Using Mineral Rights in a §1031 Exchange- Part 1

What may come as a sur­prise to many real estate investors is the abil­i­ty to use what is below the ground as a replace­ment in a Sec­tion 1031 tax deferred exchange.

May 15, 2024

By Al DiNi­co­la, AIF®, CEPA™
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC Mem­ber of FINRA/SIPC

Real estate own­er­ship typ­i­cal­ly is viewed as the land and what has been con­strict­ed on the land. In cer­tain parts of the coun­try there are air rights or above the build­ings. There is also what is from the earth’s sur­face to a hypo­thet­i­cal place towards the cen­ter of the earth.

We have received sev­er­al requests from poten­tial investors who want infor­ma­tion on §1031 exchange into a poten­tial Delaware Statu­to­ry Trust (DST) min­er­al roy­al­ty pro­gram. We recent­ly par­tic­i­pat­ed in a min­er­al rights due dili­gence sym­po­sium and want­ed to pro­vide some edu­ca­tion­al back­ground on the top­ic of min­er­al rights. 

Some of the country’s wealth­i­est fam­i­lies have been using min­er­al rights to devel­op a tax deferred exchange strat­e­gy since the min­er­al rights qual­i­fy as a like kind exchange.

By rein­vest­ing the prof­its (via §1031 exchange) from the sale of real estate and iden­ti­fy­ing and acquir­ing min­er­al rights as the replace­ment asset is a dif­fer­ent and accept­able way to defer cap­i­tal gains.  How­ev­er, there is a need to have a basic under­stand­ing of the process.

Sec­tion 1031 Tax Deferred Exchange

Sec­tion 1031 of the Inter­nal Rev­enue Code (aka 1031) enables investors when sell­ing appre­ci­at­ed real estate to defer pay­ing cap­i­tal gains tax­es when the real estate is sold.  There are a set of rules estab­lished by the IRC regard­ing replace­ment val­ue, uti­liz­ing all the cash, replac­ing any loans paid off.  There are also those dates hav­ing over investors’ heads on iden­ti­fy­ing the replace­ment prop­er­ties as well as clos­ing on the replace­ment prop­er­ties.

Min­er­al Rights Qual­i­fy as Replace­ment Prop­er­ty

Real prop­er­ty is con­sid­ered sur­face, air and below the ground. Min­er­al rights are con­sid­ered real prop­er­ty, and thus, they qual­i­fy for a §1031 exchange.  Many peo­ple con­sid­er real prop­er­ty to only be com­mer­cials prop­er­ty, rental prop­er­ties or vacant land.  How­ev­er, min­er­al rights are con­sid­ered real prop­er­ty.

Exchang­ing into and out of Min­er­al Rights

Exchang­ing into Min­er­al Rights

1. The first step may be the sale of the prop­er­ty: If you have any prop­er­ty that is held for invest­ment prop­er­ty includ­ing com­mer­cial, res­i­den­tial real estate or even vacant land, offer­ing the prop­er­ty for sale would be the first step. Sell­ing the prop­er­ty would come next.
2. A Qual­i­fied Inter­me­di­ary (QI) will be required: You must have an arrange­ment to use the ser­vices of a QI.  This is required by the IRS. The QI will hold the pro­ceeds from the sale and han­dle the nec­es­sary trans­fer of funds to acquire the min­er­al rights which is con­sid­ered the replace­ment prop­er­ty.
3. The Replace­ment Prop­er­ty (Min­er­al Rights) must be iden­ti­fied.  You have 45 days from the clos­ing of the relin­quished prop­er­ty to iden­ti­fy poten­tial replace­ment prop­er­ties. The QI will require this in writ­ing and typ­i­cal­ly the QI has a form to be signed by you. The prop­er­ty must come with a legal descrip­tion or address.  A min­er­al right may also have a longer metes and bounds descrip­tion. You can iden­ti­fy up to three prop­er­ties regard­less of their val­ue, or more under cer­tain con­di­tions (200% rule or 95% rule).
4. Min­er­al Rights are acquired. With­in a total of 180 days from the clos­ing of the relin­quished prop­er­ty you must close on the pur­chase of the min­er­al rights. The min­er­al rights must be of equal or greater val­ue to the prop­er­ty sold to defer all cap­i­tal gains tax­es.

