Keeping Uncle Sam Out of The Oil Patch
By Greg Lehrmann, Attorney
It is common knowledge that
mineral interests are changing
hands at a feverish pace. What is
lesser known is that Uncle Sam
does not always have to be a partner
in these transactions. Both
the seller and the buyer benefit
when capital-gains taxes do not
have to be subtracted from the
sales price.
The general rule is that when
people sell something for more than
they paid for it, they have to pay
income tax. Even for long-term capital
gains, this taxation can remove
15 percent or more from the profits
that otherwise would pass from the
buyer to the seller. This impact can
hinder and even halt negotiations.
At a minimum, taxation detracts
from the value of any offer. For people
who have owned their property
for decades, almost the entire sales
price can be taxable. Sellers get to
keep more wealth, and buyers can consummate
more deals more quickly if
they are knowledgeable about Section
1031 of the Internal Revenue Code.
Section 1031 states that no gain or
loss shall be recognized (taxed) if property
held for productive use in a trade or
business or held for investment is
exchanged solely for property of a likekind
to be held either for productive
use in a trade or business or for investment.
The tax is deferred at least until
events occur that the seller is usually
in control of, and often the tax is
eventually eliminated altogether.
Two basic points are key
to understanding the availability
of this tool:
1. “Exchange” does not
mean that the seller
and the buyer exchange
anything.
2. “Like-kind” does not
mean that the seller of
a mineral interest has
to buy another mineral
interest.
Exchange
Exchange means that the
seller hires a 1031 qualified
intermediary (QI) to produce
exchange documents at the
closing of the sale. The sale is
taxable if proper procedures
are not followed at closing.
The QI holds the proceeds
from the sale. The seller identifies property
to purchase within 45 days following
the sale and closes on the purchase(s)
within 180 days of the sale. A gap in the
law is the lack of regulation of QIs by
either the federal government or the
state of Texas, despite the QIs’ holding
millions of dollars of sellers’ funds.
Corporate America and prudent individuals
alleviate this risk by using national
QI companies that are owned by heavily
regulated major title companies.
In other words, an “exchange” does
not involve a swap between the seller
and buyer. Rather, exchanges are like
retirement account rollovers, where
funds are moved somewhat directly from one investment to another, with
no actual or constructive receipt by
the seller of the funds.
Like-Kind
Just as misleading as the term
exchange is the term like-kind. Many
people think a sale of a mineral interest
must be followed by the purchase of
another mineral interest. Not true. All
real estate in the United States is considered
to be like-kind to any other real
estate in the country, as long as each
property qualifies for the proper use.
The only requirement to meet the
“qualifying use” standard is that the
property is held for use in a trade or
business or for investment. Holding
property for appreciation constitutes
“held for investment.” Thus, mineral
interests that have been held for investment
(not purchased for imminent sale
after they were acquired) can be sold,
and the proceeds can be used to purchase
a ranch, residential rental properties,
commercial buildings, resort investment
property and so on. The following are
examples of valid exchanges:
• Mineral interests for an investment
resort property
• Interest in a producing oil lease
extending until the exhaustion of
the deposit for a ranch
• Overriding royalty for unimproved
real estate
• Overriding royalty for an undivided
interest in a parcel of improved
realty
• Perpetual water rights for a fee
interest in land
All of these examples can be interchanged,
and the properties can be in
different states. Interests that may not
qualify are those limited in duration.
When operating interests are exchanged,
the well equipment must be analyzed
separately from the exchange of leasehold
interests.
Property owners can have their cake
and eat it too if they check into §1031
exchanges. Check with your tax adviser
to see if you qualify.