Capital gains taxes are imposed on the gain realized from the sale of real property in the United States. A taxpayer who wishes to avoid the payment of capital gains tax may enter into a Section 1031 Exchange instead of a conventional sale if all the exchange requirements are met. A transaction that qualifies for an exchange allows the taxpayer to defer to capital gains tax that would otherwise be due as a result of a sale. For a transaction to potentially be eligible for Section 1031 treatment the property involved must be held for productive use in a trade or business, or for investment. In addition, the property relinquished must be exchanged for “like-kind” property.
Mineral Rights
Many transactions meet the exchange guidelines on their face; however, others are less clear. One type of Section 1031 Exchange that has caused much confusion is a transaction where mineral rights are involved. Whether or not this type of exchange results in non-recognition of gain depends on the facts of the case; however, the Internal Revenue Service, or I.R.S. has provide some guidance through case law and Private Latter Rulings, or PLRs, over the years. Equitable servitudes, for example, were discussed in Peabody Natural Resources Company, et.al. v. Commissioner or Internal Revenue 126 T.C. No. 14 (2006) and were found to qualify for Section 1031 Exchange treatment.
In Peabody, the taxpayer owned an operating gold mine that it exchanged for operating coal mines. The coal mines were under contract to supply coal to two electric utility companies at the time of the transaction. In disallowing the portion of the exchange relating to the supply contracts, the I.R.S. contended that the coal supply contracts were not real property, and therefore, constituted “boot” in the exchange. Ultimately, the U.S. Tax Court, or T.C., disagreed and allowed the contracts in the exchange, effectively allowing the entire exchange to receive non-recognition of gain treatment.
Equitable Servitude
When determining if an asset is real property or personal property the court looks first to the law of the state governing the transaction. In this case, the contracts were governed by the State of New Mexico. Taxpayer successfully argued that the contracts created an equitable servitude and that the equitable servitude is a real property interest in New Mexico. The I.R.S. argued that the contracts did not create a real property interest but created a contract to sell personal property and, therefore, were not eligible for exchange treatment.
As a general rule, minerals in place are considered real property; however, once they have been severed from the land they are considered personal property. The laws of the State of New Mexico treat a contract for the sale of minerals (or coal in this case) as a contract for the sale of goods. In Peabody, however, the contracts created a transferable obligation to sell the coal. Although the owner of the coal mine could sell the mine, a successor was obligated to honor the contract for the sale of the coal. That obligation, under New Mexico law, can be treated as an interest in land if the obligation amounts to an equitable servitude. In New Mexico, an equitable servitude is created when the following requirements are met:
- The covenant must touch and concern the land.
- The original “covenanting” parties must intend that covenant to run with the land.
- Any successor against whom enforcement is sought must have actual, constructive, or inquiry notice of that covenant.
The T.C. found all three elements to exist. Therefore, the court found that the coal supply contracts were an equitable servitude and, therefore, potentially qualified as an interest in real property.
The final issue was whether or not the coal supply contracts were “like-kind” to the gold mine. Just because the contracts were found to have been an interest in real property does not automatically mean they are “like-kind” to another interest in real property. Ultimately, the court held that the contracts were indeed like-kind, making them eligible for non-recognition treatment. In its analysis of the like-kind issues the court found that:
“ Peabody’s right to mine and extract coal from the Lee Ranch mine land and its supply contracts payment rights for the coal cannot be separated from its ownership of the Lee Ranch mine coal reserves. Those rights are part of the bundle of rights incident to Peabody’s ownership of the Lee Ranch mine land coal reserves.”
Essentially, the court found that since the supply contracts were inseparable from the mine itself they were part of the overall interest in real property represented by the coal mine and therefore, were like-kind to the gold mine. Taxpayer was able to claim non-recognition for the entire transaction as a result of the court’s ruling.
To learn “Ten Reasons Why a 1031 Exchange Makes Sense,” click on the button below to download the PDF.
