Every 1031 exchange is unique. During these unprecedented times, we have already experienced the full spectrum of reactions from those involved in the buying and selling of real property. Some Exchangors have gotten much more aggressive in finding deals that suit their long-term strategy while others have determined that a conservative approach is more suited for them.
One thing is certain, finding and vetting replacement property is different than it has ever been. In many cases, Realtors and Sellers have been forced to be creative in areas where Shelter in Place orders are still firm. Though many Exchangors are still successfully finding replacement property in the residential and commercial sectors and completing their exchanges, other Exchangors have asked for alternatives that they may be less familiar with that potentially offer a quick closing period.
Delaware Statutory Trusts & Tenant-In-Common Properties
Taxpayers who are seeking to exit active management of their properties often consider the possibility of entering into a Section 1031 Exchange through Tenant-In-Common (TIC) or Delaware Statutory Trust (DST) opportunities. If the transaction qualifies, any capital gains taxes that would otherwise be due can be deferred until the sale of the replacement property. Among other requirements, a 1031 Exchange eligibility requires the seller to exchange the property for a property of “like-kind.” Many savvy investors are utilizing fractional ownership of TICs or DSTs to diversify, round out the remainder of unused exchange proceeds or shift to a more passive approach to their real property holdings.
Tenants-in-Common 1031 exchanges allow property owners to defer capital gains when replacing a fractional interest in cash flowing properties. It is a form of direct ownership that is not affected by the IRC §1031(a)(2)(D) exclusion as long as the co-tenants or owners are not treated as partners for income tax purposes. Tenant In Common Interests are one way that an investor can take part in the ownership of a property that they would potentially not be able to afford on their own, such as a portion of a commercial strip mall or building leased to Walgreens. It is important to note that most TIC and DST investments require an “Accredited” Investor status, meaning that your net worth exceeds $1,000,000 (excluding your personal residence) or your income exceeds $200,000 in each of the last two years or, if applying jointly with your spouse, your income must exceed $300,000.
In 2004, the IRS released Rev. Rul. 2004-86, which allowed Delaware Statutory Trusts to acquire real estate where the beneficial interest is treated as direct interests. This allowed for the utilization of Delaware Statutory Trusts (DST) to qualify for 1031 exchange treatment. DSTs differ from TICs as they have no voting authority but also do not require forming a single-member LLC to participate. The number of investors is unlimited and determined by the structure of the DST, whereas a TIC is limited to up to 35 investors.
There are a bevy of options, including special interest DSTs, that focus on health care, government, senior living or retail properties. The key advantage to a TIC or DST interest as replacement property is their passive nature. They are terrific options if you have additional net sales proceeds to invest after identifying other property or if you are seeking a passive investment. Finally, once identified they can very often close quickly in the case that an Exchangor needs a quick replacement property solution.
Oil, Gas, Mineral, Water and Ditch Rights
Interest in oil, gas and mineral estates qualifies for 1031 exchange tax deferrals given the existence of a perpetual interest. Leases, royalties and production payments are often how perpetual interests are conveyed.
For federal tax purposes, mineral leases are considered a real property interest and eligible for 1031 tax-deferred treatment. Leases provide the Le[1] [TG2] Lessee with the right to remove minerals for a specific period of time or until depletion, along with incurring the costs of discovery and removal. Leases are also known as a working or an operating interest. The lessee may deduct the intangible drilling costs (IDCs) for removing the mineral. IDCs include labor, repair and maintenance, fuel, transportation, supplies and other related production expenses.
For federal tax purposes, royalties are considered a real property interest and qualify for 1031 exchange tax deferral treatment. Oil, gas or mineral royalties do not represent an operating interest and neither incur nor are responsible for production costs. Instead, the holder of the royalty receives a percentage interest in the materials removed for the life of the property.
Production payments are not eligible for 1031 exchanges given they are a right to the oil, gas or mineral at a specific value, produced and paid from a percentage of removed minerals. Unlike royalties, production payments are finite based upon a specified production versus royalties that are perpetual, or until the mineral is exhausted.
Often available in much smaller investment increments than found in traditional real estate, oil & gas minerals may allow you to utilize the dollars subject to “boot” while at the same time potentially benefiting your overall portfolio. Oil and gas royalties provide diversification into commodities-based assets and typically create passive monthly income that has historically been a very nice inflation hedge. With the drilling technology that has been developed over the last several years, there is a shale oil and gas boom—and resulting aggressive development occurring in many areas of the United States—that could provide you with appreciation.
Similar to DST and TIC interests, in many cases the Exchangor must be an accredited investor. If you’re interested in Oil, Gas, Mineral, Water and Ditch Rights you can also review our interview with Wolf Hanschen from Peregrine 1031 Energy partners here.
Deferred Sales Trust
Should acquiring replacement real property not be of interest, a Deferred Sales Trust can defer the gain. If the exchange is structured correctly and the Exchangor is not able to locate suitable replacement property candidates by the 45th calendar day, the Deferred Sales Trust can be initiated. To learn more about a Deferred Sales Trust, go to the following link or review the brief blog article on Five Compelling Reasons to Consider a Deferred Sales Trust.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
