When a taxpayer enters into a traditional sale of real property the taxpayer may incur capital gains taxes as a result of any gain realized from the sale. Because realized gains have historically been taxed at a high rate taxpayers often look for legal strategies that reduce or eliminate capital gains taxes. One option is to enter into a Section 1031 Exchange instead of a conventional sale. If a transaction qualifies for Section 1031 treatment, capital gains taxes that would ordinarily be levied on the gain realized from the sale are deferred. There are, of course, a number of requirements that must be met for a transaction to qualify for 1031 Exchange treatment, including:
- The property must be held for productive use in a trade or business, or for investment
- The property must be exchanged for “like-kind” property
- The entire exchange must be completed within 180 days
- A Qualified Intermediary, or QI, must be used to facilitate the exchange
Some transactions on their face clearly meet the requirements for Section 1031 deferral; however, other transactions have been the subject of much debate and litigation over the years. One area of litigation involves mineral interests in land.
Mineral Interests
When most people think of the term “real property” they envision land with or without improvements on the land. In reality, however, real property may also include what lies beneath the land in the form of minerals, oil, or gas. In fact, sometimes what lies below the surface of the land is far more valuable than the surface of the land. Understanding this, the law allows for separate and distinct rights to attach to minerals, oil or gas. What happens then if mineral interests are included in a Section 1031 Exchange? Does the presence of minerals (or something else of value under the surface of the land) prevent the exchange from qualifying on the basis that the properties are not “like-kind”?
In Beeler v. Commissioner, 73 T.C.M. 1982 (1997), the Internal Revenue Service Tax Court attempted to provide some clarification on the issue of mineral interests as they apply to a Section 1031 Exchange. In that case, Petitioners owned a significant number of acres of land in Florida that was originally purchased with the intention of expanding an existing mobile home park owned by Petitioners. The land, however, held significant sand reserves on it which Petitioners decided to exploit. Petitioners went through the lengthy and cumbersome process of obtaining all the necessary permits to sell sand from the acreage and proceeded to harvest and sell sand for a number of years. Eventually, Petitioners negotiated an exchange of the property and claimed a deferral of gain based on Section 1031. The other party involved in the transaction had no intention of selling what sand remained on the property. On the contrary, the “buyer” planned to use the land as a construction and demolition debris dump. As such, the remaining sand on the property was actually a hindrance to the buyer’s plans and was given away after the transaction was finalized. The I.R.S. disallowed the Petitioner’s claim for deferral based on the argument that in addition to real property the Petitioner exchanged business operating permits, goodwill, going-concern value, and property held for sale (i.e., sand), all of which do not qualify under Section 1031. The T.C. disagreed.
The T.C. concluded that no permits were exchanged based, in large part, on the fact that the Petitioner did not have the legal ability to transfer permits. The T.C. also found that no goodwill or going-concern value was transferred based on the record which indicated that no customer lists, management systems, or records of any type were transferred to buyers. Finally, the T.C. considered whether or not the sand located on the property was stock in trade or other property held primarily for sale. If the sand was a separate asset then it did not qualify for Section 1031 treatment as it was not “like-kind” property. In its analysis, the court stated:
“Here, sand was not separated from and was part of the land when petitioners exchanged it. The parties to the transaction did not list sand as property petitioners exchanged. Petitioners received no consideration from the buyers for unmined sand… the sand in question had not been mined or otherwise separated from the realty. In addition, we have found that the parties to the sale did not intend to sell and buy sand as part of the transaction.”
In concluding that Petitioner conveyed only land and no other assets, therefore qualifying the entire transaction for Section 1031 treatment, the court placed significant importance on the fact that the sand was not separated from the land in question and that Petitioner did not receive consideration for the sand itself in the transaction.
Own timberland and want to learn more about how 1031 exchanges apply to forest land owners. Click the button below to receive a PDF file.
