial benefits of tax deferral.

For example, a transaction may be disqualified as a like-kind exchange if the transfer of property constitutes a mere lease instead of a sale of the property. Many times a seller unintentionally loses the benefit of tax deferral when he or she disposes of a mineral estate but retains any royalty interest or oil payment in that estate. Regardless of how the transaction is classified under state law, a seller who retains an economic interest in mineral rights is not treated as making a sale of those rights for federal income tax purposes. The transfer constitutes a lease of the mineral estate and cannot qualify for tax deferral.

Sellers should also remember that despite the broad definition of like-kind real estate, which allows oil, gas and other mineral interests to be exchanged for most other real property, this rule is not without its exceptions. For instance, production payments and other interests that are limited in duration are not treated as like kind to other real property, despite their characterization as real property under state law. Consequently, the disposition of a right to an oil payment in exchange for an overriding oil and gas royalty interest, a working interest, a fee interest in real estate or an interest in other real property cannot benefit from Section 1031 exchange treatment.

An exchange of an interest in mineral properties also poses potential problems for the seller if the interest is deemed to constitute an interest in a partnership instead of an outright ownership of the mineral properties. Partnership interests are specifically excluded from qualifying for like-kind-exchange treatment. Many times where two or more people own fractional interests in the same working interests, their shared ownership may be treated as a partnership for federal income tax purposes, even if such entity is not identified as such under state law.

Therefore, before engaging in a like-kind-exchange transaction, it is essential to examine the underlying documents creating the oil and gas investment and to make an election, if necessary, to treat the partnership interest as an interest in each of the assets of the partnership. If the election is made in a timely fashion, the interest may qualify for like-kind-exchange treatment.

Sellers should also pay particular attention to whether the working interests or other property they wish to sell are subject to liabilities, such as accrued operating expenses or unpaid drilling costs, because unintended tax liabilities and other complications often arise in the absence of proper planning. Similarly, when well equipment is included as part of an exchange, the well equipment may be viewed, in certain circumstances, as an exchange of equipment or personal property, rather than real property. This characterization may result in taxable gain if the exchange involves royalty interests or other interests in real property.

Additional issues arise if multiple interests are relinquished or acquired as part of the exchange. The timing deadlines discussed above depend on when the relinquished property in the exchange is sold. Because the transfer of multiple properties, often with different closing dates, may be considered part of the same exchange, it may be beneficial in certain circumstances to structure the exchange of multiple properties in a manner that treats each property disposition as a separate exchange.

Similarly, when multiple interests in mineral (or other) properties are identified as replacement properties, the seller will be subject to certain statutory constraints placed upon the identification of multiple replacement properties. Issues often arise when the seller wishes to acquire multiple interests in mineral properties located on separate, noncontiguous legal parcels that are sold by multiple sellers, and additional planning may be necessary to address such issues.

Even if all the Section 1031 rules are strictly followed, the transaction may nevertheless result in income recognition to the seller because of the recapture tax. Specifically, when interests in oil, gas, geothermal and other mineral properties are disposed of, certain intangible drilling and development costs, exploration and other development expenditures that were previously taken as deductions may be treated as ordinary income to the extent of any realized gain (property subject to these types of deductions is generally referred to as "Section 1254 property").

However, this tax may be avoided if the mineral interests given up are replaced with sufficient Section 1254 properties. Thus, when entering into a like-kind-exchange transaction, it is important to analyze not only the like-kind nature of the properties being transferred, but also the portion of such property that constitutes Section 1254 property.

Section 1031 real estate transactions provide a tax-efficient method of disposing of mineral interests and other real property. Taxpayers contemplating a sale of oil, gas or other mineral property should consider a like-kind exchange. With minimal planning, they can avoid costly pitfalls and successfully defer paying taxes on the sale of their interests. M

Orly Sulami is an associate and Matthew Schindel is a partner in the business planning and tax section of Haynes and Boone LLP. Sulami is also a certified public accountant. They have extensive experience in like-kind-exchange transactions involving mineral interests and other types of property.

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