Exchang­ing out of Min­er­al rights

1. Min­er­al Rights may be offered for sale. One of the first deter­mi­na­tions would be to prop­er­ly iden­ti­fy the min­er­al rights.  Hav­ing the min­er­al rights eval­u­at­ed (or val­ued) and appraised is crit­i­cal.
2. Qual­i­fied Inter­me­di­ary (QI) is need­ed. A QI arrange­ment is need­ed to com­plete the exchange process.  Just as in the pre­vi­ous exam­ple there is a need to ensued com­pli­ance with all the §1031 exchange reg­u­la­tions.
3. Sale of Min­er­al Rights: The pro­ceeds from the sale of the min­er­al rights are held by the QI.
4. Iden­ti­fy Replace­ment Prop­er­ty: All of the same rules regard­ing iden­ti­fy­ing replace­ment prop­er­ties apply. Like kind prop­er­ties may include oth­er min­er­al rights, com­mer­cial prop­er­ty, rental prop­er­ty and vacant land.
5. Acquire Replace­ment Prop­er­ty: The clos­ing on the replace­ment prop­er­ty must occur with­in 180 days from the sale of the orig­i­nal min­er­al rights.

Con­sid­er­a­tions for Com­pli­ance

• Like-Kind Require­ment: For exchang­ing “into” min­er­al rights any res­i­den­tial income or com­mer­cial prop­er­ty (includ­ing land) is con­sid­ered like kind.  For exchang­ing “out of” min­er­al rights suit­able replace­ments can include oth­er min­er­al rights, res­i­den­tial, or com­mer­cial real estate.
• IRS requires Strict Time­line Adher­ence: The adher­ence to the strict 45-day iden­ti­fi­ca­tion peri­od and the 180-day acqui­si­tion peri­od is what many investors may find dif­fi­cult. This is espe­cial­ly true if the investor is not pre­pared.  Miss­ing these dead­lines can dis­qual­i­fy the exchange.
• Qual­i­fied Inter­me­di­ary Required: There is no exchange with­out the ser­vices of a QI. The QI can­not be some­one who has act­ed as your agent in the past two years, such as your attor­ney or accoun­tant.
• Every­thing needs Doc­u­men­ta­tion.  It is cru­cial to have the prop­er doc­u­men­ta­tion of the trans­ac­tion. The rules set out in the 1031 IRS guide­lines are essen­tial. The “paper trail” (elec­tron­ic) needs to include con­tracts, clos­ing state­ments, val­u­a­tions and adher­ence to all pro­ce­dur­al rules.

1031 Exchange Ben­e­fits of Min­er­al Rights

• Tax Defer­ral: The pri­ma­ry ben­e­fit is defer­ring cap­i­tal gains tax­es, which allows for rein­vest­ment of the full sale pro­ceeds into new prop­er­ty.
• Invest­ment Flex­i­bil­i­ty: You can diver­si­fy your invest­ment by exchang­ing min­er­al rights as one of your replace­ment options.  When com­ing out of min­er­al rights you can exchange for dif­fer­ent types of real estate.

Chal­lenges do Exist

• Mar­ket Val­u­a­tion: Deter­min­ing the cur­rent and future val­u­a­tion of min­er­al rights may be chal­leng­ing. There may be mar­ket fluc­tu­a­tion in the future val­ue.
• Envi­ron­men­tal and Legal Con­cerns: There may be legal and envi­ron­men­tal con­sid­er­a­tions. For­tu­nate­ly, there are experts in the field, and we encour­age inter­ac­tion with these experts.

Con­clu­sion

There are a vari­ety of min­er­al rights that can be extreme­ly valu­able to investors. Work­ing with knowl­edge­able pro­fes­sion­als is the first step.  The own­er­ship of min­er­al rights is not for all investors.  All real estate own­er­ship includes risk. In part two we will cov­er and address the poten­tial DST alter­na­tives for min­er­al rights.

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your §1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion).

Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin-Sher­wood Rd, Suite 200 Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.

NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC